Bailey McCann, Opalesque New York:

Over the course of this series, we have examined the history of tail-risk, including the strategies employed by various risk experts, funds, and fund of hedge funds, in order to protect investor wealth during a tail event. Now, we bring you the results of a survey in which we asked our readers to share their thoughts on tail-risk. Please note: the survey was entirely opt-in, and is not scientific. The results outlined below reflect only the opinions of those who responded.

We asked 13 questions on the various aspects of tail-risk. The first question asked how much of a premium investors were willing to pay for their tail-risk hedges. As noted in the introduction of this series, investors have paid anywhere from 50-200bps for tail-risk strategies, and prices can vary widely depending on when investors opt into a tail-risk strategy. Survey data also reflects this variance, 75% of respondents said they were willing to pay a premium of between 2-10%, while 25% said they would be unwilling to pay a premium to hedge tail-risk.

When asked what types of products investors would consider purchasing, the most popular products included - out-of-the-money puts, collars, and VIX products. 75% of respondents said they would prefer separate managed accounts for their tail-risk strategies and all respondents wanted a high degree of transparency.

100% of respondents said that the liquidity of the underlying investment was an extremely important consideration in their tail-risk product choices. 50% said that they wanted monthly liquidity, and 50% said they wanted daily liquidity. 100% of respondents said they planned to increase their allocations to tail-risk strategies.

We also asked investors how they perceive the current tail-risk environment and what they are doing to respond to current risk factors. 75% said that they see the European debt crisis as the tail-riskiest event in the market right now, while 25% said that tail-risk events by their nature are unknowable. More than half of those surveyed said that they are taking a proactive approach to portfolio management by rebalancing on a monthly basis in response to increases in risk factors.

For the final question we asked which books are currently undergoing stress tests. Half of respondents said they were currently using stress tests for their banking and trading books on a daily basis. No respondents said they were using stress testing for structured products.

Conclusions

Evolution is one of the key themes in this space. Many of the people I spoke with noted how managers and investors alike have changed their response to risk over time - moving from more generic market views into dynamically sized strategies that seek wealth preservation and cost efficiency. Not surprisingly, the slow recovery from the 2008 crisis has helped to keep tail-risk hedging front-of-mind for market participants. However, managers are quick to point out that they expect these conversations to become more challenging as soon as market conditions start to improve and investors once again feel comfortable with their investments.

Included below is a list of the firms that participated in the series and links to more information. We also welcome additional feedback in the comment section.

Bill Gross has cautioned that the “cult of equity is dying.” Now another heavy hitter in the markets, Nassim Taleb, is advising prospective investment managers to avoid the industry altogether.

Taleb, author of the 2007 book “The Black Swan” and a lecturer at New York University, has published a new paper titled “Why It is No Longer a Good Idea to Be in the Investment Industry.” Pure and simple: Professional investors have to be lucky to be successful, he says. Those who have gained some success within the industry will continue to thrive, but others looking to break in now will fail.

He says many of the best money managers earn their success based on “spurious performance” and these folks “rise to the top for no reasons other than mere luck, with subsequent rationalizations, analyses, explanations and attributions.”

Once they are at the top, though, they get the bulk of the allocations, creating a “winner-take-all effect” that causes distortions in the marketplace, he says.

“An operator starting today, no matter his skill level, ability to predict prices, will be outcompeted by the spurious tail,” Taleb says in his paper.

It’s the latest broadside fired at the industry. Pimco’s Gross recently pronounced investors should no longer expect consistent, annual returns from the stock market. Gross’s missive sparked a vigorous debate for the future of stocks, which have struggled to register consistent returns throughout the last 12 years.

Taleb takes it to another level.

For Taleb, he isn’t making a call one way or another on the future returns for the market. Instead, he’s saying young bucks looking to break into the industry should think twice and avoid it completely.

“If you are starting a career, move away from investment management and performance related lotteries as you will be competing with a swelling future spurious tail,” Taleb says. “Pick a less commoditized business or a niche where there is a small number of direct competitors.”

Bailey McCann, Opalesque New York

Last week we discussed how portfolio protection has evolved from initial theories of portfolio insurance to newer theories such as hedging left tail-risk and how to structure this type of hedge. This week we will continue our discussion of structure to include more controversial options such as derivatives, and volatility.

