What is Tail Risk?
“Tails” refer to the two ends of a probability distribution with ‘left tail events’ describing the most negative outcomes — such as severe, widespread market shocks — and ‘right tails’ the most positive ones. Tail risk refers to left tail events, the negative events that generate large losses that can be seen in the left tail of the probability distribution. Tail events are rare but nonetheless more common than what is described by a ‘normal’ Gaussian bell curve. In fact, it turns out tails are in fact “fatter” (non-Gaussian), or more frequent, than many people realize.
The first chart is a diagram of a normal probability distribution. This distribution describes the returns on the horizontal X-axis (marked in units of standard deviation) from the lowest on the left to the highest on the right and with the mean (average) return in the middle, and the numbers of observations on the vertical Y-axis (for instance, the number of months that produce a +5% gain, the number of months that produce a -5% loss, and so on). In a normal distribution, the largest number of observations centers around the mean and declines to the right and left as there are typically fewer observations of extreme returns (for instance -30%) thus giving it a bell shape. Units of standard deviation (‘Sigma’ noted by the symbol δ in the diagram) provide a measurement of the expected frequency of the returns. In a normal distribution, returns that are generated within one sigma of the mean are predicted to happen 68.5% of the time. Fat tails exist because extreme events are far more prevalent than is explained by the normal distribution.
These fat tails can be empirically verified (see table on left using data going back 50 years). What is readily apparent from these analyses is that not only are tail events far more frequent than what is generally believed and financial theory predicts, but they are also far greater in magnitude and thus more consequential. Following the 2008 global financial collapse, a crisis that was completely unexpected by most and which had devastating consequences not unlike the Great Depression, we are once again reminded that tail risk is very real and very serious.
Only a few people were aware of this risk before the crisis; and fewer still were as vocal as Nassim Taleb, the premier specialist of rare events. Taleb described these risks as “Black Swans”.
(Source: Welton Investment Corporation)
Only a few people were aware of this risk before the crisis; and fewer still were as vocal as Nassim Taleb, the premier specialist of rare events. Taleb described these risks as “Black Swans”.
(Source: Welton Investment Corporation)
Nassim Taleb (New York Times, April 2007): “What we call here a Black Swan (and capitalize it) is an event with the following three attributes. First, it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility. Second, it carries an extreme impact. Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable. I stop and summarize the triplet: rarity, extreme impact, and retrospective (though not prospective) predictability.
How often do these Black Swans occur? Aren’t they supposedly rare?
In finance, these negative, consequential Black Swan events happen more often than one might expect; the 1987 stock market crash, the 1990 US and Japanese real estate collapse, the 1998 Russian default and LTCM collapse, the collapse of the 2000 tech market bubble, the collapse of the 2007 real estate bubble, the 2008 stock market crash, the 2010-2011 European and US debt crisis are all examples of crises that were ‘obvious’ in hindsight but surprising during their occurrence.
Why is it important to manage tail risk and thus protect against Black Swans?
The events of 2008 are now widely understood to have been a severe Black Swan event. Protecting against these catastrophic events is not only possible, but highly effective. The chart below shows the returns provided by Universa and its Black Swan Protection Protocol, a dedicated tail protection strategy that is available to accredited investors via the Lionscrest TailPro - US Equity Fund.
How is protecting against ‘Black Swans’ different than managing ‘normal’ volatility?
Volatility (returns within +/- 1 standard deviation) can often be reduced using traditional diversification techniques (diversification by asset class, geography, industry, cap size, currency, duration etc). Black Swans, however, behave differently. The speed and severity of unexpected market declines – like the world witnessed in 2008 – are exacerbated by the interconnectedness of global financial markets and economies. As a result, correlations amongst asset classes can quickly rise to 1.0, often rendering these diversification techniques virtually useless.
Most investors have had to rely on imprecise and often ineffective hedges. These types of defensive strategies (in addition to the use of simple diversification) are widely available and commonly used by investors:
There are pros and cons to each of these strategies, of course, but none provide reliable defense against Black Swans. The protection benefit of the first three strategies results from a correct prediction of the market’s downward direction. If the prediction is incorrect, however, and the market moves up, either losses mount (due to the short exposure), or the benefits of a rising market are missed (cash and defensive stocks). A similar risk applies to being outright long volatility via VIX ETFs. These are market timing risks.
With respect to swaps, there is a cost to bear for purchasing the protection. If the market rises, gains are net of this cost. But in a true panic - as we experienced during the second part of 2008 (the Black Swan impact one is attempting to hedge against) - the counterparty to the swap may no longer be able to payout gains, effectively wiping out the usefulness of the swap. This is not an insignificant risk; one need only remember AIG. Gold, although a very popular hedge, is not at all effective as tail protection. Typically, in a crisis event, investors are desperate to raise cash to cover their losses and margin calls and thus sell anything liquid and profitable. In 2008, gold dropped by some 30%.
Most investors have had to rely on imprecise and often ineffective hedges. These types of defensive strategies (in addition to the use of simple diversification) are widely available and commonly used by investors:
- Raising cash
- Moving into defensive stocks
- Reducing market exposure through short exposure (e.g. short S&P500 ETF)
- Long volatility (e.g. VIX ETFs)
- Investing in some sort of defensive swap (e.g. CDS, Total-Return Swaps)
- Investing in gold
There are pros and cons to each of these strategies, of course, but none provide reliable defense against Black Swans. The protection benefit of the first three strategies results from a correct prediction of the market’s downward direction. If the prediction is incorrect, however, and the market moves up, either losses mount (due to the short exposure), or the benefits of a rising market are missed (cash and defensive stocks). A similar risk applies to being outright long volatility via VIX ETFs. These are market timing risks.
With respect to swaps, there is a cost to bear for purchasing the protection. If the market rises, gains are net of this cost. But in a true panic - as we experienced during the second part of 2008 (the Black Swan impact one is attempting to hedge against) - the counterparty to the swap may no longer be able to payout gains, effectively wiping out the usefulness of the swap. This is not an insignificant risk; one need only remember AIG. Gold, although a very popular hedge, is not at all effective as tail protection. Typically, in a crisis event, investors are desperate to raise cash to cover their losses and margin calls and thus sell anything liquid and profitable. In 2008, gold dropped by some 30%.
How does one protect against Black Swans, then?
There are few methods as effective as a dedicated options strategy, particularly through the use of puts. But there are limitations to employing this strategy successfully:
- Long option strategies where premiums are paid can be very expensive, especially if maintained over an extended period of time.
- The unexpected nature of Black Swans requires that protection is never allowed to lapse, lest the risk of being caught unprotected during the crisis increases. An active, ‘always on’ option strategy requires effort, diligence and expertise.
- Option market bid-offer pricing for deep out-of-the-money (OTM) puts is extremely wide, typically about 500%. Being able to trade at favorable prices can mean the difference between being able to efficiently implement the strategy or being completely priced out.
- True options expertise and experience is difficult to access.