Dynamic hedge - a way of shock-proofing your portfolio

According to DIAM’s General Manager of its International Marketing Development Group, Keiichiro Okuda, the significant theme of the last three months has been the interest shown by pension fund investors in the company’s ‘dynamic hedging’ strategies.

DIAM has applied the strategies to help its clients manage investment risk. The strategy, based on a model co-developed with Mizuho-DL Financial Technology, is designed to apply to different asset classes (such as currency, equity, fixed income) as long as their futures or forwards have sufficient liquidity. It hedges downside risk while maintaining upside potential (similar to an option) but tends to be less costly compared to options in various markets.

Mizuho-DL FT belongs to the same two financial groups as DIAM - a joint venture owned 60% by Mizuho Corporate Bank, 30% by The Dai-ichi Mutual Life Insurance Company and 10% by Sompo Japan Insurance Inc.

Clients in Japan, Okuda says have adopted one of three strategies to deal with their portfolio shortfall. “They have either diversified, hedged or sold off. Diversification is the strategy that many of them have chosen; domestic equity, international equity, fixed income and increasingly, alternatives.”

However, in the light of the post-Lehman turmoil, and the historical evidence of the good falling with the bad, Okuda observes: “The asset management industry, along with their clients, ise finally realising that correlations are higher in bear markets. So you can’t only rely on diversification as a protection for the downside.”

DIAM is one of the few Japanese asset managers offering this type of program currently. Okuda says institutional clients who have taken it up have used it within a Japanese / global equity strategy, for Japanese fixed income or for forex hedging, which is well accepted by clients now. It has also been used to access commodity exposure while controlling the risk:. “We can develop various models according to the needs of the client,” he notes.

“Japanese pension fund managers recognise the upside potential for markets, but they remain concerned about the downside, so that’s the basis of the dynamic hedge approach.
The use of put options is a tried and tested method of hedging downside risk while maintaining potential upside. The dynamic hedging approach achieves the same objective but is less costly than the option strategy. It also provides flexibility in terms of payoff selection, floor level amendment and the choice of underlying portfolio to be hedged. Okuda says, “Customers who wish to acquire or increase their exposure to a certain asset class, but cannot tolerate all the downside risk, use call type products; for example, financial institutions wanting foreign equity or commodity exposure. Customers who already hold a certain asset class, but who want to limit its downside risk use put-type products to hedge their risk. For example, pension funds have increasingly been using put-type equity and currency products, backed by the recent change in accounting standards and pension regulation, requiring plan sponsors to mark to market their pension deficit. 

“Customers who are not too aggressive, believing that the market might not rise significantly, and are willing to abandon market appreciation beyond a certain level, are users of Seagull-type products. Some pension funds prefer this type to put type.

“Stop-loss is inherent in dynamic hedging, so there is no need to have another stop-loss setting. However, while regular stop-loss can be thought of as “hard landing”, since it doesn’t reduce exposure until it reaches the stop-loss level, dynamic hedging can be thought of as “soft landing”, dramatically reducing the probability to go all the way to a given stop-loss level compared to regular stop-loss rule.”

For pension funds, the three major sources of risk are typically: domestic equity, foreign equity and currency. Accordingly, the three most widely used products by pension funds are put-type dynamic hedging of these three asset classes. Okuda observes: “These are becoming increasingly popular given the recent change in accounting standards and pension regulation.

“For financial institutions and hedge funds, call type products such as domestic equity, foreign equity and commodity are widely used since, if the manager is bullish about these asset classes, call type products allows them to maximise exposure within the same risk capital, or downside risk budget. Also, foreign bond funds, with currency hedged by put-type dynamic hedging, are popular among relatively conservative financial institutions.”

The main parameters for determining the risk asset exposure are the level of surplus (i.e. - the value of assets above the floor value), volatility and investment duration. The more surplus there is, the higher the risk exposure and vice versa; the higher the volatility of risk assets, the lower the exposure; the longer the duration, the lower the exposure.

Okuda says, “We monitor the hedging error on a daily basis, and adjust the hedging ratio accordingly. Whenever the hedging error is negative, we become more conservative in order to keep the targeted floor level.”

DIAM has been collaborating with Mizuho-DL FT to develop proprietary techniques to strictly control downside risk, adjusting for hedging error, fat-tail distribution and stochastic volatility, with discrete time trading rules to minimize trading costs. Okuda explains, “In order to forecast the volatility level to be realized by the market movement, we weight historical data in an exponential way, the more recent data receiving more weight.”

“With an ordinary dynamic hedging, the fund typically would not follow the market appreciation after using up all its surplus in a sharp market decline. We use a surplus controlling algorithm in order to dramatically reduce these probabilities, seeking to maintain market participation to a certain extent, even after a sharp market decline.”