IN CONVERSATION

Tail hedging can balance risk: PIMCO

Executive vice-president and head of client analytics at PIMCO, Sebastien Page, who is tasked with bringing the intellectual and analytical capital of the manager to clients in a new consultant-type role, says tail-risk hedging is an effective way to reduce volatility and enhance returns.In what it has coined as a new balanced approach to risk, PIMCO distinguishes itself in a number of ways from the traditional approach to asset allocation.

Where the traditional approach uses data and models, asset bucket diversification and static asset allocation, PIMCO focuses on macro-economic factors, risk factor diversification, and dynamic asset allocation.

“We don’t model risk as volatility, as a number, we look at it as exposures to large losses. We focus on tail risk and in that way tail-risk hedging is embedded in our approach.”

In a paper written in September last year with his colleague Mark Taborsky, head of asset allocation, “The Myth of Diversification: Risk Factors v Asset Classes”, Page outlines the case for a risk factor approach to asset allocation.

“Our results show that on average, correlations across risk factors are lower than correlations across asset classes, and risk factor correlations tend to be more robust to regime shifts than asset class correlations. Therefore, a risk-factor approach to portfolio construction provides a robust platform for investors to express cyclical and secular macro economic views and adapt to regime shifts. Moreover, to view the world in risk-factor space may also help investors better understand tail risk and find opportunities for cheap proxy hedging.”

Page came to PIMCO, from a distinguished career at State Street Associates in Boston as head of the newly formed client analytics group in May last year.

His group, which after three recent hires numbers seven, develops models and research related to client problems and solutions including asset allocation, risk-factor budgeting, and dynamic strategies.

The analytics group sits within the portfolio management group and Page says it has a mandate to leverage the technology, intellectual capital and market views that PIMCO develops for asset management and deploy them in solutions.

“We will load a client’s asset allocation into the PIMCO systems and develop new models and research,” he says.

The Myth of Diversification, which is one of three papers that Page has written since joining PIMCO, highlights how embedded equity risk is within institutional investors’ portfolios.

“The equity risk factor is a lot more volatile than the other risk factors, so it will explain more risk. This doesn’t mean de-risk linearly and put everything in bonds, think of risk in a non-linear way, diversifying risk premiums.”

“There are other return drivers than equity and we have high expectations for emerging market debt, absolute return and forex and high interest rate currencies,” he says. “But it is not that simple to de-risk: to harvest the risk premium you need to understand tail risk. Tail-risk hedging, changes the way clients think of asset allocation.”

He says if investors recognise the possibility that extreme unanticipated unpredictable events will occur, then instead of building a portfolio to try and time those events, they can build a portfolio to hedge against it.

“You have built your airplane, you don’t know when you’ll hit turbulence but at least know you won’t crash when you hit it,” he says.

He says PIMCO’s active management portfolio managers are constantly looking at the best way to get the hedge, looking at equity puts, credit defaults, swaps, and currencies.

“When markets do badly, tail risk does well. This is monetising, and providing liquidity when others don’t.”

The new analytics group is a business diversifier for the PIMCO business, which in the past year has also ventured into equities for the first time.

“At PIMCO every business is designed on alpha generation: now it is about client engagement,” Page says, adding PIMCO plans to launch more equity products as well as possessing an overarching aim to be a global trusted investment adviser.

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