PIMCO is using tail-risk hedging to guard against catastrophic events like the current financial crisis — a method that has allowed the company to take advantage of market weaknesses instead of succumbing to them.
Insuring against such events has helped returns for PIMCO's target-date funds and now the company is looking to expand this approach to other strategies.
Vineer Bhansali, managing director and head of analytics for portfolio management at Pacific Investment Management Co. LLC, Newport Beach, Calif., was instrumental in developing the firm's original fat-tail strategy as part of what he calls “offensive risk management.”
“Typically you think of spending money for insurance as a cost, but if you think of the performance of an investment portfolio in three or five or 10 years, you should expect to have the portfolio impacted by a fat-tail event, and having that cheap tail hedge can make the difference between surviving and having to liquidate,” Mr. Bhansali said.
The emphasis for PIMCO is not so much on anticipating the probability of a catastrophic event, but preparing for the severity of it — what Mr. Bhansali calls “just-in-case” insurance.
“When everyone sees the hurricane, you can't sell the house because everyone is trying to do the same thing,” he explained
The key to tail-risk hedging is knowing where to look. Mr. Bhansali describes it this way: “One market gets dislocated and then you have a blowout and the solution to that problem creates opportunity for cheap hedges.”
Until recently, PIMCO had been hedging liquidity risk. Today, it is hedging against the possibility of inflation.
“Inflation insurance is very cheap right now,” Mr. Bhansali said.
So far, the company has applied tail-risk hedging to its Global Multi-Asset Fund, a nine-month-old fund that Mr. Bhansali manages with PIMCO co-CEO and co-Chief Investment Officer Mohamed El-Erian and Managing Director Curtis Mewbourne, as well as its RealRetirement target-date funds.
PIMCO officials also expect to implement the strategy in portfolios where the hedges might be appropriate. PIMCO's positions in tail-risk hedged portfolios are slightly less than $9 billion in total notional value. The company manages $840 billion in assets.
Tail-risk hedging focuses on the far left end — or tail — of the probability distribution curve of investment returns. The simplest way to hedge is to not buy risky securities to begin with, Mr. Bhansali said. Barring that, portfolio managers look to invest in negatively correlated or uncorrelated securities on the tail, like U.S. Treasuries. They also seek out the cheapest instruments to buy, which may not be available in the exact markets they want to hedge but in cross markets, including equity options, bond options, currency options, inflation options, credit default swap indexes and index tranches.
Investors who use PIMCO's fat-tail strategy can end up paying 50 to 100 basis points for the underlying hedges, a costly price tag but one that Mr. Bhansali argues is worthwhile. Mr. Bhansali acknowledged that institutional investors have shown some initial reluctance to the approach, some of them reasoning that if they don't like the risks, they won't invest in them, so why bother with insurance?
“We're making significant headway but it's an interesting battle in certain areas,” he said.
Cynthia F. Steer, chief research strategist and head of beta research group at consulting firm Rogerscasey Inc., Darien, Conn., said the staffs of pension funds, foundations and endowments are still studying tail-risk hedging before making recommendations to their respective boards.
“It's still early days,” she said.
Nonetheless, she sees the strategy as a realistic option for institutional investors.
“We're in an era when we have to put risk in the portfolios as well as know when to take risk out of the portfolios,” Ms. Steer said.
She added that the likely early implementers of tail-risk hedging will be corporate defined benefit plans, followed by endowments and foundations in the next 12 to 15 months.
Erik Knutzen, CIO of NEPC LLC, Boston, said plan sponsors who are at risk of experiencing a liquidity crunch, where they would be forced sellers of assets at distressed prices, would likely see the most benefit from tail-risk hedging.
But, he added, most institutional investors don't have such a high percentage of assets that would become illiquid in an extreme environment.
“If you have a significant percentage of assets that are liquid, then the cost of the insurance can be exorbitant,” Mr. Knutzen said.
Diversified Global Asset Management Corp., a Toronto-based institutional hedge fund and funds-of-funds manager, set up an account with PIMCO in April 2007 with the sole purpose of protecting the tail of its portfolio from capital market crises and other exogenous events, according to Warren Wright, managing director and CIO of alternative strategies. Mr. Wright declined to disclose the size of the portfolio.