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.