Improving Portfolio Returns Through Risk Reduction Oct 2010 Long Version

1 Eden Rahim – October 2010

IMPROVING PORTFOLIO RETURNS

BY REDUCING RISK

USING INCOME & HEDGING STRATEGIES TO ADD TO PERFORMANCE

& DAMPEN VOLATILITY IN A LOW RETURN WORLD

EDEN RAHIM - RISK REDUCTION STRATEGIST Derivative Analyst, Portfolio Manager & Hedge Fund Manager

“Identify your Risk, Mitigate your Concern, & Improve Returns”


IT DOESN’T HAVE TO BE THIS WAY



“It doesn’t do to leave a live

Dragon out of your calculations,

if you live near him”

THE HOBBIT, J.R.R.Tolkien


WHERE HAVE WE

SEEN HEDGING

WORK?


FARMERS, COKE, SOUTHWEST & BARRICK HAVE SOMETHING IN COMMON


WHAT IS OUR DRAGON? OPERATOR PRODUCT PROCESS RISKS_______

FARMER GRAINS PLANTING HARVEST/PRICES

SOUTHWEST TRAVEL FLYING FUEL COST

BARRICK GOLD MINING PRICE CHANGE

COCOA COLA BEVERAGE WORLDWIDE CURRENCY/SUGAR

MERCK MEDICINES DRUG DEV BINARY OUTCOME

ASSET MGR RETURNS INVESTING VOLATILITY/ -VE RETURNS


WHAT DO CLIENTS WANT?

STABLE RETURNS

HIGH PREDICTABILITY

LOW VOLATILITY


By Slaying their Dragons…

Companies cope daily with unbounded Volatility

We expect them to hedge to produce predictable EPS

Do we hedge our Volatility for predictably Returns?

Is relying on markets to bounce back, a strategy?


Q: WHY NOW?

A: OUR WORLD

HAS CHANGED


WE NEED A NEW PLAN

May Jun Jul Aug Sep Oct Nov Dec 2008 Mar Apr May Jun Jul Aug Sep Oct Nov Dec 2009 Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 2010 Feb Mar Apr May Jun Jul Aug Sep Oct Nov

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S&P 1974 - 2007

GENERATIONAL BULL MARKET

S&P AFTER 2007SECULARBEAR MARKETBEGINS

NEW RULESAPPLY

S&P WEEKLY


THE WORLD AS WE KNEW IT

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

5,000Distribution of Daily S&P Logreturns 1950- July

2007 Market Top

Annual Returns +8.47%Std Deviation 13.8%


THE WORLD AS IT IS NOW –

SHIFT LEFT, FATTER TAILS & WIDER DISTRIBUTION

0

20

40

60

80

100

120

140

160

180

200Distribution of Daily Lognormal S&P Returns post market

peak July 2007 - Aug 2010

Annual Return -5.5%Std Deviation 29.85%


WHAT FAT TAIL IS BREWING NOW? Bye Bye FED MODEL - Low bond yields associated with low Equity P/Es


Confronting the Low Return Dragon

BULL MARKET BEGINNING IN 1982 REWROTE THE RULES OF PRIOR 16 YEARS

& REQUIRED A WILLINGNESS TO THINK DIFFERENTLY TO SUCCEED

WE ARE AGAIN REQUIRED TO THINK DIFFERENTLY FROM PAST 25 YEARS

OR WILL CLIENTS BE GOING FOR ANOTHER ROLLER COASTER RIDE SOON?


INVESTORS HAVE REACHED THEIR LIMIT

Clients can’t endure ANOTHER down year

Buy-&-Hold NO longer a value adding strategy

Era of Relative Performance is waning

Asset Allocation is a Bet, not a Hedge

Are you Differentiated in Crowded market?


HAVE THE TOOLS TO MANAGE 10 MORE YEARS OF THIS?

