Pensions & Investments | Tail-risk hedging strategies are gaining traction particularly with endowment CIOs

Tail-risk hedging strategies are gaining traction particularly with endowment CIOs
By: Christine Williamson
Published: April 2, 2012

Michael Edleson said a 20% drop would cause his school ‘too much pain.'

More than three years after catastrophic market declines of nearly 40% decimated institutional portfolios, investors increasingly are adding tail-risk hedging strategies to protect against future unexpected, severe market declines.
Tail-risk strategies are designed to perform well in the worst market conditions - declines of at least 20% commonly known as fat-tail losses - providing cash to the investor when most other investments are hemorrhaging, but generally underperforming in strong markets or less-severe market declines.
‘People's memories of the pain of the sharp market declines of 2008 are fading, and most investors still have not dealt with tail-risk strategies head-on,’ said Tony Werley, managing director and chief portfolio strategist of the endowments and foundations group at J.P. Morgan Asset Management, New York.
Among those that have addressed the issue are the University of Chicago's $6.3 billion endowment fund and the $6.6 billion Tennessee Valley Authority Retirement System.
Other investors are in the early stages of considering tail-risk hedging approaches.
The investment committee/investment advisory group of the Regents of the University of California, Oakland, for example, recently discussed a 2% allocation from the university's $3.6 billion Total Return Investment Pool, but tabled a decision on the proposal by Marie N. Berggren, treasurer and chief investment officer. Dianne Klein, a spokeswoman for the board of regents, said regents are in an educational phase regarding tail-risk hedge fund investments. (The university also has a $6.3 billion General Endowment Pool and an $8.1 billion Short-Term Investment Pool.)
Because of the expense, which ranges from an estimated 50 to 200 basis points per year, tail-risk hedging strategies only ‘make sense if you anticipate declines of 20% or more. You should not be spending the money for insurance against smaller declines,’ J.P. Morgan's Mr. Werley said.
The real issue, Mr. Werley said, is an assessment of ‘the organizational impacts of a large drawdown. If a big decline ... will be very disruptive to the institution, then implementing a tail-risk strategy may make sense, even if you aren't seeing those managers adding to the investment returns of the portfolio during better markets.’
For the University of Chicago, the disruption of a 20% or greater market decline will cause ‘too much pain,’ said Michael Edleson, chief risk officer.
‘The endowment has to provide the university with an annual payout of 5.5% over inflation in a good year or a bad year. The amount of risk a university can take depends on the amount of the loss. A market loss of 10% would not hurt too much, but moderate to large losses of 20% or 40% would be very difficult, making the university extremely brittle in the face of the next market loss,’ he added.
A yearlong review by the endowment's investment committee resulted in a new risk-factor-based asset allocation that includes a 2% allocation to volatility strategies, focused on mitigating the impact of fat-tail losses of more than 20%.
In December, endowment officials allocated the $125 million to three active long volatility specialist hedge funds, which Mr. Edleson declined to name.
In a market decline of 40%, when the typical endowment is down 25%, Mr. Edleson said the tail-risk hedge should reduce the endowment's decline to 19% or 20% and the $300 million or so of cash generated by the positive returns of the volatility hedge funds should be enough to meet university expenses and to invest in distressed opportunities that arise in the midst of the market downturn.
‘This is all the protection we can afford, but it should work to cover enough of the negative stream to sufficiently protect the endowment, although obviously we still will lose a lot of money,’ Mr. Edleson said.
Interest in tail-risk hedging like that of the University of Chicago's investment office staff began after the Black Swan swoon of 2008 caused astonishing losses in institutional investment portfolios as equity indexes dove that year ‘a 36.94% drop for the Standard & Poor's 500, 37.25% fall for the Russell 3000 and 41.74% plunge for the Morgan Stanley Capital International All Country World.
Hedge fund management firms that used tail-risk strategies to successfully protect their own multi-strategy hedge funds from the worst of the 2008 drawdown were asked by institutional clients to offer that strategy as stand-alone funds.
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