How to Manage Tail Risk

Winner of the 2011 AIMA Canada - Hillsdale Research Award.

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167304_roller_coasterThe recent financial crisis serves as a timely reminder of the substantial risk of investing in financial markets. It also highlights the limitations of conventional, asset allocation-based risk management strategies. The swift and relentless correction in equity, commodity and real estate markets was a clear example of why diversification, both geographically and across assets classes, is neither a sufficient nor reliable risk control mechanism. During crises, historical correlations between asset classes and their volatility characteristics tend to break down. Asset classes which have, in normal times, been uncorrelated, suddenly become correlated and alternative investments, which have been selected based on their ability to generate alpha without beta, suddenly appear to deliver high beta with little alpha. The phase-locking behavior that occurred during the most recent crisis, coupled with the jump in the level of market volatility, resulted in dramatic drawdowns for many investors and has put the spotlight on risk management.

In this paper we present a novel, cost-effective portfolio management approach that focuses on delivering returns that have a constant volatility and that do not unduly expose the investor to the risk of fat-tails.

Traditional tail-risk management techniques: portfolio insurance

For a tail risk hedge to be effective it should possess two important characteristics: the hedge must be negatively correlated to asset returns and exhibit convex behavior to the upside during periods of market stress. Typically, implementation of tail risk hedging has involved the use of equity put options. Unfortunately, the cost is often prohibitive and as a result the drag on the performance of the portfolio is significant So the question is how can investors protect their portfolios against large drawdowns without having to give up substantial upside? The answer lies in properly understanding and monitoring market volatility.

Re-thinking volatility: Black Swans vs. White Swans

Many researchers and quantitative strategists (including Black Swan enthusiast Nassim Taleb and his dedicated followers) have long advocated the importance of paying greater consideration to the tails of the distribution, calling attention to the fact that traditional risk management methods typically underestimate the frequency and/or severity of tail events. Although the normality assumption of asset returns certainly makes the mathematics a lot easier, it undeniably struggles to explain the empirical evidence.

Modern Portfolio Theory (MPT) has been the crux of the 60/40 strategic asset allocation paradigm, which many plan sponsors employ in one form or another. One of the key assumptions of MPT is that asset returns follow a normal distribution with constant volatility.  However if we examine Figure 1, which plots the levels of the S&P 500 index (blue line) and its implied volatility (red line) over the last 20 years, it clearly shows that volatility does not remain constant but in fact changes significantly over time. (Download the full paper here).

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