Some simple rules for hedging tail risk

The desire to hedge investment tails — the low-probability risks that could have a severe impact on portfolio performance — is a rational response to the sometimes irrational, unpredictable events that take place in the market.

Most investors had never experienced the market chaos that ensued in the aftermath of the 2008-2009 economic upheaval: correlations across asset classes trended toward “1”; bids for many asset-backed and investment-grade securities all but disappeared; and investors seeking to withdraw assets from real estate and hedge funds faced redemption queues and “gates.” Even historically consistent, time-tested strategies and approaches to temper volatility and downside exposure — holding bonds, value investing, portfolio diversification — failed to provide the degree of protection investors had come to expect. Additionally, the compounding effect of limited access to credit and overly leveraged investors resulted in liquidity drying up across an array of markets, all of which created an environment where investors simply had no place to hide.

Yet, there have been other recent incidents that have caused negative tail events, particularly those that occur at the far left of a return distribution and result in outsized losses. Having experienced the 2008-"09 crisis, the attacks of 9/11, the tech bubble and the Asian currency crisis, investors today are actively seeking ways to manage their investment return distribution and, specifically, the left tails.

Investors concerned about tail risk can apply some practical rules of thumb when considering the sizing of allocations and the prudent use of leverage.

In the case of large, liquid allocations such as developed market equities, a simple step is to size the allocation to properly reflect your sensitivity to drawdown risk in a year like 2008. In other words, if you cannot take the “pain,” hold less equity. In the case of less liquid investments (including alternatives), sizing the allocation properly and avoiding excessive leverage is critical. These allocations must not be thought of as a “piggy bank” or source of funds during periods of market stress. Given the time horizon for these investments, you want to avoid being a distressed seller. For instance, direct real estate funds or credit-oriented hedge funds that employed modest amounts of leverage certainly took their lumps over the last few years, but generally came through the cycle with positions intact because they were never in the position of being forced sellers.

However, many investors are looking beyond these simple steps and are considering the following for inclusion within their investment programs:

• Option strategies, including addressing their long-term costs; and

• Strategies that introduce asymmetric return patterns.

In addition to appropriate management of risk in portfolios, the most explicit and predictable method of hedging against tail risk has been the purchase of put options — effectively an insurance contract against any dramatic event. Given the amount of traditional “long” investments, there is always a strong, natural demand for out-of-the-money puts. Today there are even more investors, spooked by the events of 2008-2009, who have flocked to options as a way to hedge the tail. This has created high demand for puts, resulting in a steady increase in price. In addition, the low interest rate environment has exacerbated the situation by rendering the absolute value of put options very expensive. At the end of 2010, for example, one-year put options on the S&P 500 that were 15% out of the money cost approximately 4%, a premium implying a breakeven market decline of more than 19% — far beyond what many rational investors would pay. Faced with these high costs, investors are often presented a choice of either selling other options to mitigate the cost of buying the desired option or implementing a hedge in a related market at a lower quoted cost.

One way to disguise the high cost of buying options is to short other options on the same underlying instrument — selling calls and/or puts to reduce the upfront premiums. While making the upfront cost appear to be cheaper, this strategy changes the potential return pattern by narrowing the range of return outcomes. In the case of shorting calls, investors tend to underestimate the “regret factor” of leaving too much upside on the table if the market rallies through the call's strike price. In the case of put spreads, selling lower strike price puts to minimize the outlay for the higher strike price might appear attractive when viewing the payoff at the expiration of the option hedge. But, if the market sells off sharply in the interim and volatility increases, the value of the protection might be a lot lower than was expected at the outset. The net effect in either scenario is that there are drawbacks in trying to disguise the cost of the put by selling options.

Cross hedging (hedging a position by taking an offsetting position in a different security with similar price movements) is another strategy some investors rely on to mitigate the cost of hedging with pricey options. But changing the basis of the underlying hedge results in a hedge that is not a sure thing. Take, for example, an investor in sovereign credits in southern Europe, some of which have proven risky in recent months, seeking to hedge those investments with credit default swaps on U.S. corporate high-yield debt. That strategy appears sound and easy; it looks like a less expensive way to hedge against a related market. However, this strategy is flawed and wouldn't have worked in this case, because strong fundamentals prevented the spreads on U.S. corporate debt from widening, even as spreads on the sovereign credits blew out.

In sum, there is no free lunch. If the hedge costs materially less than the quoted cost of the put option, make sure you understand the trade-offs.

To mitigate tail risk further and introduce more asymmetry, it is useful to look back a decade or two and explore the reasoning behind what drove many large endowments to scale back on beta-one strategies (those with 100% exposure to market volatility) and shift to investing in hedge funds. These investors understood that a large exposure to domestic equities introduced a level of drawdown that was too large to tolerate and that diversification within traditional equity would provide only partial relief.

As a result, the endowments looked to reduce their dependence on beta and move toward more active management that introduced some level of asymmetric returns. For example, those interested in equitylike returns with a less bumpy ride initially turned to event-driven and long/short strategies. While there is a directional component to such strategies, event-driven and long/short managers typically employ lower levels of leverage and are focused on capital preservation in adverse markets. Over time, top-quality managers created new ways to exploit inefficiencies and generate alpha. Thus, endowments recognized that the top-tier hedge fund managers offered the potential to preserve capital better in adverse markets while keeping pace or outperforming benchmarks in strong times.

Among the myriad lessons of the 2008 and 2009 financial tumult is the acknowledgement of tail risk and the need to manage non-normal market returns. With the scenario still a vivid memory, investors have turned to basic asset allocation principles that are simple to implement yet can provide immediate benefits to portfolios.

Proper sizing of risk, accurate analysis of liquidity and effective use of leverage combine to address a significant portion of left tail risk. In addition to adhering to these principles, the use of options strategies and the inclusion of investments that deliver asymmetric return patterns help to address volatility and manage the overall return distribution of the portfolio.

While none of these strategies is the silver bullet that addresses tail risks, taken together, they can help position a portfolio to deliver a different return distribution and a more palatable upside and downside potential.