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Tail-Risk Hedging

Deciding whether to insure multi-asset portfolios against extreme events may not be as simple as you think, says Nick Samouilhan, multi-asset manager at Aviva Investors. 


 

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The huge losses incurred by many portfolios in 2007 and 2008, in the wake of the impact on markets of the financial crisis, called into question the broad range of portfolio management techniques used by fund managers. The losses suffered by many multi-asset funds during that period raised further questions and a hunt for what could be learnt to prevent a repeat performance.

 

Tail Risks

The experiences of 2007 and 2008 prompted many fund managers to question whether portfolios should have an explicit process to guard, or hedge, against extreme yet very unlikely negative scenarios. These events are known as “tail risks”, as the chance of the risks occurring is at the extremity (tail) of the distribution of possible outcomes. A more colourful term for tail risk is “black swan events”, in that nobody thought swans could be black until black swans were discovered.

 Tail events, like the financial crisis, share three specific attributes. The first is that they are incredibly rare, occurring so infrequently that they were never usually addressed as part of a standard process. The second is that when they occur, what happens and the way it happens are completely unpredictable. Lastly, while both rare and unpredictable, tail risks will have a considerably negative impact. In a portfolio context this implies large losses.

Following 2008, many fund managers began looking for ways to insulate portfolios against another tail event. To meet this need, several investment banks developed so-called “tail-risk hedging products”, many of which are now being used in multi-asset funds. While these products come in a range of different structures and varieties, three aspects are common to tail-risk hedging.

 

Tail-Risk Insurance: Common Features

Tail-risk insurance, like other forms of insurance, costs money. As such, a fund incorporating tail-risk insurance will likely underperform one without it over time. That is the price you pay for trying to remove the chance of rarely occurring events causing significant portfolio losses. Tail-risk insurance products hit potential performance in the absence of a tail-risk event. Think of having fire insurance. The insurance pays out when there is a fire, but costs money when there isn’t one.

 The second common feature is the broad nature of tail-risk events means any hedging process needs to be similarly broad and consequently untargeted. This introduces two problems. The first is that the hedging process may not work when the tail risk occurs. For instance, an exceptionally huge fall in equity markets (a tail risk) may not be offset by the tail-risk insurance product adopted. Secondly, the cost is relatively high, broad insurance being more expensive than targeted insurance. Insuring your car against fire and theft, for example, is cheaper than doing so to cover anything that could happen to it.

Finally, the unpredictability of tail risks means that by its very nature tail-risk hedging needs to be permanently in place to be effective. You cannot scale it up or down. Indeed, any view on whether markets look more or less risky than usual should feed into the tactical-asset-allocation process and not the tail-risk process.

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