Structure, part 2

Left tail-risk is often discussed in terms of an equities focused portfolio, however, the potential for a tail event exists across investments – equities, credit, commodities and fixed income. Individual investors may opt to examine or "hedge out" those risks ahead of investment in a given fund or within their existing portfolio in order to effectively size a tail-risk hedge. Dynamic sizing is an important structural component of this type of hedge in order to realize maximum protection during a tail event and control cost before an event strikes.

Funds of hedge funds do this on a bigger scale by constructing portfolios made up of different funds and different risk profiles toward a broader set of investment objectives. In this case, they look at tail-risk at both the macro and micro level. "We have an integrated risk management program, on one hand its independent from the investment committee on the other hand it’s integrated into how we pick managers and their approach," explains Oleg Movchan, Director of Risk Management, at Attalus Capital. Attalus Capital is a Philadelphia-based investment and trading firm specializing in fund of hedge funds and active core equity and bond strategies.

When it comes to choosing managers, the firm will carefully examine the risk of a given fund at first on a standalone basis as part of the due diligence process and then more broadly against the other managers already in a given portfolio and its objectives. "For us, tail-risk hedging is a component of portfolio construction, we look at the entire probability distribution, we aren't looking at just downside equity risk. Our portfolios are exposed to different kinds of risk: equity, credit, commodities, fixed income," he says.

Managing the risk of individual managers against the broader portfolio is also important in order to avoid an unintended concentration of a given strategy, according to Movchan, a bias toward a certain strategy or style can create tail-risk and potentially undermine the performance of a portfolio. He cites the quant crisis of 2007, as an example of micro-level tail-risk. Avoiding unintended concentrations also ensures a better understanding of broader financial markets activity which can, in turn, give portfolio managers greater ability to take advantage of conditions such as the mispricing of risk.

Are puts the only option?

Movchan notes that he has seen an increase in the types of instruments available to hedge against tail-risk including - vanilla derivatives, credit swaptions, inflation protection, and volatility products, in addition to the more standard choice of buying out of the money puts. Indeed, the market for tail-risk products continues to grow as markets remain choppy; this growth has also ignited a debate among investors and managers about what really constitutes a tail-risk hedge. For Movchan, each of these instruments can have a place in tail-risk hedging depending on the type of risk an investor is trying to hedge against.

"We think there are products that deal with inflation protection for example, that have a place. If a portfolio is heavily weighted in fixed income, then out of the money puts on the S&P 500 are not necessarily going to help if there is a re-pricing of inflation expectations. You also have to decide if you're going handle this issue directly, or outsource it to a manager. Volatility instruments, vanilla derivatives have a place as tail-risk hedges."

Cost is also a factor, "we seek to identify the assets that are likely to move the most and give the best return on the price of the insurance in a "risk off" scenario, be it in equity markets, currencies or bonds. Our preference is to use out of the money put options, which give us large notional exposures at low cost. Of course price is very important and when the price of the insurance (the option premium) becomes expensive, we will construct the positions differently, perhaps by using option spreads, or trading in the money put options with stop losses," says Greg McEntyre, Director, Symphony Financial Partners, a Tokyo-based firm.

Symphony manages an Asian-macro fund, Sinfonietta, that focuses on tail-risk. The fund was established in June 2008 to invest Symphony principal capital outside the scope of its existing funds with tail-risk in mind. Symphony opened the fund to outside investors at the end of 2011. The fund seeks to generate alpha through investments in equities, equity indices, derivatives, fixed income and currencies. According to McEntyre, Symphony’s approach is designed to manage the exposure of long positions and take profits during market corrections.

As an Asia-based and Asia-focused firm, McEntyre also outlines regional considerations that can come into play in terms of how they approach tail-risk. "Asian markets tend to be very liquidity driven, so one needs to be focused on liquidity flows. For example, foreign investor flows, or domestic retail flows, can be a very large part of the markets in Hong Kong, Korea and India. Central Bank flows are currently having a large impact on the Australian dollar and Australian Bond markets," these factors, in addition to cost can impact what instruments the firm uses when constructing a tail-risk hedge.

This variable approach raises some flags for other managers."Using OTC derivatives is a completely nonsensical tail-hedge – when a real Black Swan hits, like in the fourth quarter of 2008, you need to be sure that your counterparty will be able to pay, a rather unlikely and irrational expectation as financial firms that are the counterparties are most at risk of failing," says Claude Bovet, Founder and Managing Director of Lionscrest Capital. He adds that taking on basis risk is not a wise trade-off to protect against tail-risk.

