Hedging Against a Dynamic Market

Over the last month, we’ve outlined the growth vs. value rotation and the broader macroeconomic landscape that have sent shockwaves through equity markets early in 2022.

Last week, we moved the spotlight to help our community identify securities where growth and value can coexist. This week, we’ll continue down this path of action to demonstrate how managers can hedge to protect against the current market conditions.

A Representative Portfolio

We can best illustrate this week’s use case using a fundamental US all-sector long-short strategy built from selecting the most crowded long and short names in the US universe as defined by Wolfe Research.

When we analyze the portfolio’s risks below, we see the risk contribution from style factors has increased significantly over the past couple of months - particularly the contribution from the Growth factor in the Axioma US4 Medium Horizon (“AXUS”) risk model. In particular, from a macroeconomic point-of-view, the portfolio has become increasingly inversely exposed to USD 10Y Real Rates and FED Rate Expectations.

Demo US Market-Neutral Strategy - Style Contribution to Risk

Demo US Market-Neutral Strategy - Financial Conditions Sensitivities

The fundamental manager looking to minimize these risks would view these trends as increasing interference from systematic factors from which they are not looking to drive returns. Therefore, to amplify the impact of true stock-picking and reduce unwanted risks, we’ll explore approaches for creating and evaluating hedges through the Omega Point platform.

A hedge allows for the targeted mitigation of factor exposures that could stem from geographic, fundamental, industrial, macroeconomic, or thematic concentrations in a portfolio. A diversified basket of assets not only makes for a faster and more efficient solution than single stocks, but it also helps to avoid new idiosyncratic risks that fall outside the realm of the manager’s convictions. A few standard courses of action include:

1. ETFs
2. Tradeable Indices
3. Custom Baskets

This week, we’ll focus primarily on tradeable indices and custom baskets to highlight a more tailored approach to hedging than single stocks or ETFs would provide.

BALANCING THE GROWTH/VALUE SCALE

As we saw above, Growth has recently become our portfolio’s most significant style contributor to risk due to overexposure to the factor. Given the potential continuing of the Growth/Value rotation we’ve been in since November, let’s see what we can do to pull that exposure closer to neutral and increase potential alpha. To attack the Growth bet in our portfolio, we’ll use JPMorgan’s curated Top Growth and Bottom Growth tradeable indices on a long and short basis, using the Omega Point Simulator.

Pre and Post-Trade - JPMorgan Top Growth and Bottom Growth Tradeable Indices

Comparing the original and rebalanced versions of the portfolio above, we’ve created a material impact on the tradeoff between factor and specific risk, moving specific risk contribution from 34% to over 40%. Most importantly, we severely reduced our exposure to the Growth factor. Growth’s exposure was trimmed by 60% from 0.27 to 0.11.

LEANING INTO RATES

Shifting the focus to the macroeconomic risks we noted above, the large underexposure to rates and FED action might cause concern. Given the FED’s current posture in combatting inflation, our portfolio as a whole is likely to experience headwinds as rate hikes take form. To counteract the downside risk, we’ll leverage a US 10Y Yield tradeable basket from Quant Insight, again on both a long and short basis, using the Omega Point Simulator.

Pre and Post-Trade - Quant Insight US 10Y Yield Long and Short Baskets

From a fundamental model perspective, we have succeeded in reducing the systematic risk in the portfolio from a 66% factor contribution down to 57%. In addition, the sensitivities to key, relevant macroeconomic factors have also been largely hedged, particularly the sensitivity stemming from USD 10Y Real Rates, which was cut almost in half from -0.25 to -0.15.

A TAILORED APPROACH

In addition to targeting specific factors and themes, some managers look for a comprehensive portfolio factor hedge. Using Omega Point’s Smart Portfolio functionality, let’s supplement the hedges we’ve simulated thus far with a custom basket curated by a factor-aware optimizer.

To start, we feed in our existing portfolio with our Growth and Macro hedges and select the objective inputs to guide the basket’s construction.

