RISK MANAGEMENT TOOLS

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1 RISK MANAGEMENT TOOLS Pavilion Advisory Group TM Pavilion Advisory Group is a trademark of Pavilion Financial Corporation used under license by Pavilion Advisory Group Ltd. in Canada and Pavilion Advisory Group Inc. in the United States.

2 PAGE 2 This document provides a brief overview of several, different approaches to managing market or tail risk. The following approaches are examined: diversification, low volatility equity strategies, risk parity, portfolio insurance, volatility products and dynamic beta exposure. 1. Diversification The conventional portfolio risk management solution is achieved through the use of asset allocation modeling and structuring, often based on Modern Portfolio Theory (MPT). In its simplest form, MPT states that through diversification an investor can reduce the total risk of his/her portfolio by choosing different assets; the returns of which are not completely correlated. There are a number of important assumptions that we need to be mindful of when we employ portfolio optimization techniques based on MPT. These include the assumptions that asset returns are normally distributed, and that volatilities and correlations can be not only calculated/estimated with precision but also that these parameters are constant over time. Unfortunately, these assumptions are not always met, particularly in periods of market stress during which we observe a breakdown in correlations between assets and significant spikes in their respective volatilities. As market volatility increases, the distribution of asset returns flattens and the tails fatten relative to their average historical levels. It is during these periods of high volatility that portfolios tend to suffer large drawdowns and investors endure the shortcomings of conventional, asset allocationbased risk management strategies. 2. Low volatility equity strategies Low volatility investing relates to constructing portfolios which hold equity securities with lower historical and/or expected price fluctuations than the overall market. Historically, those low risk stocks have tended to outperform their risky peers. This is becoming a more popular investment strategy and, in the last several years, index providers have begun to deliver low volatility indices and associated products. An issue with these methods is that they are capacity constrained strategies that will become crowded as a larger number of plans and institutional investors adopt them. Low volatility stocks may become increasingly expensive and increasingly volatile as investors allocate greater capital to them. In addition, these strategies are appropriate in certain market environments but will under-perform in other environments. Early adopters may benefit, but the window of opportunity may have passed for this strategy to be a long-term sustainable portfolio risk management solution.

3 PAGE 3 3. Risk parity Risk parity focuses on allocation of risk, usually defined by volatility, rather than allocation of capital. Risk parity portfolio construction looks to build a portfolio where the volatility of each asset class is similar, i.e. a form of equal weighting of portfolio risk. In the chart below, allocations consist of long treasury bonds (TLT), investment grade corporate bonds (LQD), and S&P 500 Index (SPY) ETFs. The risk parity approach asserts that when asset allocations are adjusted (leveraged or deleveraged) to the same risk level, the risk parity portfolio can achieve a higher Sharpe ratio and can be more resistant to market downturns than the traditional portfolio. There are two concerns with risk parity. The main issue with risk parity relates to the fact that volatility is assumed to be an effective (and complete) measure of risk for all assets. Risk parity strategies tend to invest across a wide spectrum of assets, some of which are less liquid than stocks and treasury bonds. Volatility tends to greatly underestimate the true risk of illiquid assets. Furthermore, equating risk to volatility implicitly assumes that return distributions are symmetric. Assets such as credit have a very negatively skewed distribution for which volatility is an inappropriate risk measure. The second and lesser issue relates to the need for considerable leverage in order to construct a true risk parity portfolio. Since the volatility of fixed income instruments is substantially lower than stocks, it may be necessary to apply leverage in order to increase the risk to a point that it is equal. Risk Parity Allocation (May 09, 2003 to September 7, 2012) 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% TLT LQD SPY