Volatility

The use of VIX-based instruments is often also included in tail-risk discussions. The VIX is a measure of the implied volatility of the prices of S&5 500 futures. When the 2008 crisis hit, the CBOE Volatility Index (the VIX) soared – up 126% over the S&P 500. Since then, the VIX has been getting the attention of investors looking for protection from tail events. VIX futures were first offered in 2004, but investing in the VIX didn’t really take off until 2009 when the first VIX exchange-traded products were added. Since then, average 30-day trading volume in VIX futures has increased significantly, making it a multi-billion dollar market.

One of the more common approaches is to be long volatility, however, this can be very expensive as the VIX tends to trend and can trend against a long-only position. VelocityShares, a US-based firm, offers Volatility products as part of its tail-risk solutions, including six volatility ETPs that have 2x leveraged long and inverse positions on the S&P 500 VIX short-term futures index and the S&P 500 VIX mid-term futures index. According to Will Lloyd, Managing Director at Velocity shares, the inverse positions are critical – "being both long and short the VIX gets you the convexity that you need to effectively hedge tail-risk without the costs associated with being just long volatility."

He notes that the severe contango, or upward-slope of the VIX futures market is what makes it so expensive to buy and hold long positions. Lloyd and other VelocityShares principals Nick Cherney and Geremy Kawaller, wrote a paper for IndexUniverse describing the consequences of this trend in detail. In it, they show that the VIX was in contango from mid-2009-July 2011. However, coupled with the use of daily resetting leveraged and inverse products which exhibit positive convexivity, (a concept discussed in part three) that cost can come down.

Lloyd also notes investors can get in and out quickly, "with futures you can liquidate pretty immediately, where as out-of-money put strategies often have 30, 60, or 90 day liquidation terms." However, he explains that the strategy needs to be more actively managed as exposures can vary based on the performance of the VIX futures index.

Ultimately, all men agree that buyers of tail-risk products need to go in with eyes wide open about the cost and structure of this type of hedge. Movchan says these products are likely to remain in the consciousness of investors over the near term as global economic growth stays relatively weak. "Longer term, the big concerns we have in portfolio solutions are dealing with potential imbalances that have been built into the system as a result of central bank intervention since 2008."

Bailey McCann, Opalesque New York

In our previous installment of this series, we examined how risk experts define tail risk and if certain tail events can be predicted. Now we will turn to how tail risk hedges are structured relative to the rest of the portfolio.

Evolution

Traditional portfolio construction typically had large clients at a 60/40 split between stocks and bonds. For institutional investors, this split also gave itself to being long-only, and operating on a "buy and hold" approach. With the rise of alternative investments, portfolio construction evolved to offer investors more options for their allocations including strategies that go both long and short, and offer access to a broader asset class mix.

Over this course of this evolution, the risk profile of a given portfolio has also changed often to reflect increased risk as a result of pursuing higher returns. In response to this, investors have seen the rise of a variety of risk mitigation measures, with some notable failures. Leland and Rubinstein’s portfolio insurance, which was designed to replicate the performance of a put option systematically, was one approach, and is now generally acknowledged to have exacerbated the 1987 crash.

Other, synthetic instruments, originally created for one purpose and then broadly utilized by people who handle them poorly, can have similar consequences. Take for example, the multi-billion dollar write-downs during the credit crisis resulting from collateralized debt obligations (CDOs), that were poorly constructed, underwritten and rated, yet used writ large by banks and hedge funds alike. CDOs are a type of asset-backed security (ABS) that have multiple tranches and are collateralized by debt obligations including loans. The poor use and misuse of these types of instruments can help precipitate tail events when used as broadly as these were, even though they are typically used because of their reputation to have low risk or act as a risk mitigator to the broader portfolio.

As such, left tail risk hedges have become more popular recently, as a means of protecting the portfolio from an event several standard deviations outside of its normal risk profile.

Some of the most well-known research on left tail risk hedges has been done by Dr. Nassim Taleb, who has authored several books explaining in detail the underpinnings of tail events and their impact. He is also a principal at Universa Investments LP an investment management firm that specializes in convex tail-hedging and tail-investing, ranging from hedging stock market crashes and inflation to macro and equity options strategies. Universa runs tail-hedging and tail-investing strategies for institutional investors, and manages the world’s first tail-protected ETFs launched in May 2012 and traded on the TSX via Horizons ETFs.

