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
650
700
750
800
850
900
950
1000
1050
1100
1150
1200
1250
1300
1350
1400
1450
1500
1550
1600
1650
S&PAFTER2007
SECULAR
BEARMARKET
BEGINS
NEWRULES
APPLY
S&PWEEKLY

THE WORLD AS WE KNEW IT
0
500
1,000
1,500
2,000
2,500
3,000
3,500
4,000
4,500
5,000
Distribution 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
200
Distribution 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
7.0
7.5
8.0
8.5
9.0
9.5
10.0
10.5
11.0
11.5
12.0
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 J un J ul Aug Sep Oc t N ov D ec 1998 Feb Mar Apr May J un J ul Aug Sep Oc t N ov D ec 1999 Feb Mar Apr May J un J ul Aug Sep Oc t N ov D ec 2000 Feb
21.0
21.5
22.0
22.5
23.0
23.5
24.0
24.5
25.0
25.5
26.0
26.5
27.0
27.5
28.0
28.5
29.0
29.5
30.0
30.5
31.0
31.5
32.0
32.5
33.0
33.5
34.0
34.5
35.0
35.5
36.0
36.5
37.0
37.5
38.0
38.5
39.0
BARRICK (ABX) 1997-99 DURING GOLD BEAR MARKETP
P
P
P
P
P
P
P
P
P
P
BA RR IC K 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
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
RIMM SETTLES INFRINGEMENT SUIT.
FOR BINARY EVENT, POSITIONED
IN OTM CALL-SPREAD THAT RETURNED
OVER 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
160
170
180
190
200
210
220
230
240
250
260
270
280
290
300
310
320
330
340
350
360
370
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
i
HEDGING 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
J une
12 19 26 3
J uly
10 17 24 31
Augus t
7
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
O
O
IRON CONDOR JUNE 2006 ON SPYDER S
* MA RK ET COR RECTED -7% & VOLATILITY R OSE +75% TO 21%
FR OM ONLY 12% 6 WEEKS EAR LIER - THE HIGHEST IN 2 YEA RS
* DETERMINE +/- 1-SIGMA = 21%*SQRT(39/252) = 8.2 P TS
* THER EFORE, SELL CALL & PUT SPREA DS A T 123+8 = 131 & 115
* SOLD 2 PTS PUT SP READ FOR $0.35 & CA LL SPREA D FOR $0.45 = $0.80 CREDIT
INITIA TE CONDOR
EXPIRATION
AT EXPIRY, CREDIT SPREADS EXPIRED AT $0
$0.80 / NET MARGIN ($2.00 - $0.80) = +67%
SP Y D ER S (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 61
35 47
35 26 22 38
23 5 3 2 2 2
0
100
200
300
400
500
600
700
800
900
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
INVERTEDCURVESPREAD
0
5
10
15
20
25
30
35
40
45
50
EQUITYVOLATILITY(%)

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
700
800
900
1000
1100
1200
1300
1400
1500
1600
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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