4 PAGE 4 4. Portfolio insurance Purchasing put options The traditional way to protect the value of a portfolio from declining below a certain level is through the purchase of put options, written either directly on the portfolio or on the securities constituting the portfolio. The insured amount equals the capital invested in the portfolio less the cost of the put option, also referred to as the insurance premium. Protective Put (Net Position) Limitations on this option-based model arise from the scarcity of options on the actual portfolio (generally one will use index options) and the cost of such options. Options are priced using a forward looking (implied) volatility measure which is on average considerably higher than the realized market volatility. Furthermore, given the dynamic nature of volatility, the cost of insuring a portfolio varies substantially over time and this cost can be prohibitive during periods of market uncertainty (i.e. 2009). The next graph plots the cost of buying a three- month, 10% out-of-the-money put option on the S&P500 over the period. To avoid the cost of paying the implied volatility premium, one can synthetically replicate the downside protection that a put option offers. Price of a three-month 10% OTM put (as% of assets price) 10.0% 9.0% 8.0% 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0%

5 PAGE 5 Dynamic option replication and CPPI (constant proportion portfolio insurance) Dynamic option replication is similar to the put options strategy but attempts to replicate the strategy synthetically and on a dynamic basis. CPPI strategies are similar to tactical asset allocation strategies that actively allocate between two assets - a riskless asset and a risky asset which could be equity, hedge funds, commodities, etc. In rising markets, the strategy allocates more towards the risky asset, while in falling markets the strategy allocates more towards the safe asset. The advantage of using dynamic option replication (or even CPPI) to insure a portfolio is that you do not need to pay the implied volatility option premium which can be significant. Over the long run, synthetic replication should prove to be a better proposition in terms of cost than the static purchase of put options. The disadvantage is that unlike a put option which guarantees a floor price, dynamic replication attempts to create a floor price but there are no contractual guarantees. It is an active strategy that requires continuous monitoring of the portfolio and rebalancing at regular intervals. If, for some reason, the portfolio manager cannot trade or markets gap down, it is possible that the target floor is not respected. Collars Establishing a collar to protect a portfolio involves purchasing put options for downside insurance, while at the same time selling call options, with the premium taken in financing, at least in part, the cost of the put options. The purchased puts will have a strike price less than that of the calls sold and, very commonly, both options are out-of-the-money when the position is established. The short calls will limit upside profit potential of the portfolio; the degree to which depending on the strike price chosen. The sale of calls can be used to partially or even totally offset the cost of the puts. It is important to note that the price of OTM calls and puts are not equivalent, as the implied volatility surface is not flat. During periods of crisis, puts tend to be considerably more expensive than calls (implied volatility higher for OTM puts than OTM calls), and therefore the amount of upside that needs to be sacrificed to finance downside protection can make a zerocost collar unappealing. Contrary to options on stocks and ETFs, index options are cash-settled. This is an important feature as the collar (specifically the short call) exposes the investor to potential assignment on in-the-money call contracts. Collar (Net Position) Regardless of the portfolio insurance approach, it will always result in a drag on performance during bull markets. There is an explicit cost to any form of portfolio insurance

6 PAGE 6 5. Volatility products Variance Swaps Variance swaps are over-the-counter (OTC) contracts on volatility in which the buyer agrees to swap a fixed variance level on a particular market index for actual realized variance from now until the maturity date. As such, variance swaps provide pure exposure to the realized volatility of an asset. The potential drawbacks of variance swaps are their relatively illiquidity, counterparty risk, limited capacity, pricing based on the prevailing level of implied volatility and generous brokerage premiums. VIX products VIX is a measure of the implied volatility of the S&P 500 index. It is calculated using a crosssection of options (OTM calls and OTM puts) that have the same term to maturity. Usually we are referring to front month when we talk about the VIX. An investor that has acquired a long position in the VIX will profit if the level of implied volatility increases over his/her holding period. Unlike variance swaps, the return of a VIX strategy is not a function of the realized volatility of the underlying, but simply the change in the level of the implied (or expected future) volatility. The main difficulty in trading implied volatility is that the spot VIX index is not investable, and therefore one must acquire exposure to the VIX through futures contracts. These contracts have a fixed maturity and therefore must be rolled, resulting in significant costs due to the upward sloping (contango) nature of the VIX termstructure. On the upside, VIX futures contracts are exchange traded and therefore counterparty risk is greatly reduced relative to trading variance swaps or other OTC products. Forward starting variance swaps Similar to the VIX in terms of payoff, the forward starting variance swap (FSVS) is a pure play on implied volatility. The FSVS can be constructed using two variance swaps of different maturities. As long as the holder of the FSVS closes the position prior to the maturity of the Forward, he/she will profit if the level of implied volatility increases over his/her holding period. The drawback is similar to VIX exposure where, if the term-structure is steep, there will be a significant cost of carry associated with these contracts. Furthermore, the contract is traded OTC and therefore is less liquid and exposed to counterparty risk. 6. Dynamic beta exposure Dynamic beta exposure is an alternative to buying volatility products and is meant to take advantage of the observable information relating to volatility. The idea of using volatility as a risk conditioning variable to optimize the portfolio has been proven to be extremely efficient. By

