Wag the investor

Tail-risk hedging the talk of the town

Strategy generating interest and questions about implementation

Tail-risk hedging is the summer buzzword among institutional investors still unnerved by 2008's losses and scared anew by the May 6 flash crash and other global market events.

Investors are looking for ways to protect both equity and fixed-income investments from tail risk, typically defined as a low-probability, large deviation event that will negatively affect their investment.

“Tail-risk hedging is the talk of the conference circuit, but there's a hodgepodge of approaches. The real question is how to eliminate tail risk at no cost. That's the holy grail,” said Stephen L. Nesbitt, CEO of alternative investment consulting firm Cliffwater LLC, Marina del Rey, Calif.

Market losses and the volatility of the past 18 months have led many institutional investors “to recognize the risk of the '90s paradigm of heavy equity allocations” and convinced them that they need to “do something to mitigate tail risk,” he said.

“Tail-risk hedging clearly is a topic that's front and center among leading endowments,” said Deirdre Nectow, director of business development at investment consultant Cambridge Associates LLC, Boston. “Clients are increasing allocations or adding allocations to global macro, cash, gold equities and Treasury bonds. They also are reducing risk via non-traditional approaches such as the use of equity, interest rate or currency derivatives.”

Some money managers have seen enough demand from institutional clients for assistance in tail-risk hedging to persuade them to offer stand-alone hedge funds, customized hedge funds of funds or options overlay solutions.

Credit hedge fund manager Pine River Capital Management LP, Minnetonka, Minn., launched a tail-risk hedge fund that's “built like an insurance policy” in response to demand from institutional investors, said Angela Samfilippo, director of marketing and investor relations. The fund opened with $147 million from three institutional investors that Ms. Samfilippo said she could not identify. Pine River manages a total of $2 billion.

The strategy is built to profit from directionality, volatility and convexity during tail-risk events in equity and credit markets, Ms. Samfilippo said.

“We have always used tail-risk management in our multistrategy, relative value funds and it was fairly simple to carve out that approach and offer it in a master-feeder structure. It's very efficient, because all of our hedge funds now use the tail-risk fund, and it also is offered as a stand-alone fund to institutional clients. It's very liquid and transparent; all clients have exactly the same terms,” Ms. Samfilippo said. The fund charges a management fee, but no incentive fee because “the fund is not designed to generate alpha,” she said.

The fund could lose a minimum of between 1% and 1.5% per month or between 12% and 18% per year just from the cost of the options strategy. “But people anticipate more tail-risk events,” Ms. Samfilippo said, which is swelling Pine River's new-business pipeline with interest from existing clients and new prospects.

Customization sought

Median quarterly performance dispersions

Hedge fund-of-funds managers also are being asked by clients to customize downside protection.

K2 Advisors LLC, Stamford, Conn., has fielded 10 serious inquiries in the past year about tail-risk hedging because “clients want to control their drawdowns,” said David C. Saunders, managing partner of the fund-of-funds manager.

In response, K2 created separate accounts for two non-U.S. clients, which Mr. Saunders said he could not name, that combine long-volatility hedge fund strategies, such as global macro, currency, short-biased and convertible arbitrage, with an overlay. The approach is designed to work in concert to control tail risk with the goal of “making money when markets go down and not to lose any money or to be up only a little when markets go up or are flat,” Mr. Saunders said.

“It comes down to a discussion about correlations,” he said, arguing that the approach “builds embedded negative correlation into the portfolio to protect against tail risk through diversification.”

By contrast, Prisma Capital Partners LP, New York, has long incorporated tail-risk management in its funds of funds. Rather than create a stand-alone tail-risk solution for clients, Prisma is advising clients to use hedge funds explicitly to “curtail left tail or negative skew results,” said Girish V. Reddy, co-founder and managing partner.

“By combining both long/short equity and long/short fixed-income hedge funds with long-only managers within their portfolios, it's not only a more efficient way to participate in the upside gains and to protect against downside losses, but it's also much cheaper than relying on a portfolio of long-only managers together with a put-spread overlay,” he said.

Mr. Reddy said three Prisma clients that he said he could not identify are using long/short fixed-income hedge funds of funds to mitigate tail risk in their bond portfolios.

Clients of Hewitt Investment Group LLC also are “putting more money in hedge funds with lower correlations to equity returns, such as long/short equity, to take a little of the edge off equity losses,” but many seek to control tail risk through broader asset allocation approaches, said Robert L. Penter, a Hewitt principal and senior investment consultant based in Atlanta.

In particular, well-funded plans tend to use a dynamic asset allocation to manage assets within a strict risk budget, Mr. Penter said.

“When you reach 100% funded status, it's all about tail-risk management. When the funded status of a plan hits a certain point, that's when the asset allocation dictates that you begin to lower risk,” he said.

Dynamic approach

About 20% of the 30 large institutional clients served by Russell Implementation Services are explicitly managing tail risk through dynamic asset allocation approaches, while the rest “wrestle” with the considerable cost of tail-risk hedging, said Michael Thomas, chief investment officer of Russell Implementation Services, a division of Russell Investments, Tacoma, Wash.

Mr. Thomas' group recently priced an options overlay that would provide protection for the next 12 months for a decline greater than 10% of the Standard & Poor's 500 index at a cost of 6.7% of the assets to be protected.

Although a number of vendors have created packaged options overlays, Mr. Thomas and other sources said very few of their institutional clients have opted to use such an approach.

“At this point, I'm not seeing more than the lips moving on this idea. It's like buying insurance when the house is on fire. It's now expensive. In hindsight, people wish they got it when it was cheaper,” said Jim McKee, director of hedge fund research, Callan Associates Inc., San Francisco, in an e-mail.

Erik Knutzen, chief investment officer at NEPC LLC, Cambridge, Mass., stressed that “off-the-shelf strategies are designed to fight the last war. They just aren't client-specific enough. If you're going to do this, you need a dedicated tail-risk strategy that uses a customized derivatives overlay that will protect against the plan's specific risk exposures.”

In fact, he argued that only a fraction of institutional investors actually need a dedicated tail-risk hedge strategy, specifically plans with very illiquid investments, a large cash flow need or Taft-Hartley plans at low funding levels.

“You need a dedicated tail-risk hedge strategy if your plan is in danger of having to sell assets as a distressed seller in an extreme market. For the vast majority of institutional investors, time and asset allocation are sufficient to manage tail risk,” Mr. Knutzen said.

Hewitt's Mr. Penter agreed that most plans will survive without a dedicated tail-risk hedge. “Tail-risk hedging can be very expensive, especially if it's put on for a long time. For most institutions, the loss won't be catastrophic and most plans are doing some self-insurance, like calculating how much cash they need to have on hand to deal with a big loss.”