1898 1899 1900 1901 1902 1903 1904 1905 1906 1907 1908 1909 1910 1911 1912 1913 1914 1915 1916 1917 1918 1919 1920 1921 1922 1923 1924 1925

6.0

6.5

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8.0

8.5

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12.0

A

B

C

1835 - 1843 BEAR MARKET

DOWNLEG A: MAY 1835 - APR 1837 ( -39%)

DOWNLEG B-C: MAY 1839 - JAN 1843 ( -39%)

RANGEBOUND MARKET FROM 1901 TO 1921 THAT INCLUDED 4 BEAR MARKETS > -40%

-46% -48%

-24%

-40%

-46%

WW 1

SPX MONTHLY 1800


PLAY DEFENSE WITH

HEDGING

PLAY OFFENSE WITH

INCOME CAPTURE


HEDGING CLARIFIES DECISIONMAKING

MANAGERS IMPACTED BY EMOTIONS AT HIGHS & LOWS – I KNOW

DECISIONS ARE DIFFICULT UNDER EITHER SCENARIO

TO HEDGE OR LIFT HEDGES IS AN EASIER DECISION

THINK DIFFERENTLY WHEN YOUR BACK IS COVERED

RAPIDLY ALLOCATE TO CASH OR BUILD UP CASH

REPAIR AN ILL-TIMED ALLOCATION


WHAT ARE CONCERNED CIOs NEXT MOVE?

FINDINGS OF THE KBW ASSET MANAGERS CIO SURVEY

50% plan to Increase allocation to Hedge Funds, PE & RE

Your most valuable asset is the one you now manage

75% of CIOs reviewing managers - replacement cycle

Novel strategies are getting CIOs attention over Long-Only

Courtesy Keefe, Bruyette & Woods (KBW) July 2010


HEDGING IS NOT A HEDGEFUND

IMPROVE RISK ADJUSTED RETURNS VALUED BY CIO’S

EMPOWER MANAGERS TO PURSUE ABSOLUTE RETURNS

ADDRESS FUNDING or DISTRIBUTION GAPS

NECESSITY TO EXPLORE ALL MEANS TO ADD TO RETURNS

PUT EVERY PORTFOLIO COMPONENT TO WORK


WHAT WOULD HEDGING COST?

50 BASIS POINTS OF RETURN FOR THE YEAR IF…

ON $1 BILLION AUM 50 BPS = $5 MM

FOR THAT WE CAN HEDGE AWAY SUBSTANTIAL RISK

COST FURTHER REDUCED BY SELLING CALLS

NOTHING EXOTIC - ONLY EXCHANGE LISTED OPTIONS

NO UNLIMITED RISKS OR “SURPRISES”


HEDGING OVERLAY STRATEGY

Want to improve returns? – There is a Roadmap!

DYNAMIC VOLATILITY MODELS TELL US WHEN TO HEDGE

MULTISTEP PROCESS ALLOWS US TO ISOLATE RISKS

UTILIZE TOOLS & STRATEGIES THAT WORKED FOR 2 DECADES

CONSISTENTLY HARVEST OPTION PREMIUM FROM THE MARKETS

INCREASED QUARTILE RANK ACROSS MANY FUND MANDATES


16 YEARS AGO, THE PROCESS WAS PIONEERED AT RBC -

NOW IT’S A TURNKEY PROCESS TO GET UP & RUNNING.


My interests are

unequivocally aligned

with Your best interest

- NO CONFLICTS-


I WILL PROVIDE THE ONGOING SERVICE TO…

Review your eligible portfolios & holdings each day

Determine beneficial Income or Hedging opportunities

Evaluate Risk/Benefit profile and Cost each strategy

Discuss with your CIO, PM or Head Trader

Execute through your Trader once agreed upon

Monitor all open positions and provide updates

Coordinate NI-81-104 compliance/accounts with your Legal


A SAMPLE OF 10 HEDGING AND

INCOME CAPTURE STRATEGIES

EXECUTED OVER THE YEARS.

RESULTED IN OVER $100 MILLION IN

UNITHOLDER RISK REDUCTION


TRIED & TRUE HEDGING & INCOME STRATEGIES

BRE-X CATASTROPHY HEDGE - 1997

BARRICK & PLACER COVERED WRITE PROGRAM 1997-1999

RIM CALL SPREAD AHEAD OF INFRINGEMENT RULING - 2006

RIM COLLAR OF RISK AHEAD OF EARNINGS 2008

BIOVAIL PUT OPTION HEDGE POST-EARNINGS - 2002

BBH BIOTECH PUTS HEDGE SECTOR OVERWEIGHT IN FUND – 2000

NORTEL EARNINGS EXPOSURE PUT HEDGE - 2001

INCOME SPREADS ON SPYDERS ON VOLATILITY SPIKE – 2006

LOCKING IN PROFITS ON JDSU INCLUSION INTO S&P INDEX - 2000

LOW COST CURRENCY HEDGE IN GLOBAL BOND FUND –1996 – 1998


REMOVING EXTREME EXPOSURE

1. HEDGING THE BRE-X DEBACLE WITH A RISK-REVERSAL

IN 1997, EXTREME CALL OPTION SPECULATION, VOLATILITY & HEAVY

VOLUME WERE WARNING SIGNS OF TROUBLE. AT $26, I SOLD 2,000 30-

STRIKE CALLS & USED THE PROCEEDS TO BUY 2,000 24-STRIKE PUTS. WHEN

BRE-X CRASHED, THE PUTS WERE EXERCISED & DELIVERED AT $24.


