Case Study: Why Portfolio Protection for an Endowment

Mike Edleson

Chief Risk Officer

The University of Chicago

Volatility Investing

19 April 2016

It’s a Conspiracy against Linearity

Markets

Products

Strategies

Structural (Brittle)

Agency issues

Your Beta / Exposure isn’t what you think it is, when it matters most

Wrong-Way Risk & Investing

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0

10

-50 -40 -30 -20 -10 0 10

Right-Way

Linear

Wrong-Way

β= .75 always

β> .75,increasingwith losses

Lossesaccelerating

Lossesslowingβ< .75,

risk flattening with losses

Overall Market Return (%)

Po

rtfo

lioLo

ss (

%)

0

10

20

30

40

50

60

70

80

90

500 700 900 1100 1300 1500

Leve

l of

VIX

SPX TR Index Level

Past 13 years, weekly observations

Relationship of Volatility and Market Level

Aug-Oct 2008

-0.1

0.0

0.1

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0.5

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0.8

0.9

1.0

EM Equity Credit Real Estate Commodities

Ro

llin

g 1y

co

rrle

tio

n w

ith

S&

P500

(Mo

nth

ly R

etu

rns)

Correlations Spiked During Financial Crisis

Before Crisis

Average correlation measure with Equities for 18 months before and after Sept 2008

Cre

dit

sp

iked

ha

rd,

a fe

w q

ua

rte

rs e

arl

ier

thruNov

'07

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1

-60.0% -40.0% -20.0% 0.0% 20.0% 40.0% 60.0%

Esti

mat

ed

Be

ta (

40d

, pre

vio

us

2 yr

s p

rice

dat

a)

Return on GEF Index in previous 2yrs

2y GEF Beta v 2y Return on GEF Index(assuming current portfolio)

end Aug 2008 - Sep 2010 since Sep 2010

before May 2004 Jun 2004 - Aug 2008

Sep - Nov 2008

-8%

-6%

-4%

-2%

0%

2%

4%

6%

-25% -20% -15% -10% -5% 0% 5% 10% 15%

Figure 6 Non-linearity and negative convexity in hedge fund returns, 2003-13

Full sample

Drops 'Outlier'

S&P 500 Return

CS Agg HFI Return

Outlier ?

Investment Return

w/Performance Fee

-30%

-20%

-10%

0%

10%

20%

-20% -10% 0% 10%

Credit's Negative Convexity to Equity Markets, 1990-2011

High Yield Distressed

Corp High Yield

SPX Monthly

Risk steeper to the downside

Vols Spike Correlations Spike Betas Spike Carry in Products Non-Linear Fees

Negative Convexity in HF Returns

AND Rebalancing as a Short Put Illiquidity & Leverage Push for Returns

Wrong-Way Risk-Return Profile

ALL ENDOWMENTS HAVE NEGATIVELY CONVEX RETURNS / WRONG-WAY RISK PROFILE

Our beta for up markets is 175% of our beta for down markets

Meeting the Needs of the University Tail Risk vs. The Higher Purpose

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-5%

0%

5%

Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09

Quarterly Reported

Monthly Reported

Time-Matched

Proxy Illiquid

Fiscal year

Losses Steeper than you think in Crisis

Real Economic

Loss

5% Spending Rule (5.5% here)

–40% Scenario ▼

9.2% payout

70-75% Privates

for a few years

Is a 9-10% payout with 25-30% in “liquid(?)” assets sustainable?

Liquidity Needs: $1.2 – 1.4B in replay of crisis (while $7 →$4.7B)

Predictable Cash Flow to meet Important LT Strategic Operations

Does our “long term” investment horizon really excuse all sins?

Not just returns +%

Reduces crisis beta

Cash in a Crisis

Reduces leverage

Buys time, prevents disaster

Survival of the “Enterprise”

Enterprise Risk Perspective

Gifts not only smaller, but not given (high β)

Debt shoots up, Enterprise more levered

Hospital & Grants revenue potentially collapses

At this exact point, our liquidity disappears, and our investment risk skyrockets. Is this OK?

Tail

Pro

tect

ion

Behavioral & Cultural Issues • Committee Behavior & Governance Breakdown

• “Buy High, Sell Low”

• Is Staff confident enough to invest when returns are the highest (but markets are scariest)?

In a world of similar track records, the response to a crisis can make-or-break an endowment

Tail protection, economically and behaviorally, helps work against our most destructive human tendencies.

-15%

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5%

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30%

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Total Capital Raised v Cohort Return(since 1990)

Private Capital Raised $B Performance (Cohort IRR) %

351

Expected returns generally highest after a crisis

- Publics (but we must sell then)

- Privates (but we stop investing then)

- Most E&F simply stopped private investments and didn’t restart until 2011 / later..

“Everybody’s got plans…until they get hit.” – Mike Tyson A Tail Hedge program is like a mouth guard. Keeps the brain from getting too rattled during a crisis so we can keep our head in the game.

We Planned & Positioned for this

We have the cash, the risk capacity, and the confidence to take advantage of the opportunities being offered by the market

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BONUS

In practice, strategic hedging of our negative convexity risk-return profile makes us keenly aware of “fake alpha” carry returns in our investments…this leads us to focus on the best, highest “true alpha” among them.

Risk Culture extends to convexity as well.

Implementing a Protection Program

What Risk Drivers

What portion of tail? …true “crisis”?

Governance Support / Fatigue

Sizing A Protection Program

• Capital/Budget/Bleed/Cost

• To Linearize return profile

• To truncate most painful losses

• To outperform peers in crisis

• To provide $X of needed liquidity

• To support %C of portfolio in carry/illiquid strats

• To not impair long-run performance

Who does it (managers?)

Strategic or Tactical?

Monetization

Robustness

NOTE on COST A small strategic portfolio protection program costs far less than most think. Nearly everyone gets the math wrong on this. Our actual experience, implemented over 4+ years, has been a (very) small gain.

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Our Protection Program

Focus on Enterprise economic crisis, & linearize endowment beta (governance control)

2% Capital Allocation

65 bps budget, “bleed” limit

Expected LR standalone cost, 15-20 bps

Expected LR portfolio return drag ~10 bps

TRIP Returns

Global Equity Markets

Illustration of Wrong-Way Beta

.60

Upside GEF Beta.75

'Normal' GEF Beta

.85Downside

GEF Beta

BEARDEPRESSION CRISIS BULL

1.00Deep Downside

GEF Beta

“Linearize”: Fill That Gap

Pro

tect

ion

Pay

off

BUCK

Balancing Bang for the Buck and Basis

Various Hypothetical Strategies' Economics Shown

BANG

Expected Cost

Too Linear?

Ineffective

Too Expensive?

Basis Risk Too High?

Can Size Down

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