"Nassim Taleb is really the grandfather of the tail-hedging field. What he is doing in terms of work on tail risk and its influence on the financial industry is not unlike Markowitz’s impact on portfolio management back in the 1950’s, and in fact counterbalances the mistakes of Markowitz’s followers that created flawed models like Value at Risk," explains Claude Bovet, Founder and Managing Director of Lionscrest Capital, which acts as the conduit for institutional investors seeking to invest in Universa’s tail-hedging and tail-investing strategies through its own TailPro series of comingled funds.

Universa, is the dominant player in the tail risk space, managing approximately $6bn in assets and providing much of the research basis for understanding how to hedge these events. According to Bovet, following Lehman’s collapse in September 2008 (a Black Swan event) until the end of the year, the S&P 500 lost -30% whereas a tail-protected S&P 500 using Universa’s tail-hedging strategy would have been up +15%. The Universa strategy's stand-alone gain notionally was more than 130% for that period and on a cash basis using a typical funding rate of 5% was over +2,600%. The key driver of these returns is how the hedge is structured.

Structure

"If your objectives are to keep beta near zero, mute volatility, and catch the upside of your trades, you have to have a tail hedge plan in place to meet all three of those conditions," says Warren Wright, CIO of Diversified Global Asset Management (DGAM), a Canadian fund of hedge funds. DGAM implemented a proprietary, direct tail risk hedging strategy in 2007. According to the firm, when the 2008 crisis hit, their approach to left tail risk generated 600-800bps of positive return across all portfolios.

Left tail risk hedges are dependant on size and capturing convexivity. "Sizing a hedge in a portfolio is a function of the perceived level of market risk, the amount of risk embedded in the portfolio, the cost of hedges, and an investor’s utility or objective function," explains David Hay, Managing Director, DGAM. A significant tail event, is usually a minimum of 2 or 3 standard deviations outside of the normal risk profile, or a loss of 20% or more. Investors considering left tail risk hedges will then determine what they are willing to pay in premium now to keep the portfolio flat or cover that 20%.

Once the size is clear, buying convexity when it is cheap in order to achieve that size, is a way to keep costs low when putting on a tail risk hedge. Convexity is a measure of how sensitive the duration of a bond is to changes in interest rates. If the convexity and duration of a trading book is too high, so is the risk – effective hedges bring this down. This is especially important for institutional portfolios, like pension funds, which are mandated to generate low-risk returns.

The most common structure for a left tail risk hedge is to buy out-of-the-money put options, essentially taking a position contrary to the current upside. DGAM has also used synthetic credit instruments including equity market calls, super senior tranches, single name credit protection, and CMBX – a group of indexes made up of 25 tranches of commercial mortgage-backed securities (CMBS). "We use a range of instruments across all asset classes. We consider the cost of a hedge versus its potential upside while remaining cognizant of the basis risk between that instrument and our underlying portfolio," Hay says.

"At times we have held entirely credit based hedges, while at other times we have held exchange traded equity options. The relative cheapness of equity options, a reduction in counterparty risk and enhanced liquidity were key drivers of the decision to exit credit hedges in favor of equity hedges in the spring of 2008, as one example. The point of DGAM’s tail hedge is to capture the asymmetry between a well diversified portfolio of high Sharpe ratio assets and lower Sharpe ratio market factors."

According to Wright, tail risk hedges should be discretionary, and cannot be market timed, "acting on an ex-ante basis is critical." Both men note that making tail risk hedges discretionary is also tied to the need for dynamic hedge sizing, in order to remain ahead of changes in the market. Hay offers two examples of how this works for investors, "in August 2011, underlying fund managers were cutting back on risk so we pulled back on our hedges, generating material gains during that time.

We also often look at the steepness of the volatility curve, monitoring the shape of that curve and the price of VIX options against the shape of the curve, in some instances we have been paid to put on hedges."

Bovet notes that liquidity is also an important structural component, "tail-hedging strategies (particularly pooled funds) that require long lock-ups have extreme liquidity risks and cannot be relied upon when mitigating tail-risk."

In addition to these instruments, others including swaptions and volatility plays are controversially included in tail-risk plans. Next Monday, we will look at these structures, their risk, and whether they can realistically be included as a tail risk hedge.

