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Worst-case scenarios
Fat-tail attraction
Investors’ interest in hedging tail risk is growing
Mar 24th 2011 | NEW YORK | from the print edition
Is it a bird, an extreme event or a cliché?
“TAIL-RISK” hedging was the talk of Wall Street in 2008 after global markets nosedived and traumatised investors tried to figure out how they could protect themselves from extreme or “black swan” events—those well outside an ordinary distribution of outcomes—that cause massive losses. Interest is revving up again as revolutions in the Middle East and Japan’s earthquake have destabilised markets and increased volatility, leaving battered investors searching anew for protection.
Peddlers of tail-risk products like to compare them to insurance: investors pay premiums every year to avoid financial catastrophe later. Some even get philosophical. Vineer Bhansali of PIMCO, a big fund manager, has likened tail risk to Pascal’s wager—the argument that you’re better off believing in God than suffering the consequences of being wrong. The same is true with drastic dives in markets.
Tail risk is technically defined as a higher-than-expected risk of an investment moving more than three standard deviations away from the mean. For mere mortals, it has come to signify any big downward move in a portfolio’s value. There are different ways to hedge tail risk, but a popular one is to create a basket of derivatives that will perform poorly during normal market conditions but soar when markets plunge. These include options on a variety of asset classes, such as equity indices and credit-default-swap indices.
Sellers naturally claim it is worth the cost. Mr Bhansali of PIMCO, which offers several tail funds, estimates that it costs investors between 0.5% and 1% of assets to hedge against tail risk, but that investors will break even in three to five years. That is partly because the market does not have to crash in the way that it did in 2008 for hedges to pay their way. PIMCO now oversees around $30 billion in tail-risk products, mostly in separate accounts. Other funds have also seen inflows. Take, for example, Universa Investments, a tail fund advised by Nassim Taleb, author of “The Black Swan”, which has grown from $300m in 2007 to around $6 billion today.Some banks have started to sell tail-risk products. Deutsche Bank has created the ELVIS index, which generates returns when stockmarket volatility increases. Big asset managers like BlackRock and PIMCO have made a business of advising customers on managing for the worst case. Hedge funds have also got in on the act. Several “tail funds”, which invest in assets that should rise in bad economic times, have started up in the past few years. These funds tend to lose around 15% each year when the market is normal but can return 50-100% when the market dives. Or more: 36 South, a hedge fund, saw its tail fund gain 234% in 2008. According to Gaurav Tejwani of Pine River, which launched a tail-risk fund last year that now manages over $200m, “It costs money in most good years or average years, but it makes you a fairly large return when all your other assets are performing very poorly.”
Even so, Mark Spitznagel, the boss of Universa, complains about complacency among investors. Demand is very uneven. The price of hedging varies, rising when markets are volatile and investors most need it, and declining during bull markets. It is difficult, after all, to keep stomaching losses from hedged positions as markets rise: “The kids outside playing in the snow without sweaters and scarves seemed to have much more fun than those of us who were bundled up,” says Steven Englander of Citigroup
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