Macro Tail Risk: A Targeted Equity Protection SolutionMacroTailRisk:ATargetedEquityProtectionSolution

1. What is Macro Tail Risk (MTR)?

PGIM Wadhwani’s proposed MTR strategy is a defensive liquid alternative strategy aiming to offer a dynamic multi-asset equity protection solution. MTR is designed to meet the challenge of strong reliability during equity market drawdowns without the consistent return cost experienced by holding options-based strategies. MTR leverages the expertise and long track record of our flagship Trend Plus capability, launched in 2005. MTR utilises trend, non-trend directional, and relative value models. Our highly agile process combines signals intelligently to be dynamic and nimble in changing markets.

2. Why was Macro Tail Risk Solution created?

We created MTR as a more targeted risk-mitigation solution compared to our more unconstrained and all-weather Trend Plus strategy. The solution takes the components of Trend Plus that we believe are best suited to solve for the equity protection problem to create a multi-asset portfolio utilising trend, non-trend directional and relative value models.

Additionally, MTR aims to provide a more cost-efficient approach to drawdown protection compared to put-options-based strategies. Options-based strategies will provide reliable equity downside protection, but at a cost (paid out when equity markets perform well). A trend- following strategy that is only applied to equity markets is mathematically akin to a put option; therefore, this is one way of providing reliable protection, but again, at a cost. In MTR, by contrast, we add non-trend models (such as macro and value strategies) alongside the trend models in order to generate some alpha in periods when equities do well, thereby paying for this cost.

3. What is the expected return profile of MTR?

We expect MTR to have a reliable return profile during equity market drawdowns, where our analysis shows we tend to achieve higher returns during periods of greater equity market declines (so convex on the downside), and flat to slightly positive returns during periods of positive equity markets. We believe our strategy has been inherently designed to produce such an asymmetric return with a target volatility of 12.5% and a return target of US Tbill+6% ¹.

By emphasizing the models within Trend Plus that are more reliable on the downside, we believe we’ve achieved an effective targeted solution to equity protection. MTR should essentially adjust the risk/reward ratio associated with different levels of performance of the S&P 500.

4. How could MTR be used?

• As a dedicated liquid alternative strategy, focussed on providing downside protection and diversification to improve the portfolio’s overall risk-adjusted returns.
• As a customised overlay solution alongside a dedicated beta strategy to improve the risk-adjusted returns of the beta holding.

5. What strategies comprise MTR portfolios?

MTR portfolios will consist of multi-asset factors designed to protect equity, utilising three well-established styles designed to lead to diversified and defensive (convex) returns

• Trend directional: uses price data to inform asset allocation decisions
• Non-trend directional: utilises non-price factors (macro, value, carry, sentiment and inter-market linkages) to inform asset allocation decisions
• Relative value: uses both price and non-price factors to invest within asset classes in a relative value manner

We believe MTR’s collection of strategies should lead to a relatively reliable equity protection pattern and at lower cost than option-based strategies. The proposed portfolio is a combined solution formed from six sleeves, all live models within the flagship Trend Plus strategy:

• Directional Short Equities²
• FX Equity Hedge
• Relative Value Equity Sectors
• Directional Commodities
• Directional Fixed Income Strategies
• Relative Value Yield Curve

6. How is MTR structured?

MTR is a natural extension of the Trend Plus strategy. We began by considering what would happen if we apply a simple filter to Trend Plus’ equity signals – only using them when they are short in order to improve reliability when equities fall. As depicted in the charts below, this enhancement took us a long way towards the type of solution we wanted to create, however we felt we could improve upon this somewhat simple change. Trend Plus optimises its SAA model allocations by assigning weights to maximise the Sortino Ratio³. In the second enhancement made for MTR, we adjusted the optimiser to also include a proxy weight to long equity beta, so the weights chosen for the rest of the portfolio by the optimiser were the most diversifying to equities (an objective that isn’t present within Trend Plus).

When we do so, some current Trend Plus models have a zero or low weight. These zero-weighted Trend Plus models are then excluded from the MTR portfolio.

7. Can MTR be customized?

Yes. MTR is an evolution of our flagship Trend Plus strategy, which has been leveraged to create a number of other Wadhwani solutions including Systematic Absolute Return (SAR), SAR Plus, and Commodities & Macro Tail Risk (CAMTR). We are able to structure a number of natural extensions of MTR to accommodate the return and risk profiles desired by clients.

8. What are some examples of how existing solutions are tailored for MTR?

As an example, within the Directional Short Equity sleeve, we have taken the actual historic equity signals used within Trend Plus, including trend and non-trend strategies, and filtered only for the short signal. Essentially, we’ve adapted it such that we remove any net long exposures. Therefore, on any given day, this system may have no positions (e.g. when all our signals are positive) or it takes short positions in markets where our signals are negative. Our analysis shows that the reliability in down equity markets is very good – in the ten worst three-month episodes for the S&P 500 from January 2008 - December 2021, the short equity model delivers positive returns during periods of major market drawdowns. During the equity market drawdowns experienced in the first half of 2022 the MTR strategy also performed well. The non-trend signals play a particularly powerful role in working alongside our trend signals to proactively increase the short book ahead of equity market falls and proactively cut the short book as markets recover.

Another example is the defensive FX Equity Hedge sleeve in which we focus on safe haven currencies, while managing the cost component. Our algorithm selects a portfolio of currency crosses based on each pair’s correlation with S&P 500 returns while allowing for the impact of carry and avoiding crosses with unfavourable price trends. For this sleeve, again our analysis shows positive hypothetical returns.

9. How can MTR fit into a portfolio?

Investors cannot predict when equity market drawdowns will occur or when recessions are forthcoming. Therefore, the most sensible way of building portfolios is to diversify their investments across investment opportunities with low correlations to one another. MTR can offer this characteristic given its design of having a negative correlation with equities during periods of market stress. Importantly it doesn’t rely on fixed income beta to do so. However, the real value add of the strategy is its asymmetric return profile, where during periods of equity upside, the strategy shouldn’t cost an investor money, but generate slightly positive returns. This is unlike many tail risk hedging strategies which cost money to hold over most periods, making them a more tactical tool. Our research shows that our dynamic asset allocation approach should allow us to offer this attractive return profile.

10. Why is there a need to consider tail risk hedging/equity tail protection today?

In an environment of rising interest rates coupled with recession risk, asset owners need to employ agile tail-risk hedging strategies. Remaining diversified across asset classes, investment styles, and time frames, and choosing solutions with a low beta to traditional markets over a full market cycle remain imperative. Liquid alternative solutions that combine trend following with directional and relative value strategies can be advantageous diversifiers in any market environment. For those scenarios when equities are performing particularly poorly, a dynamic multi-asset defensive solution that emphasizes macro tail risk and capital preservation to address volatile market environments can provide reliable diversification. Amid an uncertain backdrop, investors need to be more dynamic with their investment allocations and ready their portfolios for the inflation scenario most likely to prevail.