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Tail-risk hedging (TRH) strategies profit from significant market corrections. They may be used alongside or to replace traditional risk management strategies (e.g., diversification via asset allocation) where the core portfolios have a significant allocation to equities or other volatile assets. They may also be used on a standalone basis to profit from market corrections (think The Big Short). I briefly discuss various applications at the end of this article.

Before delving into the details of TRH strategies, I will first discuss the traditional approach to managing risk within investment portfolios. I will then explain some of the problems associated with the ill-fated strategy of market timing.

The TRH strategies discussed here are based on the equity and equity derivatives markets. However, I also make a comparison to some of the speculative credit derivative strategies used to profit from the collapse of the housing bubble approximately 10 years ago.

Diversification via asset allocation

The conventional approach to managing portfolio risk involves diversifying investments amongst various asset classes. If the assets are not correlated, this will mitigate the impact from a significant decline in any one asset class. However, it will dilute the upside potential of higher growth asset classes.

For example, consider a standard portfolio comprised of just stocks and bonds. Stocks have historically outperformed bonds by a significant amount over longer time periods. So the performance of portfolios with larger allocations to bonds has tended to lag those with smaller or no bond allocations. Indeed, when looking at rolling 10-year windows since the start of the Great Depression, stocks outperformed bonds 84% of the time. Moreover, the windows when stocks lagged bonds for a decade or more were clearly clustered around periods where stocks started with extremely high valuations (like now). I discussed the drivers behind these historical trends in more detail in my Asset Allocation article.

Figure 2: 10-year rolling returns

Tail-Risk Hedges

Source: Standard and Poor’s, Federal Reserve Board

Many investors (professional and retail) implement diversification via fixed asset allocations through time. That is, they maintain their percentage allocations to various asset classes via periodic rebalancing. This approach is fairly standard within the investment management industry. However, this fixed asset allocation approach is better characterized by risk avoidance than risk management. Indeed, it systematically reduces stock exposures.

This leads to the challenge of how to manage equity risk without simply reducing or avoiding it. One answer is to insure the portfolio against market losses via put options. I discuss this and other strategies in the TRH section, but the bottom line is that put options are very expensive and result in a net-negative result over the long term. Another option is to step out of equity market at time when risks are high. This is known as market timing and it is the focus of the following section.

By Aaron Brask, read the full article here.