SUMMARY
S&P Dow Jones Indices, in collaboration with Milliman, introduced the S&P Managed Risk 2.0 Indices, which seek to provide core equity strategies with an embedded risk management feature. The key features of this strategy are the following.
- The cost of the protection embedded in the strategy is stable and is financed through a reserve asset, the S&P U.S. Treasury Bond Current 5-Year Index. During times when equity markets are under stress, the correlation effects between equities and the reserve asset class have historically provided a counterbalance through positive returns. This is in contrast to strategies that use cash, which do not provide that benefit.
- Since protection is available, the strategy may provide the ability to participate more in the upside while keeping the overall risk at a low level. This shows up in the higher upside capture and similar or better downside capture than other risk management strategies.
Before diving into the details of the construction and performance of the strategy, it is helpful to consider why this strategy has been developed and the potential benefits it can provide.
FROM RISK CONTROL TO MANAGED RISK
Many readers may be familiar with risk control strategies.[1] These strategies, which can use a single asset or multiple assets, dynamically adjust the exposure of a risky asset to target a predefined volatility level. They became popular as a solution to reduce risk while retaining much of the gains to be had from “risky” assets like equities.
However, risk control strategies have some major limitations.They transform the distribution of investment outcomes in a linear and symmetric way, meaning that downside could be significant, although reduced, during severe and sustained market declines.
Therefore, a number of managed risk strategies[2] have been created recently to improve the traditional risk control framework. These strategies add an additional layer of risk management using a synthetic put hedge, seeking to stabilize volatility around a target level and, on top that, defend against losses during sustained market declines.
Note that this protection comes with a cost. Although options on broad market indices are usually expensive, put option replication in the presence of volatility management tends to have lower and more stable performance costs. Therefore, these strategies enable more upside participation compared with the traditional risk control strategies.