Bailey McCann, Opalesque, New York

In our previous installment of this series, we laid out a basic introduction to tail-risk that outlined what it is, its most common variations, and discussed the debate around whether these events can be adequately hedged. In this installment, we will take a deeper view with two risk experts who say that investors should be employing tail-risk hedge strategies.

The Paradox

"Tail-risk funds are going to be popular until the markets improve again," says Damian Handzy, CEO of Investor Analytics, a US-based risk management firm.

Tail-risk is often simplified as an insurance policy against adverse market events, akin to a homeowners policy. On the surface this looks like an easy sell, however, the same people that can readily imagine various levels of home destruction often have a difficult time imagining portfolio destruction. This is especially true at the top of a market the precise point when investors should have a tail-risk plan in place. "Tail-risk protection is needed the most at the top of the market, but people start panic buying at the correction, when it's too late and too expensive," he says.

Part of the problem is that tail-risk strategies in of themselves arent especially cheap at any point. It is less expensive overall to take an out-of-the-money position at the top of a given market, but its not free. According to Richard (Jerry) Haworth, Co-Founder and CIO, of UK-based investment firm, 36 South Capital Advisors, investors need to examine the cost relative to the return.

"A tail event is a rare event so you should get paid multiples. If its likely to occur once every ten years and itll pay 10 times, then the pay off equals the probability and that makes sense. But, if it looks to happen every 10 years and only pays 3 times, thats very expensive, then it becomes tail insurance not a tail fund opportunity. It comes down to what the investor is willing to pay for both of those."

What color is your swan

In order to understand the probability of these events and their potential effect, investors and managers alike have to understand what tail events are and if they can be adequately predicted. "People have a hard time defining tail-risk, (we say a move greater than three standard deviations ), but they dont know what volatility to apply to get to that number, or how to implement an effective hedge. Ive seen some ridiculous strategies. Hedging for a ten percent move is not a tail event." Haworth explains.

"There are two types of tail events grey swans and black swans. Black swans are unknowable. Grey swans are knowable. What we see going back to 1987 is that about every five years you see a tail event '87, '94, '97, '98, '2000, '01, '08. So we try to be realistic in making those predictions. To Paulson, 2008 was not a black swan event. It was a grey swan event."

He defines a grey swan as having medium probability with medium impact. Whereas, black swans have a low probability and high impact when they occur. According to Haworth, a key realization that people need to make about portfolio management overall is that volatility and correlation are not constant. Once investors and mangers shift their perspective, they can begin to understand risk and tail-risk hedges more appropriately.

These distinctions are what separate tail-risk hedges from plays on volatility. "Some people interpret tail-risk as extreme volatility but they are fundamentally different. Volatility players use a combination of options and aren't always focused on extreme events," Handzy says. "Tail-risk hedges are focused solely on extreme price movements."

Understanding the nuances around tail-risk is important to constructing a strategy that will be an effective hedge without simply transferring risk or moving money to the sidelines.

Cash is not always king

"You need a bespoke tail-risk solution that looks at targeted securities. The idea of a generic tail-risk fund is tricky to me. Tail-risk hedges are typically buying deep out of the money puts, buying a lot of put options is a really expensive proposition, if you're just doing it without a plan as a big hedge," Handzy says.

According to Haworth, if a tail-risk strategy is going to be effective, it should be at least a 5 year plan, that buys convexivity when its cheap and has the full backing of the investment committee. Poorly constructed tail-risk hedges without a long-term plan can simply transfer the risk. "Writing calls to buy puts is a bad tail-risk hedge, all you are doing is swapping the risk of one tail for another, if say, there was a significant increase in inflation," Haworth says. Both men agree that investors cannot simply diversify their way out of tail-risk. Handzy notes that during the 2008 crisis all correlations went to 1, making diversification irrelevant.

Some investors and managers argue that a significant cash position is another way to approach tail-risk. However, both men note that while going to cash does effectively remove the risk, it can create its own set of complications. Cash makes investors heavily dependent on timing in terms of when to get back into the market, it can also expand the length of time it takes for them to recover losses. While having an effective tail-risk hedge in place would have paid out when the rest of the portfolio was going down.

"Just going to cash is not really a viable hedge against a tail event. Youre just taking all the risk off the table, and youre saying deflation is on the horizon. If it goes to inflation theres not a light at the end of the tunnel there, youre looking at an oncoming train," Haworth says.

