Skip to main content
PGIM Quantitative Solutions LogoPGIM Quantitative Solutions Logo
  • Learn About Us
    • Our Solutions
    • Our History
    • The Team
    • Diversity, Equity & Inclusion
    • Contact Us
    • Newsroom
  • All Insights
    • ESG
    • Market Views
    • OUTcomes Series
  • Sustainable Investing Overview
    • Insights
    • ESG Policy
    • Stewardship
  • Overview of Solutions
    • Quantitative Equity
    • Multi Asset
    • PGIM Wadhwani
  • Client Log In
  • Careers
Snow Skiing Man
Markets

Four Ways To Avoid The Pitfalls Of Down Markets And Abnormal Return DistributionsFourWaysToAvoidThePitfallsOfDownMarketsAndAbnormalReturnDistributions

Nov 2, 2021

10 mins

Share
  • Mail
  • LinkedIn
  • Twitter
  • Copy URL
Read more

Share

Institutional investors know that asset allocation decisions determine strategic portfolio risk and return profiles. But a major challenge in constructing and evaluating strategic portfolios lies in the fact that the return distributions of both the portfolios and their components are often not normally distributed. So what’s the best way to construct and evaluate those strategic allocations? Read on to learn about four key points to consider when thinking about how to protect portfolios during down markets:

1. Go beyond conventional measures of return and standard deviation to target multiple measures of risk simultaneously.

Investing in the markets is inherently uncertain, with many types of risk to think about when building strategic portfolios. Beyond the most common measures of risk, like standard deviation or variance, investors also face risk in terms of falling short of investment objectives, portfolio drawdowns (the fall of investments from a peak to a trough), and the tendency of riskier assets to drawdown together. Looking at multiple risk measures simultaneously, like historical and simulated future drawdowns and asset class correlations in different market environments, provides investors additional tools and metrics to manage unforeseen adverse market events and to meet investment objectives.

2. Look at past and simulated future drawdowns, higher moments of the return distribution, and conditional correlations in different investment environments to insulate portfolios against the risks of non-normal return distributions

To build long-horizon strategic portfolios to meet long-term funding requirements that incorporate risk beyond the conventional metrics of mean and variance, forward looking simulations provide a powerful tool for evaluating portfolio outcomes during both expansions and recessions to assess the probabilities of potential drawdowns of the major asset classes that comprise portfolios. These robust simulations look at periods of crisis that produce bigger drawdowns than would be found using only static average expected return and covariance forecasts. Furthermore, these types of simulations can show correlation patterns for different asset classes under those varying economic scenarios. For example, US equities typically have a moderate positive correlation with commodities during expansions, but this positive correlation becomes more pronounced during recessionary periods. Similarly, US equity correlation with US Aggregate bonds also turns positive during recessions, but is slightly negative in expansions.

3. Mitigate risk by adding tail-risk hedging assets, such as a defensive equity allocation

Because stock market volatility is higher than that of other investments and equity returns aren’t normally distributed, including a defensive equity allocation to help to manage higher risk can help keep returns within your target. A defensive equity allocation that uses long-dated S&P 500 call options together with US Treasury bonds, like PGIM Quantitative Solutions’ Market Participation Strategy (MPS), can allow upside participation when the US equity market advances, while reducing the downside risk when markets fall. The call options let investors participate in rising markets, while US Treasury bonds serve as a safe haven during turbulent markets by providing downside protection. Using a disciplined process to actively manage market exposure, volatility, and duration can help to insulate strategic portfolios during changing market environment. In fact, a defensive equity allocation can generate approximately 85% of the annualized return of US Large Cap Equities with considerably lower volatility and reduced drawdowns over the long term.

 

Past performance is not a guarantee or reliable indicator of future results. Based on composite returns from 1/1/1992 – 9/30/2021. Source: PGIM Quantitative Solutions, S&P Dow Jones Indices LLC.

4. Introduce forward-looking simulations based on historical characteristics of asset classes to generate a range of possible portfolio options to determine which outcomes meet or fall short of investment objectives.

We’ve explained how simulating expansionary or recessionary market environments is generally more effective in estimating potential asset class drawdowns than looking only at normally distributed asset class simulations in assessing those potential drawdowns. Although normally distributed expected risk-adjusted return, or Sharpe ratio, is easy to calculate and provides one of the best measures of portfolio efficacy, it doesn’t address the risks of non-normal asset class distributions found in most multi-asset portfolios. That’s why looking at multiple historical and simulated risk characteristics is beneficial in constructing strategic portfolios. By using forward-looking simulations, we can generate a range of possible portfolio outcomes that can help determine whether we’ll meet or fall short of investment objectives. By evaluating multiple risk metrics, analyzing historical outcomes, and using forward-looking simulations that realistically incorporate more than one type of market environment, investors can apply strategies to help mitigate unforeseen risks.

