Updated with correction
Tail risk — the risk of extraordinarily large losses — has become a major concern for institutional investors.
Many seek to insure against tail risk directly by steadily purchasing put options or similar derivative strategies.
Unfortunately, experience and financial theory suggest that the long-term cost of such insurance strategies will be larger than the payouts. No surprise, since the expected return for perpetual buyers of insurance is negative and conversely positive for insurance sellers (see the entire insurance industry). It is reasonable to assume that there is a premium from bearing tail risk, so attempting to benefit from traditional assets while passively removing the tail is an expensive proposition. Worse, the long-term cost of insurance means that investors might abandon the strategy after a long period of calm markets — potentially the worst time to bail out.
Equities are the greatest source of tail risk in most institutional portfolios, and to address this risk, investors would be better served by a fundamental approach, one that changes the portfolio structure itself. Consider the following approaches, which we think are most effective in combination.