‍Note: We’ve scaled down the sizes of the previous baskets to maintain a consistent overall hedge of 10% long and 10% short, when combined.

Next, we define a trade universe from which the optimizer can select its constituents. Users can utilize existing trade lists or leverage Omega Point’s Security Search criteria to limit qualitative and quantitative metrics to ensure both fit and feasibility.

Once we have defined our inputs, we can add constraints to help accommodate liquidity, concentration, the total number of positions, and factor exposure limitation targets.

IMPROVING OUR OUTLOOK

The resulting hedge, compared alongside our initial portfolio, shows effective results. We’ve taken a portfolio that was previously almost two-thirds factor-driven to a portfolio driven primarily by idiosyncratic risk. The hedge will help us realize more performance through alpha instead of swaying in the winds of common factor risks.

Pre and Post-Hedge - Risk Decomposition

We accomplished this by targeting exposures to fundamental style and industry factors and critical macroeconomic factors revolving around interest rates and the FED. Sizing these factor-tilts down dampens the volatility the portfolio will inherit from the broader market.

Pre and Post-Hedge - Style Exposures - Axioma US 4 MH

Pre and Post-Hedge - Financial Conditions Exposures - Quant Insight

Using a quick analysis, we’ve identified, simulated, tested, and created a successful hedge against factor risks in our portfolio. Rather than choosing between efficiency and effectiveness, managers can implement strategies that allow their alpha-generating ideas to flourish without sacrificing time or return. Omega Point’s platform provides the flexibility to identify and execute those unique strategies easily.

If you are interested in exploring factor hedges to navigate the current market better, please don’t hesitate to reach out.

‍US & Global Market Summary

US Market: 02/07/22 - 02/11/22

• All three major stock indexes ended fell for the week, with S&P 500 and Nasdaq Composite losing 1.8% and 2.2%, respectively, and the Dow ended down at 1%.
• Stocks plummeted on Friday as investors fretted about deepening tensions between Russia and Ukraine.
• Data released on Thursday showed that consumer prices surged 7.5% in January, the biggest annual increase in 40 years. Investor sentiment was further rattled following St. Louis Federal Reserve President James Bullard statement about aggressive rate hikes.
• Oil prices ended at seven-year highs as escalating fears of an invasion of Ukraine by Russia, a top energy producer, added to concerns over tight global crude supplies.
• A University of Michigan survey showed U.S. consumer sentiment fell to its lowest in more than a decade in early February on expectations that inflation would continue to rise in the near term.
• The CBOE volatility index hit its highest level since the end of January.

Normalized Factor Returns: Axioma US Equity Risk Model (AXUS4-MH)

• Market Sensitivity finished on top for the second straight week and finally crossed into positive territory.
• Growth continued to blaze upward and counter Value which fell again this week.
• Medium-Term Momentum kept on climbing and shed its oversold status.
• Size and Volatility both moved upward again following several weeks of so-so performance and sit in positive territory for now.
• One week after its recent positive push dithered, Profitability fell hard and moved a step closer to oversold terrain.
• Earnings Yield finished last for the third consecutive week while moving closer to negative status.
• U.S. Total Risk rose by 0.47% this week.

Normalized Factor Returns: Axioma Worldwide Equity Risk Model (AXWW4-MH)

• Size followed up last week’s runner-up finish wth the top spot this week while leaving oversold terrain.
• Volatility put on the jets after its strong move last week and crossed into positive territory.
• Market Sensitivity kept on climbing and finally crossed into overbought terrain.
• Growth maintained an upward course and landed at -0.84 SD below the mean, only 1 BP away from its US counterpart.
• Exchange Rate Sensitivity moved skyward for the seventh straight week but its rocket trajectory of late appears to be slowing down.
• Earnings Yield fell for the seventh consecutive week and moved deeper into negative terrain.
• Value contined its fall as it left extremely overbought territory and finished at the bottom of this week’s global leaderboard.
• Global Total Risk rose 0.19% this week.

Regards,
Kevin