“Better to prepare for events that don’t happen than unprepared for events that do.”
– Mohamed El-Erian
According to Nassim Taleb, philosopher and author of The Black Swan, we are living in a “fat tail” world where extreme events are common, while our ability to predict them is nil.
Tail events are very rare in a normal curve, but market tails are in fact “fatter” or more frequent, than many people realize.
A tail event is a low probability event which has massive consequences. In portfolio terms, it is defined as an event where stock markets are down between 30% and 50%. These events are responsible for significant wealth destruction, and so it’s vital that we as a fund but also you as an investor develop a realistic assessment of your investment portfolio’s true tail risk probabilities. Tail risk is almost always underestimated in frequency and severity.
Typical tail risk events, like the 9/11 attacks or the Japanese tsunami are classic examples. Others like the 1987 stock market crash, the spectacular collapse of Lehman Brothers or more recent the Covid-19 pandemic crash are slightly more predictable but can still have catastrophic consequences.
Our tail risk hedging strategy is designed to protect our portfolio against extremely rare events and to outperform in difficult market circumstances. More so our strategy is designed to act as an automatic stabilizer, providing us with a source of liquidity at a time
when many funds are locking assets in. Liquidity that will ensure the ability to profit from the massive dislocations arising from these events. In many respects our tail risk strategy should be considered as a form of risk management rather than a stand-alone strategy.
In the current environment of monetary distortion, overvaluation and economic uncertainty our tail risk strategy will protect our assets and will enhance our long term return profile.
Always having a tail risk hedge in place will allow us to stay in the game at any time. Not a luxury, a necessity. How many people own a house without insurance on the house?
How do we hedge this tail risk? Our instrument of choice are options on indices and volatility products and must contain the following characteristics:
- Negatively correlated to the portfolio we are hedging
- Asymmetry – we pay a small premium to make a large pay off
- Convexity – the larger the event the exponentially higher the pay-off
The price paid for the options are a strong determinator of its worthiness. Because it’s impossible (and so we don’t even try) to time the market cycle / tail risk event, the correct timing and allocation has everything to do with the level of volatility. The volatility cycle cannot predict the event but it gives us an idea of when the insurance is cheap and when it is expensive. Why? Because volatility is the biggest determinant of the price of an option. So the lower volatility becomes the cheaper the hedge becomes and vice versa.
For our tail risk strategy we always seek options with the largest asymmetry and convexity. At the right price, long dated out-of-the-money options (rare event options) have the greatest exposure to volatility and best characteristics in terms of convexity and asymmetry. The expected payoff depends greatly on at what level of implied (future) volatility we bought the options. Depending on where we are in the volatility cycle we either run a rolling short-dated strategy or a long dated strategy.
A successful tail hedging strategy depends more on implementation skill than devising a formula. Through our monthly allocation of 10 to 30 bps to our tail risk strategy we have a sufficient hedge in place without relying on a timing decision. The exact implementation entails real time assessment of our portfolio / market position and detailed evaluation of market complacency. In turn, this requires an experienced portfolio management team, a deep understanding of the macro-environment and a solid grasp of behavioral psychology. Assigning the right probabilities to the seemingly endless possibilities is at the heart of what we do every day.
Not only for us, but also for you as an investor, one of the most important and timeless issues, is how to protect your investment portfolio from these tail risks (severe weakness in the stock market). At the foundation of modern portfolio theory is the concept of diversification. Traditionally bonds have been the most favored choice as diversifier. However in the current environment of ultra-low interest rates, the risk profile of the traditional 60% equities and 40% bonds portfolio has undergone a fundamental change in the current environment.
With current low interest rates and the central banks’ explicit expectation that they remain low, bonds have definitely lost their attractiveness as an asset class.
Not only have bonds lost their income function, but even more importantly, they no longer offer protection in economic downturns. With interest rates at current levels, any price gains on bonds from this level would seem far from realistic.
Worse still, there is a real risk of bonds exacerbating equity losses, something especially likely if we enter an unexpected period of much higher and sustained inflation. With this in mind we think it’s sensible to explore other options for portfolio protection.
We often get the question – are tail risk hedges worth it? We think they are worth it when their presence in the portfolio improves the expected value of the portfolio over time. Simple as that. We use it as a portfolio stabilizer, as an insurance to stay in the game and as a source of liquidity to be able to profit from extreme dislocations. Although we can never provide 100% certainty, we can offer the next best thing – a high degree of confidence based on professional and rigorous analysis.
We remain at your disposal for more insights on this topic or any questions you might have.