EARNING INCOME/REDUCING RISK

2. SELLING CALLS ON ABX & PDG 1997-99 (GOLD BEAR)

Persistently sold thousands of Calls against Barrick & Placer positions every

few months, to capture income. Harvested millions $ every few months that

contributed to Gold Fund remaining 1st Quartile during range-bound period

Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 1998 Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 1999 Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 2000 Feb

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BARRICK (ABX) 1997-99 DURING GOLD BEAR MARKETP

P

P

P

P

P

P

P

P

P

P

BARRICK C$ (48.7000, 49.2400, 48.3300, 48.9800, +0.16000)


HANDICAPPING OUTCOME WITH LOW RISK SPREAD

3 RIM AHEAD OF PATENT SUIT OUTCOME

RIM is notoriously volatile and large index weight. Ahead of the infringement

ruling, uncertain of the outcome, an OTM Call-spread @ $1.70 was

established. After it surged post settlement, the spread was sold for $6.50.

27 6

March

13 20 27 3 10

April

17 24 1

May

8 15 22 30 5

June

12 19 26 3 10

July

17 24 31 7

August

14 21 28 5 11 18

September

25 2 9

October

16 23

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RIM TUMBLES 30%

ON DISAPPOINTING

EARNINGS.

A RISK-REVERSAL

SAVED THE DAY

RIMM SETTLES INFRINGEMENT SUIT.FOR BINARY EVENT, POSITIONEDIN OTM CALL-SPREAD THAT RETURNEDOVER 3X INVESTMENT.

RIMM (50.5500, 51.8100, 50.3900, 50.7100, +0.45700)


RISKY BUT I STILL HAVE TO HOLD IT HEDGE 4. RIM RISK-REVERSAL AHEAD OF EARNINGS

RIM was a large weight in NAMF, as in most Growth funds. In Sept 2008

estimates were declining & the behavior was weak. Yet it would be too risky,

NOT to hold it ahead of pivotal news. I overlaid short-dated risk-reversal for

nominal cost. RIM crashed -35% but NAMF experienced only 7% of the drop.


BIG INDEX WEIGHT BUT POOR QUALITY EARNINGS

5. BIOVAIL’S POOR EARNINGS - APRIL 2002

Conference call confirmed poor quality earnings, so entire Biovail position

was hedged with $2 OTM Put options. BVF crashed & Puts sold over $12


TIMING HEDGE AS ILLIQUID SECTOR SOLD

6. OVERWEIGHT VOLATILE BIOTECHS WITH LIQUIDTY IMPACT

Hedge Sector first then Sell large holdings as market would permit.

Biotech is 30% weight in $800mm fund. Buy 2,000 BBH 225-175 Put

spreads for $8 to reduce cost. BBH fell 30% or 80 pts next 4 weeks.

31

February

7 14 22 28

March

6 13 20 27 3

April

150

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R

AT HEIGHT OF BIOTECH BUBBLE IN MARCH 2000

* HEDGE 30% BIOTECH WEIGHT IN $800 MM RBC GROWTH FUND

* PURCHASE 2,000 BBH 3-MONTH 225-175 PUT SPREADS FOR $8

* THE BBH PLUNGED -30% OR 80 POINTS THE NEXT 4 WEEKS

* SOLD THE PUT SPREAD FOR A 400% GAIN & WIDENED PERFORMANCE

GAP OVER COMPETITORS.

MERRILL BIOTECH HOLDERS (93.3500, 93.6700, 92.3710, 93.0700, -0.28000)


RISK REDUCTION

7. HEDGING NORTEL POSITION FROM EARNINGS IMPACT

IN FEB 2001, BOUGHT 10,000 NORTEL PUTS TO HEDGE LARGE POSITION,

CONCERNED ABOUT RISK OF LARGE INDEX WEIGHT ON PERFORMANCE. NT FELL

ALMOST -40% UNITHOLDERS WERE SAVED $17 MILLION IN LOST ASSET VALUE

December

11 18 27 2

2001

8 15 22 29 5

February

12 19 26

300

350

400

450

500

550

600

650

iHEDGING NORTEL POSITION FEB 2001

* NT REMAINED A LARGE INSTITUTIONAL HOLDING

* EARNINGS ESTIMATES WERE DETERIORATING

* YET MANAGEMENT REMAIN SANGUINE

* PURCHASED 10,000 NT ATM PUT OPTIONS.