Bailey McCann, Opalesque New York

Conversations surrounding tail-risk started gaining more frequency with both investors and funds starting with the collapse of Long Term Capital Management as a result of the 1998 Russian debt default crisis. Since then, rolling crises from the 2007 "quant" crisis, to the 2008 global financial meltdown and most recently Grexit have made tail-risk hedging a hot topic. New funds, books, papers, and summits are springing up throughout the financial universe discussing tail-risk, whether it can be effectively hedged and how investors can fund the experiment. In this series, Opalesque will examine some of the more common tail-risk hedges, the funds in this space and what investors can expect.

The 10,000 foot view

Tail-risk strategies are essentially designed to perform well in the worst of market conditions. They act as insurance policies, requiring investors to pay in to a losing strategy until something bad happens. Tail-risk hedges are said to be most effective in environments where market participants see declines of at least 20%, providing much needed liquidity while the rest of their portfolio is spiraling toward the bottom. These declines are commonly known as fat-tails or black swan events. The individual strategies themselves are derived from calculating the probability of such events.

Tail-risk hedges are gaining more attention from institutional investors like public pension funds which have a mandate to provide a certain level of return and have been on more or less shaky ground since 2008. Tail-risk hedges can however, act like a double edged sword for this type of investor as they lose money until a fat-tail event happens, thereby making it seem as though the fund just allocated into a strategy doing the exact thing it seeks to avoid.

Tail-risk hedging can take a variety of forms most of which require fairly technical understanding of investing, but, in essence an investor or fund will take a contrarian macro position. One of the more popular forms of this is buying long-term "put" options. Put options give a fund the right to sell an underlying stock or security on the expectation of a drop in price. Long-term put options are typically available in smaller quantities and become more expensive as volatility increases. Other variations on this theme include variance swaps a derivative that bets on the magnitude of volatility.

The CBOE Volatility Index (The VIX), also known as, "the fear index," is a measure of the implied volatility of S&P 500 index options. The VIX, as an index, also serves as the basis for several Exchange Traded Products (ETPs) which track its performance. As a result, many products which track the VIX often get lumped into tail-risk hedges – this is where things get murky for investors and some managers trying to understand tail-risk.

The debate

Some financial observers have said that you can’t actually hedge tail risk, because black swan events are by their very nature meant to be unpredictable. Felix Salmon at Reuters wrote a piece on this last year, noting that conceptually tail-risk hedges are offering probability based bets on events which by their nature are improbable.

More recently, investors have also started to voice concerns that managers themselves are too unclear on the difference between managing tail-risk and betting on volatility. In a piece on endowment involvement in tail-risk funds, in Pensions & Investments, Christine Williamson writes that investors can expect to see an expense of between 50-200 basis points per-year for tail-risk strategies, which may really be a tail-risk/volatility bundle.

Critics of tail-risk strategies argue that investors would be better served to diversify through more cost effective means. In a paper entitled, "Chasing Your Own Tail (Risk)," AQR Capital Management urges investors to look more closely at uncorrelated alternatives and low-beta equities, rather than allocating to tail-risk hedges.

However, in a different paper, "Tail Risk and Hedge Fund Returns," co-written in March of this year, by Professor Bryan Kelly, at the University of Chicago, and Professor Hao Jing, at Erasmus University, they argue that investors must better distinguish between the skill of hedge fund managers and their propensity to take on extra risk. They note that many of the high returns generated by funds are precisely because they are much more tail-risky, especially capital-seeking early stage managers.

They write, "We have shown that hedge funds exhibit persistent exposures to extreme downside risk. For instance, the very same hedge funds that underperformed in the 1998 crisis suffered predictably lower returns during the 2007-2008 crisis…we find that tail risk is an important determinant of the time-series and cross-section variation of hedge fund returns." According to the authors, the data presented is, "consistent with the notion that a significant component of hedge fund returns can be viewed as compensation for providing insurance against tail risk."

Despite concerns, assets keep flowing into tail-risk funds. JP Morgan Chase & Co’s global asset allocation group shows that assets in tail-risk hedge funds were approximately $38bn in April 2011. Bloomberg reports that volatility funds are also pulling in assets at a solid rate. Recent, periodic drops in the VIX have so far had little effect on inflows into tail-risk strategies and as Opalesque has reported recently, new funds and ETFs have been launched within the first half of this year.

This debate will be the basis for the rest of the series in which we will examine the structures of these investments and their effectiveness.

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

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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