Almost two years after Lehman Brothers Holdings Inc.'s failure caused world markets to seize up, Pacific Investment Management Co. is planning a fund that will offer protection to investors against market declines of more than 15%.
Morgan Stanley strategists estimate demand for hedges against such cataclysms helped drive as much as a fivefold increase last quarter in trading of credit derivatives that speculate on market volatility.
The PIMCO Tail Risk Hedging Fund 1 will be the first in a potential series of partnerships, according to a private placement filed June 23 with the Securities and Exchange Commission. The initial fund will be designed to protect investors from a drop of more than 15% in a benchmark index that Mr. Bhansali declined to identify.
Deutsche Bank AG and Citigroup Inc. are among firms offering clients tail-risk protection, either through funds or traded instruments that act as hedges.
Deutsche Bank is marketing a tail-risk hedging index that gains in value when investor expectation of stock-market volatility increases, according to material the bank sent to clients. The so-called equity long volatility investment strategy, or ELVIS, uses variance swaps linked to the S&P 500 that bet on the index's volatility.
Citigroup hired John Liu, director of public equities at the Indiana Public Employees Retirement Fund, a few months ago for a newly formed unit that will advise pension plans, endowments and foundations on tail-risk hedging. Mr. Liu previously had been managing director of equity strategies at Vanderbilt University, Nashville, which in late 2005 tried to hedge portions of its endowment by using tail-risk insurance.
Other asset managers that have been hedging against improbable events are creating funds to take advantage of demand. Pine River Capital Management LP, a Minnetonka, Minn., with $2.1 billion in assets under management, started the Nisswa Tail Hedge Fund LP last month, according to a June 15 filing with the SEC. The partnership was formed at the request of investors wanting access to the hedging techniques used by Pine River's primary multistrategy fund, which gained 40% during 2008 and 2009, according to Aaron Yeary, a co-founder.
“By buying prudent hedges and staying liquid, it allowed us to be on the offense during the crisis,” said Mr. Yeary, who is running Nisswa Tail Hedge with Nikhil Mankodi. “Some sold their liquid investments and were left with garbage,” he said, adding that Nisswa Tail Hedge has about $200 million in assets.
Capula Investment Management started a tail-risk fund in March with about $100 million, which has grown to about $650 million, according to a person familiar with the fund, who declined to be identified. It may top $1 billion in the next two months, the person said.
Ionic Capital Advisors LLC, a New York-based investment firm founded by former employees of Highbridge Capital Management LLC, is offering tail-risk protection through Ionic Select Opportunities Fund LLC, according to a private placement notice filed with the SEC on June 11. Mary Beth Grover, a spokeswoman for Ionic, declined to comment.
Demand for protection against so-called tail risks, extreme market moves that Wall Street's financial models fail to detect, is increasing as investors react to events such as the May 6 stock market rout that briefly moved the Dow Jones industrial average down almost 1,000 points, or Greece's sovereign debt crisis, which on June 7 sent the euro to a four-year low against the U.S. dollar.
For much of the year before Lehman's collapse, investor and author Nassim Nicholas Taleb warned bankers that they relied too much on probability models and had become blind to potential catastrophes, which he labeled black swans, a reference to the widely held belief that only white swans existed — until black ones were discovered in Australia in 1697. His 2007 book, “The Black Swan,” contends tail risks are becoming more severe.
To hedge against tail risks, investors usually look for the cheapest insurance against a cataclysmic market sell-off, mainly through derivatives that are expected to multiply in value as prices plummet for everything from stocks to the Australian dollar.
The $14.1 billion Indiana PERF, Indianapolis, asked financial institutions in January to send information on a tail-risk management program that would protect it against “an extreme market downturn,” according to a request for information on the fund's website.
The term long-tail risk is derived from the outlying points on bell-shaped curves that forecasters use to plot the probability of losses or gains in a given market. The most probable outcomes lie at the center. The least probable, such as a decline of 5% in an index that most days rises or falls by less than 0.25%, are plotted at the “tails” of the curve. The greater the deviation, the longer the tail.
Despite the new entrants in tail-risk protection, Mr. Taleb said few will have the stomach to stick with the strategy.
“They will drop like flies,” said Mr. Taleb, now a professor at New York University's Polytechnic Institute, who in 1999 set up tail-risk hedge fund Empirica LLC, which he ran for six years. “They and their customers will give up at some point. I've seen it before.”
The seemingly growing occurrences of events that fall on the fringes of probability are prompting pension fund executives and other institutional investors — who once shunned costly hedging strategies — to reconsider. And they're doing it even as economists predict the U.S. economy will grow an average of almost 3% through 2012 and as analysts forecast the Standard & Poor's 500 index will gain 17% through year end.
“People are trying to move beyond historic notions that tail risk events are so infrequent on the one hand, and so extreme on the other hand, that there is nothing you can do about them,” said Eugene Ludwig, who started a Washington-based risk management firm called Promontory Financial Group after serving as U.S. Comptroller of the Currency under former President Bill Clinton.
PIMCO CEO Mohamed El-Erian developed tail-risk strategies when he was manager of Harvard University's endowment in 2006 and 2007, and wrote about the importance of such hedging in his book, “When Markets Collide.”
Mr. El-Erian, who describes America's economic future with the term “new normal,” advocated the strategy he applied at Harvard on returning to PIMCO in January 2008. PIMCO, which manages about $1.1 trillion, opened its first mutual fund aimed at minimizing risks from systemic shocks that October. The PIMCO Global Multi-Asset Fund is co-managed by Mr. El-Erian and Vineer Bhansali.
PIMCO is using strategies in many of its funds to protect against tail events, said Mr. Bhansali, chief architect of the Newport Beach, Calif.-based company's tail-risk management program.
“You don't want to try to be too smart in trying to forecast what is going to happen and which hedge is going to perform better,” said Mr. Bhansali. “What you want to do is accumulate cheap protection.”
Investors should be cautious in following the herd, said Eric Petroff, director of research at Wurts & Associates, a Seattle-based consulting firm that oversees about $30 billion on behalf of institutional investors.
“Products that protect you from tail risk tend to crop up after the tail has occurred,” he said. “Back in 2007, it made a lot of sense to hedge tail risk but now it just seems brilliantly misguided.”
Mr. Taleb said sticking with a tail-risk strategy can be psychologically challenging because payoffs, while big, are less frequent.
“If you looked at numbers over a period of time — six, seven, eight years — there's much higher return,” he said. “But if you watch a trader in any given year, he looks like an idiot. No trader wants to feel like he's an idiot.”