FT - Demand for extreme risk protection rises

By John Keefe
April 1, 2012

As military generals are always prepared to fight the last war, many investment managers and institutions are advancing on today’s markets with the weapons that proved most effective in the 2008 crisis: hedges against left-tail risk – the sudden and severe drops in markets which quickly spread across asset classes. A few farsighted fund managers were early in offering tail risk protection, and it is rapidly becoming part of the order of battle for hedge funds, investment managers, a few pension funds and investment banks. The increased interest, however, has made these doomsday defences very costly.

An environment of rising equities markets, reduced volatility, as well as the increasing distance from 2008, might have reduced investors’ preoccupation with unthinkable risks, but the cost of protecting a portfolio’s left flank remains very high.

“Downside risk protection is in general extremely expensive today,” says Antoine Seguad, head of equity derivatives structuring and strategy at BNP Paribas in New York.

“As we see it, the option market gives a 5 per cent probability that the S&P 500 would trade 60 per cent lower [the left tail] in one year’s time, and for Eurostoxx the 5 per cent probability is priced at a 70 per cent drop. These are very high.”

Other bankers and fund managers echo his views. “The cost of hedging the extreme left-tail risk in recent years has become expensive and remains so – mainly due to expensive long-dated volatility pricing, but it’s also difficult to get an effective tail risk by buying equity put options,” says Anthony Limbrick, portfolio manager and principal with 36 South Capital Advisors, London, which has delivered tail-risk protection for 10 years. “That’s the result of huge interest in these strategies.”

Volumes of put options have grown since 2008, but trading in volatility has expanded much more.

As interest in downside protection has increased, both from institutions and retail investors, pricing of left-tail hedge components also has been hurt by diminished willingness of dealers to provide liquidity, a result of tightening regulation on market-making, says Mark Spitznagel, president and chief investment officer at Universa Investments, tail risk specialists in Santa Monica, California. Black swan expert Nassim Taleb is the group’s distinguished scientific adviser; he and Mr Spitznagel have been successfully investing in several categories of extreme events for 15 years.

With costs elevated to such a degree, designers of tail-risk protection have moved to more efficient strategies.

At Société Générale in New York, head of global engineering Ramón Verástegui traces the evolution: “One way to hedge against a big shock is to sell an underlying that depreciates when the market is collapsing,” namely by buying puts on equities.

However, he adds that in backtests since 2006 a strategy of buying S&P 500 puts has systematically lost money due to inherent high cost, compounded by the need for reinforcement through rolling the options every few months.

“Another way is to take advantage of the contagion effect across asset classes, and buy volatility,” says Rebecca Cheong, head of advisory at Société Générale. This can be done with forward variance swaps on the S&P 500, or with listed options on the CBOE Volatility Index, or Vix, which draw on option pricing to estimate implied future equity volatility.

Ms Cheong says long volatility strategies have outperformed equity index put options in the long run because they tend to show higher leverage during tail events, and deliver positive results in a wider range of markets. In her view, the most effective tactic of all is buying call options on the Vix that are longer term, and have an exercise price well above the current market price (making them “out of the money”); these would be less expensive at the time of purchase, yet offer effective tail risk protection in the event of a spike in volatility.

Another tactic to reduce the cost of tail hedging is to stake out less ambitious protection.

“Protection against an extreme downside move is overpriced, but that means that more moderate downside moves – say, protection against a move between zero and 35 per cent – are more reasonable,” says Mr Seguad of BNP Paribas. The tactic involves a put “spread,” buying and selling two puts with different exercise prices, and while significantly lowering the cost of the hedge, he explains, “you would still participate in the first 30 per cent of a downside move”.

In view of the high cost and change in mindset that tail risk hedging calls for, the strength of investors’ philosophical arguments becomes more important.

“It’s not even so much a matter of pricing,” contends Jeff Geller, chief investment officer for the Americas in JPMorgan Asset Management’s Global Multi-Asset Group. “If you had conviction that the US stock market will sell off 20 per cent in the next six months, who cares if you pay 3.5 per cent for an out-of-the-money put, rather than 3 per cent? But you had better be right.” For long-term investors, he instead recommends risk mitigation through adjusting asset allocation.

Defending tail risk hedges, Mr Spitznagel of Universa says: “Where people get tail hedging wrong is in failing to consider the intertemporal opportunity costs, rather than just static hedging costs. It’s about having the equity exposure that people want, especially in overextended and overvalued markets like today’s, perhaps at a slight cost, while retaining the dry powder in the event of a crash for opportunistic buying – as if one were overweight in cash throughout.

He adds: “The actual probability of a crash starts to matter less – assuming one could even quantify such a thing.”

Copyright The Financial Times Limited 2012