* NT CRASHED ALMOST 40% ON DISAPPOINTMENT

* HEDGE SAVED UNITHOLDERS $17 MILLION

NORTEL (0.18000, 0.18500, 0.18000, 0.18500, +0.00)


INCOME ENHANCEMENT AFTER VOLATILITY ROSE

8. IRON CONDOR INCOME CAPTURE JUNE 2006

IMPLIED VOLATILITY SPIKED 75% WHEN S&P DROPPED -7% IN A MONTH – A

MISMATCH. ESTABLISHED IRON CONDOR WITH STRIKES 1-SIGMA ABOVE & BELOW

SPOT. THE MARKET STAYED IN THE RANGE & THE PREMIUM WAS COLLECTED.

15 22 30 5

June

12 19 26 3

July

10 17 24 31

August

7

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138

OO

IRON CONDOR JUNE 2006 ON SPYDERS

* MARKET CORRECTED -7% & VOLATILITY ROSE +75% TO 21% FROM ONLY 12% 6 WEEKS EARLIER - THE HIGHEST IN 2 YEARS* DETERMINE +/- 1-SIGMA = 21%*SQRT(39/252) = 8.2 PTS* THEREFORE, SELL CALL & PUT SPREADS AT 123+8 = 131 & 115* SOLD 2 PTS PUT SPREAD FOR $0.35 & CALL SPREAD FOR $0.45 = $0.80 CREDIT

INITIATE CONDOR

EXPIRATION

AT EXPIRY, CREDIT SPREADS EXPIRED AT $0$0.80 / NET MARGIN ($2.00 - $0.80) = +67%

SPYDERS (109.540, 110.380, 108.910, 109.790, +0.20000)


HEDGING WINDFALL GAIN FROM TAX CONSEQUENCES

9. LOCKING IN JDSU PROFITS ON INCLUSION INTO S&P - 2000

4,500 3-month ATM Put options were bought to lock in a superficial gain. By

expiration, JDSU had declined over 30% & the Puts had appreciated 10-fold.


MINIMAL COST CURRENCY HEDGE

10. HEDGE C$ IN GLOBAL BOND FUND – THE SHORT SEAGULL

EXECUTED DURING THE MID-to-LATE 1990s TO HEDGE US$ POSITIONS BACK INTO C$, AT

MINIMAL COST – POST 1995 REFERUNDUM VOLATILITY – IN GLOBAL BOND PORTFOLIOS.

BUY ATM C$ CALLS & SELL FAR OTM CALLS & PUTS. VOLATILITY & THETA NEUTRAL.


QUALITIES IN DETERMING HEDGING SECURITIES

Correlation is over-rated

From experience, Liquidity of Hedge is a priority

Tight bid/ask spreads improves execution & pricing

Ability to “hedge the hedge” off-hours is important

Multiple market participants in hedge securities


BOOSTING PERFORMANCE NOW!

A FEW STRATEGIES:

ADDING ⅓% per MONTH INCOME ADDS UP BY YEAREND

DAY-IN-DAY-OUT, COVERED OPTION WRITING ON OUR POSITIONS

INCOME SPREADS ARE IDEAL OVERLAY – SAFELY ADDS INCOME

PROTECT GIVING BACK GAINS WITHOUT SELLING POSITION

SUBSTITUTE STOCK FOR OPTIONS AHEAD OF RISKY SITUATIONS

REPAIR BROKEN POSITIONS WITH RATIO SPREADS & PUT SALES


WHO CAN FULFILL A HEDGING MANDATE?

EDEN RAHIM

RISK REDUCTION STRATEGIST “Identify your Risk, Mitigate your Concern, & Improve Returns”


APPENDIX:

MODELING VOLATILITY CHANGES

DETERMINING WHEN TO BUY, SELL OR SHORT

VOLATILITY

TO ENHANCE PORTFOLIO RETURNS


ANTICIPATING CHANGES IN VOLATILITY

Systematic approach is based on Market-signals & Credit based Indicators

telegraphed to position for changes in volatility

Indicators are meant to filter out “Volatility of Volatility”

Persistence or Clustering determine whether to Buy or Write premium.

