How to Hedge Against Tail Risk

Coverage of the 2012 Risk Management Conference.

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story_images_black swan_sizeMany investors remember 2008 as the year when diversification failed. The global financial crisis caused historical relationships between many asset classes to break down and correlations to rise, so that even carefully diversified portfolios suffered. Since then, recurring volatility has driven investors to seek strategies that provide better protection, particularly in periods of extreme market stress or “tail risk.”

The trouble with put options

One popular way of hedging tail risk is to purchase equity put options. These give the owner of the contract the right to sell at a specified price—effectively helping to put a floor under potential losses if stock prices fall significantly. A common approach is a “buy and hold” strategy with out- of-the-money put options. While the most intuitive way to hedge tail risk, the performance experience since the crisis has been suboptimal, compelling investors to ask, ”is there a better way?”

When investors own assets that carry a risk premium, such as emerging-market currencies or high-yield bonds, we think of them as being “short volatility”. This is because when volatility rises, they are likely to lose money. The goal is to identify investments and instruments that are highly price sensitive to rising volatility and can be used to balance these exposures.

The best results can be achieved by seeking hedging strategies across multiple asset classes, dynamically allocating funds across these opportunities in a way that seeks to minimize the cost of implementation. Examples of such strategies include equity put options, strategies on equity volatility, currencies, interest-rate through duration exposure and yield-curve strategies, credit and commodities. There are two main benefits of a multi-asset approach. First,  it offers better diversification. Second, it allows a portfolio manager to monetize profits from one strategy and asset class while being able to change to another strategy as valuations shift.

Managing the cost

The cost of tail risk can be managed by constructing strategies that allow investors to be “long volatility” in a very cost-efficient manner. One way to do this is to make an exchange, whereby one trades off (sells) insurance against higher-frequency/low-impact events in order to fund the purchase of insurance against the much more damaging lower-frequency/high-impact events. This opportunity presents itself in many different markets and could be compared to an automobile insurance premium with a high deductible. In insurance, the higher the deductible, the lower the annual premium charged by the insurance company. If you have a high deductible, you are willing to cover the costs of dents, scratches and other minor incidents (high frequency, low impact) in order to have a lower premium for collision and other major accidents (low frequency, high impact).

While portfolio diversification has served investors well under “normal” market conditions, it may fall short in periods of extreme market stress. The challenge is to protect against tail risk at times of crisis, while actively managing any negative carry costs associated with the protection. An effective tail-risk hedging strategy can help investors by buffering their portfolios when extreme events occur. In these markets, the best solution is an agile, active approach that dynamically allocates funds between strategies depending on current market pricing and prevailing conditions.

Joel J. McKoan is chief investment officer, absolute return strategies, AllianceBernstein.

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