Should I hold a trend-following program or hedge with out-of-the-money put options? It is an old question but a critical one for any investor currently worried about downside risk in today's markets. Over the last ten years, trend-follower have used the term "crisis alpha" as their catch phrase for tail risk protections, yet many investors have been disappointed with the concept. Nevertheless, when compared with using puts, trend-following has shown to be a better way of gaining tail risk protection.
Many have preached the theoretical benefit of trend-following over puts; however, this potential advantage is an empirical issue. When the numbers are compared over a long period, the value of holding a trend-following portfolio based on return surpasses anything constructed as a put strategy. First, it is a better long-term investment. Second, it still does well during equity drawdowns and the worst equity return months. (See the new paper, "Tail Risk Hedging: Contrasting Put and Trend Strategies" from the researchers at AQR)
There may still be skeptics about the benefit of trend-following over a put strategy so it is valuable to review the reasons for why trend-following will work, and puts will not. It may seem natural that holding puts on an equity index would be the perfect tail hedge, but that view misses the point that any strategy has both benefits and costs.
There is a strong difference between the base strategy between buying puts and buying a trend program. A put buying program is explicit insurance and solely concerned with return protection. Trend-following is implicit insurance that is still foremost focused with return generation. Buying puts generates a negative risk premium associated with insurance. Trend-following may a negative risk premium given it will do well during down markets, but also has a positive premium associated with risk-taking from exploiting trends. Puts are expected to do well only when there are adverse market conditions when the insurance is needed.
A put buying strategy is not like normal insurance whereby you pay a premium for downside protection against a rising equity index value. Investors buy a put that has a strike, an expiration date, and is valued based on expected volatility. There is protection at a certain strike that will last until expiration if it is not rolled and is priced based on market volatility. At expiration, the option will have no value at prices above the strike. All the premium will be paid except against an adverse move, and insurance costs will increase with higher volatility, all else equal.
A put strategy has to be managed and the put only offers protection based on market conditions. It may do better if there is a sharp surprise decline but will offer only limited protection for a slow trend lower. Managing a strategy of buying puts with different maturities and strikes out-of-the-money will create different pay-offs but will still produce a negative risk premium. Gains are only achieved under special tail conditions.
A trend-following strategy is a correlation hedge. The amount of protection will be related to the type of down trend faced. Hence, it is not clear the level of protection received. Past history can tell investors the likelihood of gains from a hedge but there are no guarantees.
There is a major benefit with trend-following that is not available from a put strategy - positive convexity. A trend-following program may do well if there is a market downturn, but it will also do well if there is a long-term trend higher with equity indices, albeit the correlation with equity indices will be related to the amount of risk held in the equity index and other markets.
Forget language like crisis alpha and just focus on the key feature of convexity from trend-following. By definition, a trend-following program will hold long (short) positions in up (down) equity indices which will support tail risk hedges. The correlation between a trend-following program and equity downside is variable, which is its main tail hedge risk. However, the odds suggest that hedge protection is highly likely from trend-following with the added benefit of potential return upside instead of a guaranteed return drag from put insurance.
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