Is Volatility based on Gap moves, Speed of move, Swings within a range, a > 1-

Std Dev Trending move, or Anticipatory ie Gulf War, TARP vote etc?

Is it caused by the Equity market developments, or external Macro events in

Sovereigns, Mortgages, Currencies, Credit, Commodities, or Contagion?

The approach is somewhat agnostic about market direction & more

concerned about whether uncertainty is building or abating in expectations.


VOLATILITY ADJUSTS RAPIDLY, THEN CLUSTERS

0

14

468

731

548

726

604

576

701

511

334

232

171

107 94 70 6135 47

35 26 22 38 23 5 3 2 2 20

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500

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1000

8 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 60 70 80 90 100 125 151

# VIX CLOSES AT VARIOUS LEVELS(Since 1986)


KEY TOOLS & INDICATORS

YIELD CURVE INVERTED & PUSHED FORWARD 18 MONTHS – R.I.P.

VIX 1-MONTH/6-MONTH CROSSOVER OF 55-DAY MOVING AVG

VIX 5-DAY minus 200-DAY MOV. AVG. CROSSOVER MODEL

21-DAY EQUITY CALL-TO-PUT RATIO

NORMALIZED STOCK/BOND RATIO ON Z-SCORE SCALE

EUROYEN STRESS BAROMETER OF RE OR DELEVERAGING

SLOPE OF HYG/ TLT

2-YEAR DOLLAR SWAP RATES LEAD VIX CHANGES

2-YEAR SWAP SPREAD - HIGH YIELD (Baa) LEADS VOLATILITY


THIS PREDICTIVE INDICATOR IS NOW OBSOLETE – R.I.P.

It perfectly predicted a sharp rise in volatility into 2007-2008, which I

pointed out in 2006. With rates at zero, the Yield curve can never again

Invert, which had forecasted 7 or the past 7 recessions 1 year ahead.

YIELD CURVE SPREAD (BPS) VS EQUITY VOLATILITY (%)

(yield curve inverted & lagged 18 months)-200

-100

0

100

200

300

400

500

Sep-95 Feb-97 Jul-98 Dec-99 May-01 Nov-02 Apr-04 Sep-05 Oct-06

INVE

RTE

D C

UR

VE S

PREA

D

0

5

10

15

20

25

30

35

40

45

50

EQU

ITY

VOLA

TILI

TY (%

)


VIX CROSSOVER MODEL (1997-2010):

CROSSOVER ABOVE OR BELOW THE 55 DAY MA OF THE 1-MONTH minus 6-MONTH VIX MA

SIGNALS WHEN TO ADAPTIVELY OR HEDGES, OR BUY OR WRITE OPTION PREMIUM


VIX DEVIATION CROSSOVER MODEL (1997-2010):

High probability signal when to be a Net Buyer or Net Seller of Volatility.


21-DAY EQUITY CALL/PUT RATIO -

IS COMPLACENCY OR DESPAIR PRICED INTO EXPECTATIONS?

Market reversals, shocks & surprises occur when Expectations are positioned

at the opposite extreme. Few indicators anticipate this as effectively. At the

April peak, this indicator at a 10-year high, screamed Volatility reversal risk.

1.00

1.50

2.00

2.50

3.00

700800900

1000110012001300140015001600

F-05 A-05 F-06 A-06 F-07 A-07 F-08 A-08 F-09 A-09 F-10 A-10

S&P

S&P vs 21-day Equity Only Call-to-Put Ratio


NORMALIZED STOCK/BOND RATIO CHART

Prior to the LTCM Crisis in 1998, Bonds & Stocks were correlated since 1982.

During periods of Financial Asset Deflation, they move inversely. On a Z-Score

Scale, this Ratio signals Volatility extremes that predict a mean reversion


EUROYEN STRESS BAROMETER

Captures financial markets deleveraging or re-leveraging. Liquidation

due to deleveraging has a powerful impact on Volatility.


RELATIVE PERFORMANCE OF HIGH YIELD relative to TREASURIES


2 YEAR DOLLAR SWAP RATES LEAD VIX CHANGES


2-YEAR SWAP SPREADS LEAD HIGH YIELD CHANGES, WHICH IMPACT VOLATILITY


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Improving Portfolio Returns Through Risk Reduction Oct 2010 Long Version

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