Read more
  • About Us

    • Overview
    • Our History
    • The Team
    • Inclusion & Diversity
    • Contact Us
    • Newsroom
    • Careers
  • Insights

    • All Insights
    • ESG
    • Market Views
    • OUTcomes Series
  • Sustainable Investing

    • Overview
    • Insights
    • ESG Policy
    • Stewardship and Governance
  • Solutions

    • Overview
    • Quantitative Equity
    • Multi Asset
    • PGIM Wadhwani
PGIM Quantitative Solutions Logo
  • Terms & Conditions
  • Privacy Center
  • Accessibility Help
  • Cookie Preference Center

For Professional Investors only. All investments involve risk, including the possible loss of capital.

PGIM Quantitative Solutions LLC (PGIM Quantitative Solutions or PGIM Quant), formerly known as QMA LLC, is an SEC-registered investment adviser and a wholly-owned subsidiary of PGIM, Inc. (PGIM) the principal asset management business of Prudential Financial, Inc. (PFI) of the United States of America. Registration with the SEC does not imply a certain level of skill or training. PFI of the United States is not affiliated in any manner with Prudential plc, which is headquartered in the United Kingdom or with Prudential Assurance Company, a subsidiary of M&G plc, incorporated in the United Kingdom.

The content and materials presented here are for informational and educational purposes only and should not be construed as investment advice or an offer or solicitation in respect of any products or services to any persons who are prohibited from receiving such information under the laws applicable to their place of citizenship, domicile or residence. 

In the United Kingdom, information is issued by PGIM Limited with registered office: Grand Buildings, 1-3 Strand, Trafalgar Square, London, WC2N 5HR. PGIM Limited is authorised and regulated by the Financial Conduct Authority (“FCA”) of the United Kingdom (Firm Reference Number 193418). In the European Economic Area (“EEA”), information is issued by PGIM Netherlands B.V. with registered office: Gustav Mahlerlaan 1212, 1081 LA  Amsterdam, The Netherlands. PGIM Netherlands B.V. is authorised by the Autoriteit Financiële Markten (“AFM”) in the Netherlands (Registration number 15003620) and operating on the basis of a European passport. In certain EEA countries, information is, where permitted, presented by PGIM Limited in reliance of provisions, exemptions or licenses available to PGIM Limited under temporary permission arrangements following the exit of the United Kingdom from the European Union. These materials are issued by PGIM Limited and/or PGIM Netherlands B.V. to persons who are professional clients as defined  under the rules of the FCA and/or to persons who are professional clients as defined in the relevant local implementation of Directive 2014/65/EU (MiFID II). PGIM Quantitative Solutions LLC, PGIM Limited and/or PGIM Netherlands B.V. are indirect, wholly-owned subsidiaries of PGIM, Inc. (“PGIM”).

In Canada, PGIM Quantitative Solutions LLC relies upon the “International Advisor Exemption” pursuant to National Instrument 31-103 in certain provinces of Canada.

In Australia, these materials are distributed by PGIM (Australia) Pty Ltd (“PGIM Australia”) for the general information of its “wholesale” customers (as defined in the Corporations Act 2001). PGIM Australia is a representative of PGIM Limited, which is exempt from the requirement to hold an Australian Financial Services License under the Australian Corporations Act 2001 in respect of financial services. PGIM Limited is exempt by virtue of its regulation by the Financial Conduct Authority (Reg: 193418) under the laws of the United Kingdom and the application of ASIC Class Order 03/1099. The laws of the United Kingdom differ from Australian laws. PGIM Limited’s registered office is Grand Buildings, 1-3 The Strand, Trafalgar Square, London, WC2N 5HR.

In Singapore, information is issued by PGIM (Singapore) Pte. Ltd. (“PGIM Singapore”), a regulated entity with the Monetary Authority of Singapore under a Capital Markets Services License to conduct fund management and an exempt financial adviser. This material is issued by PGIM Singapore for the general information of “institutional investors” pursuant to Section 304 of the Securities and Futures Act 2001 of Singapore (the “SFA”) and “accredited investors” and other relevant persons in accordance with the conditions specified in Section 305 of the SFA.

In Hong Kong, information is provided by PGIM (Hong Kong) Limited, a regulated entity with the Securities & Futures Commission in Hong Kong to professional investors as defined in Section 1 of Part 1 of Schedule 1 of the Securities and Futures Ordinance (Cap.571).

In Japan, the investment management capabilities and services described in the attached materials are offered by PGIM Japan Co., Ltd (PGIMJ), a Japanese registered investment adviser (Director-General of the Kanto Local Finance Bureau (FIBO) No. 392). Retention of PGIMJ for the actual provision of such investment advisory services may only be effected pursuant to the terms of an investment management contract executed directly between PGIMJ and the party desiring such services, It is anticipated that PGIMJ would delegate certain investment management services to its US-registered investment advisory affiliate.

In Korea, PGIM Quantitative Solutions LLC holds cross-border discretionary investment management and investment advisory licenses under the Korea Financial Investment Services and Capital Markets Act (“FSCMA”), and is registered in such capacities with the Financial Services Commission of Korea. These materials are intended solely for Qualified Professional Investors as defined under the FSCMA and should not be given or shown to any other persons.

PGIM, PGIM Quantitative Solutions logo and the Rock design are service marks of PFI and its related entities, registered in many jurisdictions worldwide.

© 2023 PGIM Quantitative Solutions. All Rights Reserved.
 

You are viewing this page in preview mode.

Edit Page