7 PAGE 7 measuring the prevailing level of volatility, one should be able to effectively hedge against changes in that volatility and greatly reduce tail risk and potentially improve a portfolio s riskadjusted returns. Because most assets tend to exhibit volatility clustering, the recent (realized) volatility of an asset provides useful information about the near-term risks. The underlying principle of constant volatility is to systematically adjust the exposure to a given asset (or portfolio of assets) conditional to its current volatility in order to maintain a pre-specified level of risk. Similar to dynamic option replication, the strategy attempts to manage tail-risk and market exposures using active exposures replication, not options and, as a result, there are no contractual guarantees. In certain market environments, the strategy may result in a drag on performance which is consistent with other portfolio insurance solutions. Additionally, the strategy can be complicated to administer as it requires daily trading oversight and maintenance of margin balances. There are three steps that need to be addressed in implementing a constant volatility strategy. The first step is to establish the appropriate level of volatility to target, keeping in mind factors such as risk tolerance, return objectives and strategic asset mixes. The second step, is deciding on the most appropriate approach for measuring the current volatility of the portfolio. There are a range of possibilities, from the simple calculations of the historical standard deviation or the exponentially weighted moving average (EWMA) to more complex and realistic econometric techniques for modeling and forecasting volatility, such as the GARCH family of models. The final step is developing a robust framework for deriving the required exposure that ensures that the portfolio s volatility is maintained at the target level. Possible approaches range from a simple calculation of the ratio of the target volatility over actual volatility (or the ratio of the variances), to a more comprehensive distributional targeting approach as proposed in the Hocquard et al, Journal of Portfolio Management (Winter 2013) paper. Constant volatility strategy OBJECTIVES Target a Normal distribution Eliminate fat-tails and negative skewness Actively manage exposure to keep risk constant Hedge changes in volatility Non-Normal distribution with fat tails: - Exposed to large drawdowns - Volatility (and risk) is not constant Normal distribution with constant volatility: - In-Line with assumptions about asset risk - Consistent with short- and long- term risk budget - Consistent with actuarial assumptions - Better control of tail risk

8 PAGE 8 References Hocquard, A., Ng, S. and N. Papageorgiou (2013), A Constant Volatility Framework for Managing Tail Risk, Journal of Portfolio Management, 39 (2), p Montreal Pavilion Advisory Group Ltd René-Lévesque Blvd. West, Suite 4030 Montréal, Québec H3B 4W8 Canada Tel: Fax: Winnipeg Pavilion Advisory Group Ltd Corydon Avenue, Suite 300 Winnipeg, Manitoba R3M 0B6 Canada Tel: Fax: Chicago Pavilion Advisory Group Inc. 500 West Madison Street, Suite 2740 Chicago, Illinois Tel: Fax: Disclaimer Pavilion Advisory Group is a trademark of Pavilion Financial Corporation used under license by Pavilion Advisory Group Ltd. in Canada and Pavilion Advisory Group Inc. in the United States. This information is intended for sophisticated and/or accredited investors in Canada and is for illustrative use only. While the assumptions, data and models used to develop the information contained herein are from sources deemed to be reliable, there can be no certainty or guarantee regarding the likelihood of the outcomes as presented. This document is not and should not be construed as a solicitation or offering of units of any fund or other security or as legal, taxation or investment advice. Any investment advice would be delivered pursuant to a written investment management agreement and legal and taxation advice should be obtained from appropriate and qualified professionals. No part of this publication may be reproduced in any manner without our prior written permission Pavilion Advisory Group Ltd. All rights reserved. February 2013