Alternative Investing

Embracing Downside Risk

Topics - Alternative Investing

${ numberSection } ${ text }
Embracing Downside Risk

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.

Published In

The Journal of Alternative Investments

AQR Capital Management, LLC, (“AQR”) provide links to third-party websites only as a convenience, and the inclusion of such links does not imply any endorsement, approval, investigation, verification or monitoring by us of any content or information contained within or accessible from the linked sites. If you choose to visit the linked sites, you do so at your own risk, and you will be subject to such sites' terms of use and privacy policies, over which AQR.com has no control. In no event will AQR be responsible for any information or content within the linked sites or your use of the linked sites.

 

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. The views and opinions expressed herein are those of the author and do not necessarily reflect the views of AQR Capital Management, LLC, its affiliates or its employees. This information is not intended to, and does not relate specifically to any investment strategy or product that AQR offers. It is being provided merely to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own view on the topic discussed herein. Past performance is not a guarantee of future results.

 

Hypothetical performance results have many inherent limitations, some of which, but not all, are described herein. Hypothetical performance results are presented for illustrative purposes only.

 

Diversification does not eliminate the risk of experiencing investment loss.

 

Certain publications may have been written prior to the author being an employee of AQR.

This material is intended for informational purposes only and should not be construed as legal or tax advice, nor is it intended to replace the advice of a qualified attorney or tax advisor.