Embracing Downside Risk
January 15, 2017
Topics - Alternative Investing
This paper shows that downside risk tends to be the main source of long-run returns in equities and other asset classes, and argues that long-term investors may be better off embracing downside risk in certain cases.
- It is well-known that investors have asymmetric preferences when it comes to bearing downside risk versus participating in the upside.
- Options arguably provide the most direct downside hedge, but at a significant cost reflecting investor preferences. This cost, commonly referred to as the volatility risk premium and measured by the difference between the option’s implied volatility and its underlying asset’s realized volatility, is paid by option buyers to sellers for bearing undesirable downside risk. Options markets therefore provide a useful and intuitive way to quantify these asymmetric preferences by way of the returns associated with being on the other side.
- We show this using equity index options, and find that most of the empirical equity risk premium reflects compensation for downside risk — in fact, upside participation earned hardly any reward in the long run, reflecting an asymmetry that might be surprising to some investors.
- We extend this analysis to other asset classes (bonds, gold and crude-oil futures, and credit) to show similar (though in some cases weaker) results.
- Data and economic theory suggest that investors who attempt to deal with downside risk by being long options should expect to underperform.
To many, it may sound risky to actively seek out concentrated downside exposure. Yet, for example, the insurance industry is seemingly devoted to accepting the risk of potentially significant loss for profits that are capped at moderately sized insurance premiums. Although it may appear rather unconventional to do so in financial markets, we show that downside exposure has the potential to offer greater rewards than does the highly sought-after upside participation.
This document has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed by the author and AQR Capital Management, LLC (“AQR”) to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. This document is not to be reproduced or redistributed to any other person. The information set forth herein has been provided to you as secondary information and should not be the primary source for any investment or allocation decision. Past performance is not a guarantee of future performance.
This material is not research and should not be treated as research. This paper does not represent valuation judgments with respect to any financial instrument, issuer, security or sector that may be described or referenced herein and does not represent a formal or official view of AQR. The views expressed reflect the current views as of the date hereof and neither the author nor AQR undertakes to advise you of any changes in the views expressed herein.
The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Charts and graphs provided herein are for illustrative purposes only. The information in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, neither AQR nor the author guarantees the accuracy, adequacy or completeness of such information. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. There can be no assurance that an investment strategy will be successful. Historic market trends are not reliable indicators of actual future market behavior or future performance of any particular investment which may differ materially, and should not be relied upon as such.
The information in this paper may contain projections or other forward-looking statements regarding future events, targets, forecasts or expectations regarding the strategies described herein, and is only current as of the date indicated. There is no assurance that such events or targets will be achieved, and may be significantly different from that shown here. The information in this document, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons.