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April 02, 2012 01:00 AM

Investors eye tail risk to hedge against market plunges

Tail-risk hedging strategies are gaining traction particularly with endowment CIOs

Christine Williamson
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    Beth Rooney/University of Chicago
    Hurting: Michael Edleson said a 20% drop would cause his school 'too much pain.'

    More than three years after catastrophic market declines of nearly 40% decimated institutional portfolios, investors increasingly are adding tail-risk hedging strategies to protect against future unexpected, severe market declines.

    Tail-risk strategies are designed to perform well in the worst market conditions — declines of at least 20% commonly known as fat-tail losses — providing cash to the investor when most other investments are hemorrhaging, but generally underperforming in strong markets or less-severe market declines.

    “People's memories of the pain of the sharp market declines of 2008 are fading, and most investors still have not dealt with tail-risk strategies head-on,” said Tony Werley, managing director and chief portfolio strategist of the endowments and foundations group at J.P. Morgan Asset Management, New York.

    Among those that have addressed the issue are the University of Chicago's $6.3 billion endowment fund and the $6.6 billion Tennessee Valley Authority Retirement System.

    Other investors are in the early stages of considering tail-risk hedging approaches.

    The investment committee/investment advisory group of the Regents of the University of California, Oakland, for example, recently discussed a 2% allocation from the university's $3.6 billion Total Return Investment Pool, but tabled a decision on the proposal by Marie N. Berggren, treasurer and chief investment officer. Dianne Klein, a spokeswoman for the board of regents, said regents are in an educational phase regarding tail-risk hedge fund investments. (The university also has a $6.3 billion General Endowment Pool and an $8.1 billion Short-Term Investment Pool.)

    Because of the expense, which ranges from an estimated 50 to 200 basis points per year, tail-risk hedging strategies only “make sense if you anticipate declines of 20% or more. You should not be spending the money for insurance against smaller declines,” J.P. Morgan's Mr. Werley said.

    The real issue, Mr. Werley said, is an assessment of “the organizational impacts of a large drawdown. If a big decline ... will be very disruptive to the institution, then implementing a tail-risk strategy may make sense, even if you aren't seeing those managers adding to the investment returns of the portfolio during better markets.”

    For the University of Chicago, the disruption of a 20% or greater market decline will cause “too much pain,” said Michael Edleson, chief risk officer.

    “The endowment has to provide the university with an annual payout of 5.5% over inflation in a good year or a bad year. The amount of risk ... a university can take depends on the amount of the loss. A market loss of 10% would not hurt too much, but moderate to large losses of 20% or 40% would be very difficult, making the university extremely brittle in the face of the next market loss,” he added.

    A yearlong review by the endowment's investment committee resulted in a new risk-factor-based asset allocation that includes a 2% allocation to volatility strategies, focused on mitigating the impact of fat-tail losses of more than 20%.

    In December, endowment officials allocated the $125 million to three active long volatility specialist hedge funds, which Mr. Edleson declined to name.

    In a market decline of 40%, when the typical endowment is down 25%, Mr. Edleson said the tail-risk hedge should reduce the endowment's decline to 19% or 20% and the $300 million or so of cash generated by the positive returns of the volatility hedge funds should be enough to meet university expenses and to invest in distressed opportunities that arise in the midst of the market downturn.

    “This is all the protection we can afford, but it should work to cover enough of the negative stream to sufficiently protect the endowment, although obviously we still will lose a lot of money,” Mr. Edleson said.

    Interest in tail-risk hedging like that of the University of Chicago's investment office staff began after the Black Swan swoon of 2008 caused astonishing losses in institutional investment portfolios as equity indexes dove that year — a 36.94% drop for the Standard & Poor's 500, 37.25% fall for the Russell 3000 and 41.74% plunge for the Morgan Stanley Capital International All Country World.

    Hedge fund management firms that used tail-risk strategies to successfully protect their own multistrategy hedge funds from the worst of the 2008 drawdown were asked by institutional clients to offer that strategy as stand-alone funds.

    Space is growing

    “The tail-risk fund space is growing,” said Paul Britton, CEO and founder of Capstone Investment Advisors LLC, New York, estimating that about $30 billion already is invested in 40 dedicated tail-risk and relative value hedge funds that focus on long/short volatility investments. Capstone manages $1.3 billion in volatility-oriented hedge funds, including an 18-month-old tail-risk fund with $200 million.

    Among other hedge fund companies that launched dedicated tail-risk funds after 2008 are Capula Investment Management LLP, Pine River Capital Management LP and Saba Capital Management LP.

    Pacific Investment Management Co. LLC offered customized tail-risk hedging for its clients before 2008 (Pensions & Investments, Aug. 10, 2009). Last month, PIMCO was awarded an allocation of $33 million by TVA, Knoxville, in order to “mitigate large market losses and provide liquidity in times of market stress,” according to minutes from the pension fund's March 16 meeting.

    Toronto-based Diversified Global Asset Management's tail-risk hedging strategy worked well during 2008's market crash, adding between 600 and 800 basis points of positive return.

    A number of clients have since asked the firm to run customized strategies, said CIO Warren Wright. Clients include a $140 billion sovereign wealth fund he couldn't identify, for which DGAM is running a custom tail-risk hedge strategy on its $3 billion hedge fund portfolio.

    The influx of cash that the tail-risk hedge threw off in 2008 improved the return of the firm's flagship DGAM Unique Strategies Fund, bringing it to -6.96%, compared to -19.86% for the HFRI Fund of Funds Conservative index.

    Mr. Wright said the cash generated by the tail-risk hedge allowed the firm to buy high-quality assets selling at distressed prices at the bottom of the market in 2008 and early 2009. Those fire-sale investments aided the fund's performance, offsetting the flat or negative returns of the tail-risk hedge in positive market cycles.

    DGAM manages $5.5 billion in hedge funds of funds for institutional investors.

    Investment consultants remain skeptical of specialized tail-risk hedge funds or customized, derivatives-based hedging programs because the cost is prohibitive for many institutional investors. Properly diversified portfolios should provide sufficient protection, consultants say, and for some clients, periodic use of various derivatives to hedge out specific risks also makes sense.

    “Strategies that hedge risk have a long-term cost,” said Terry A. Dennison, senior partner and U.S. director of consulting in the Los Angeles office of Mercer LLC's investment consulting business.

    Mr. Dennison said Mercer's analysis shows that full-time use of put options — one common way to hedge risk — would cost between 100 and 200 basis points of equity returns every year.

    “Continuous use of a tail-risk hedge like this starts to look very expensive,” Mr. Dennison said.

    "Learned a lesson'

    Expense notwithstanding, Makena Capital Management, Menlo Park, Calif., “learned a lesson” in 2008, when “everybody was reminded that diversification has its limits,” said Bill Miller, partner.

    Makena added an internal tail-risk hedging program in 2009 and, earlier this year, invested in a customized fixed-income tail-risk strategy from a credit hedge fund specialist Mr. Miller declined to identify.

    “In this environment, growth will be retarded for the next 10 years. The only way to make money is going to be by buying low, in the downturns. It's the only defense,” Mr. Miller said. The positive cash flow generated by tail-risk strategies during deep declines will make it easier to take advantage of good opportunities priced well below their value. Makena Capital manages $15 billion for endowments.

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