Real Returns by Dan Mikulskis

Tail risk hedging seems to be a popular topic at the moment, why?

Markets are at highs, but plenty of risks remain. While equity markets have rallied considerably in recent years – The equity market (as measured by the MSCI World Index) is up over 30% since Mario Draghi proclaimed the ECB had “removed tail risk for Europe” in September 2012  –  with only short periods of losses (relative to history) and low levels of volatility, there are plenty of macro risks out there that could threaten stability. But at the same time there are diminishing opportunities out there in other asset classes (notably credit). Investors don’t see many alternatives to equities but worry about what big falls could do to their portfolio.

So what risks are people protecting against, and what is the best way of doing it?

There are many definitions of tail risk, but I prefer one that relates it back to the objectives of the pension scheme or other investor. For example, if our objective is to produce returns of (say) 4% above inflation over the long term (defined, lets say by rolling 5 year periods) then suffering a negative asset return of -15% makes that objective pretty hard to achieve. In fact returns would have to be well over 7% p.a. above inflation for the rest of the 5 years to get close to the target. Even pushing the objective out to 10 years still makes it seem tough to achieve (returns would have to be around 6% p.a. over that period to make up for the capital loss, and achieve close to the objective).

I see many, many assets cited as tail risk hedges. Everything from bonds, commodities, options, the VIX and CTA strategies to name a few. But what really works?

I think really there are 3 layers of portfolio risk management as shown below, and we can group possible candidates for tail risk hedging into one of the categories.

1. Diversification

2. Risk Control

3. Downside Protection

A portfolio consisting of a single asset class is likely to have a relatively low sharpe ratio (a measure of the risk adjusted return. Meaning it may well generate returns, but the path to generating them is likely to be rocky. Combining several different assets gives us an improved portfolio through diversification (as long as the new assets are genuinely different risk factors or risk premia). This portfolio might well give the same return but the path will be smoother. Adding Risk Control (strategies that can curb exposure to assets at times of greater risk) is a further layer that improves the sharpe ratio of a portfolio.

It is important to note that steps 1 and 2 alone will improve the likely expected losses or drawdowns of a portfolio over a given period of time, however, neither are a tail risk hedge. They won’t protect the portfolio in all scenarios, there are still situations where all assets can fall at the same time.

The final layer of risk management is downside protection. This can be achieved by direct hedges using options on the assets in the portfolio. If the underlying portfolio uses risk control to curb exposures at times of maximum risk, then the cost of these option will be minimized as there is less likelihood of a large payout. This is important as almost all tail hedging strategies are expected to create a negative drag on returns through time. Sometimes they will generate a large payoff, but often the “insurance” will expire with no value and be seen as a negative drag on returns. The key is making sure that the drag on returns is not too high that the return of the overall investment strategy becomes unattractive.

we recently did work to review the Diversified Growth Fund (“DGF”) market. We met with 15 managers who generally have a brief to generate returns over cash of 3-5%, aiming for a volatility of 10%. Many of these managers are household names and between them they manage around £100bn of assets. Almost all of these managers employ the first two layers of risk management – investing across risk factors and controlling risk – in order to generate their returns at a lower level of risk than equities by themselves. Additionally, 13 out of 15 of these managers were using some form of tail risk hedging in their portfolios including:

– Rolling put option protection

– Rolling collar strategy on a low volatility index

– using call options to minimize downside

– Trading volatility using variance swaps or the VIX index

For a more detailed look at some of these strategies please see this paper that I co-wrote earlier this year on the subject

Three conclusions about tail risk hedging

Relating back to objectives is vital. Effective tail risk hedging programs take the objectives of the pension scheme or investor into account – assessing what sort of crash would call into question the investment objective, and putting in place a strategy to hedge this.

Diversification and risk control are important building blocks to building a portfolio that can generate higher returns at a lower level of risk than a single asset class, but neither by themselves are a tail risk hedge. This can be provided by direct hedges using options.

What does it cost? There is usually some give-up in expected return associated with a tail risk hedging strategy (akin to buying insurance) and while it isn’t easy to get a handle on this, its an important basis for evaluating the strategies.

For more detail on all of the above points do please see this presentation.