Diversification across asset classes is a cornerstone of most investors’ portfolios and offers good protection against drawdowns during normal market conditions. However, during times of severe market stress, tail risks materialise and simple cross-asset diversification offers inadequate protection. Tail risk is a low probability market event with large impact and occurs more often than stipulated by conventional financial markets theory, as shown by the Coronavirus pandemic, the Financial Crisis in 2008, and the TMT bubble.
Adding or increasing exposure to popular assets such as private equity, infrastructure and real estate have improved diversification levels over the last decade. But, as a consequence of increased globalisation and financial markets becoming ever more interconnected, even these asset classes - as well as many other strategies being promoted as uncorrelated - are today more highly correlated than they used to be. Bespoke tail risk hedging strategies that are truly uncorrelated are needed to achieve tangible downside protection.
What risk factors could trigger a sell-off?
It is a futile task to try and time the next large downturn and only with hindsight can experts identify the tipping point. Therefore, it is vital to regularly review risk factors and assess their impact on a portfolio. Here are some of the risk factors that could trigger a larger sell-off in the short- to medium-term:
End of QE - How will tapering asset purchases from central banks globally impact market liquidity and asset prices?
Rising inflation - Is the latest spike in inflation only transitory? If not, how will this impact nominal assets in particular?
Supply-chain disruption - Will it have a prolonged effect on global economic growth? How will corporate earnings be impacted?
Frothy valuations - How sustainable are current historically high valuations in certain market segments? Is there a risk from contraction of valuation multiples?
Next phase of COVID - How will the pandemic develop and what will its impact be on economic activity and investor sentiment?
A proactive game plan
In the aftermath of the Financial Crisis in 2008, a plethora of tail risk products were launched by banks and asset managers as tail risk was on top of investors’ agenda after the crash. Instead of such procyclical behaviour, the key to successfully protecting a portfolio against tail risk is to define a game plan before it happens.
Nobody has a crystal ball to predict when the next downturn will happen. But, defining in advance how to react to events unfolding is crucial to achieving above-average long-term investment results.
Protecting against tail risk typically comes at a cost. Most investors define risk individually and the first step is to address the following strategic questions:
Risk tolerance - What level of drawdown can you accept?
Time horizon - How long can you bear losses?
Direct costs - What risk budget can you allocate?
Opportunity costs - What upside potential can you miss?
Tail risk strategy examples
After assessing the above questions, specific tail risk strategies should be considered, as they are not one-size-fits-all.
The table below compares six tail hedge strategies:
With SigTech, you can develop and implement all of the above tail risk strategies - and more - in an efficient and standardised manner.
3 tail hedging strategies to build in-house
Fuelled by the ongoing trend to build customised investment strategies in-house, demand for tools to build bespoke tail risk strategies is increasing. To create and analyse how a certain strategy would have performed historically, investors need access to comprehensive backtesting and analytics tools, including market data for a wide range of asset classes and instruments.
We built three examples of tail risk overlay strategies to hedge an investment in the S&P 500 index (SPX) against larger drawdowns:
1. Buying puts
The strategy invests in 5% out-of-the-money 1M put options on the SPX every month. The portfolio’s overall exposure to the put options is determined by the rolling beta of the tail risk strategy to the SPX.
The strategy systematically buys 25% out-of-the-money 3M SPX put options, which is financed by selling 25% out-of-the-money SPX call options where the portfolio’s overall exposure is determined analogous to the buying puts strategy.
3. Dynamic collar
A dynamic version of the collar strategy where the exposure to the call options changes over time using a threshold based on the strategy’s realised volatility.
In our empirical tests, we have deliberately calibrated the strategies to better distinguish each strategy’s features. Accordingly, they have a significant impact on the portfolio’s risk-/return characteristics. The risk budget allocated to any tail risk strategy is individual and needs to be tailored to each investor’s circumstances.
Tail risk strategies reduce overall portfolio risk, but at the cost of lower returns in a bull market.
A generic buying puts strategy adds significant value during large drawdowns, but over time exhibits a hefty performance drag from option premiums paid.
Tail risk strategies offer valuable protection during severe sell-offs but are slow to increase beta exposure during strong rebounds (e.g. Q2 2020).
Fixing the roof while the sun is shining
The obvious advantage of tail risk strategies is limiting short-term portfolio losses but they also have a secondary benefit. Reducing drawdowns enables investors to act anti-cyclically in times of crisis and reallocate to assets that exhibit higher return expectations than they did before the downturn. For example, institutional investors, asset managers and hedge funds increasing their allocation to equities during the Covid sell-off in March/April 2020.
The key to successful tail risk management is to define your game plan before tail events materialise. In addition, applying a systematic approach carries the positive effect of being able to shut out various behavioural biases that often negatively impact the decision-making process in chaotic market environments.
The last decade has seen some of the strongest portfolio performances on record. However, the first clouds are appearing on the horizon and the risk of a downturn is increasing. Now is the best time to build your game plan for which tail risk strategies to apply and when.