How to Protect Yourself Against Tail Risk Events

How to Protect Yourself Against Tail Risk Events
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“The punch that you don’t see is the one that gets you” – Old boxing saying

Tail risk is the measure of risk caused by severe and infrequent “black swan” events such as the global financial crisis of 2007-2008 or the European debt crisis. The tail is a reference to the extreme left tail of a return distribution for an individual asset class or portfolio. Drawdowns for both individual asset classes and allegedly diversified portfolios are severe, in the high double digit range.

How to Protect Yourself Against Tail Risk Events

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Investment managers use several tools to curtail tail risk such as:

  1. Diversify portfolios with low or non correlated asset classes: For example, a manager may structure a portfolio with 40 percent stocks, 30 percent bonds, 10 percent real assets, 15 percent alternative assets, and 5 percent cash. The stocks will probably be diversified in US, developed and emerging markets and bonds will likely be a combination of investment grade and floating rate bonds. Real assets may be a basket of commodities such as oil and grains together with precious metals. Alternative assets may contain hedge funds and private vehicles, both with the flexibility to have long and short positions. During the global financial crisis of 2007-2008, correlations between assets skyrocketed and diversified portfolios did not protect values as expected. However, a diversified portfolio with alternative investments that included managed futures and properly placed short positions reduced the portfolio’s beta relative to equity markets, hence mitigating losses from tail risk better than a portfolio consisting only of stocks and bonds.
  2. Manage or profit from volatility:

a. Long volatility strategies:  VOLATILITYS&P500 (INDEXCBOE:VIX) futures and variance swaps can be used as a hedge for equity exposure. VIX1m holds a combination of futures contracts to maintain a constant time to maturity (e.g. 30 days). Variance swaps are designed to receive the actual variance after a certain period (30 days, 3 months, 6 months) and price is struck at the implied variance when entering the contracts. Long volatility strategies are profitable if market becomes more volatile due to a “black swan” event as stocks tend to go down during a spike in volatility

b. Options and Futures: These include buying put options, selling covered calls, or structuring a collar on the S&P 500 (INDEXSP:.INX), underlying stocks, interest rate futures, or currencies. Buying a put option on a stock allows the buyer to have the right to sell such stock at a predetermined price, even when the price of the stock drops in the market. Selling a covered call allows the seller to receive a premium for selling the right to buy her stock at a predetermined price. The premium serves to mitigate the losses on the stock shall it go down in value beyond the strike price of the call. A collar is a protective put combined with a covered call, which helps mitigate losses from a drop in value of the stock and also makes put protection cheaper as the premium of the short call can be used to pay for the put.

3. Negative Beta Investing: Strategies that provide negative beta relative to stock portfolios and that benefit from stock market return anomalies. For example, long-short equity funds with a short bias, perform well during equity market downturns provided positive performance of short positions. For example, Hussman Strategic Total Return Fund (HSTRX) provided a positive return of 6.34 percent in 2008 versus a negative 38.4 percent return for the S&P 500. In equity market uptrends, negative beta investing may present a drag in the portfolio.

The most effective tail risk strategy is the one that provides a minimal performance drag and high probability of protection. Diversifying investments with cash provides a high level of protection; however it comes with a significant performance drag.

The long volatility strategies rank low in probability of protection as actual variance received can differ significantly from expected variance.  Hedging with puts only proves to be overly expensive resulting in a significant performance drag, investors are better off using covered calls or collars. Negative beta investing fares best in both high probability of protection and performance drag.

Sources: “Quantitative: Cross-asset Volatility strategies – Society Generale April 2013” and “State Street Global Advisors: A Comparison of Tail Risk Protection Strategies: Performance Drag and the Certainty Measure 2012”

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