July 1, 2014
An Analysis of Tail Risking Strategies
Given today’s elevated global capital markets and decreased VIX levels, many investors are revisiting “tail-risk” strategies for their investment portfolios. A variety of strategies exist. Most are designed to mitigate losses from a correction in the equity markets and generally include the use of derivatives to gain synthetic exposure to a particular index.
When viewed as insurance, the premium paid for “tail-risk” protection is analogous to the price required to mitigate a particular negative market scenarios. Oftentimes these strategies are coupled with “selling” future upside (caps) and establishing future “re-entry” points (floors) to offset the cost of implementing these approaches. Parametric Clifton provided the graph on the following page depicting the current cost matrix of various strategies intended to insulate equity portfolios from any type of negative market correction:
In the simplest example, an investor can insure against any future losses in an S&P 500 portfolio over the next year by paying a premium of roughly 650BPS. Should the S&P 500 increase in value or produce a return less than 650BPS, the investor loses the premium paid. A more creative example includes the highlighted gray boxes and involves “selling” the upside of the S&P 500 (writing a call) and “buying” downside protection past -10% (buying a put). The cost for this 1-year trade is further offset by “selling” disaster protection to another investor for roughly 65BPS. A potential payoff pattern for this trade is as follows:
Any potential strategy should be viewed in concert with current implied volatility levels as well as the “price” associated with implementing a strategy. By looking at the historical context for particular implementation strategies, an investor can obtain a better sense of the premium paid for “tail-risk” protection during multiple market environments.
In the chart above, a 1-year 5% out of the money put is purchased in concert with the sale of a +20% cap and -20% re-entry put. The resulting cost of this strategy is plotted over time. At the height of the credit crisis in December of 2008, investors were paid to implement this strategy. As markets normalized, this relationship stabilized and today the premium to implement this type of protection for the equity portion of the portfolio is approximately 300BPS.
In 2011 James Montier from GMO authored a notable piece on tail-risk hedging and we found this particular paragraph insightful:
“The very popularity of the tail risk protection alone should spell caution to investors. Keynes’s edict with which we opened would suggest that the degree of popularity of tail risk protection helps to undermine its benefits. Effectively, you should seek to buy insurance when nobody wants it, rather than when everyone is excited about the idea. An alternative way of phrasing this is to say that insurance (and that is exactly what tail risk protection is) is as much of a value proposition as any other element of investing.”
Montier goes on to compare and contrast various investment strategies (albeit with a look back bias) that could have offset losses during the credit crisis.
The graph above highlights various strategies intended to protect against a market downturn with a fully invested portfolio in the S&P 500 as a point of reference. An investor holding the S&P 500 throughout this particular time period would have fared just as well as a more conservative investor who introduced a 25% cash position. The more conservative investor certainly would have enjoyed a more stable ride, substantially protecting on the down side.
A strategy introducing long volatility by borrowing cash combined with a fully invested portfolio would have fared slightly better in the downturn than a 100% S&P portfolio, but would have lagged in the bull market that followed. In the most extreme case (70% S&P/30% Long Volatility) an investor would have done a marvelous job in protection on the downside, but would have bled away this relative gain as global equity markets marched forward.
Timing and pricing of these strategies remains paramount and difficult. By combining these two elements with an organizational risk profile that accounts for sharp portfolio corrections and a committee’s tolerance for absolute volatility, an institution can make an educated decision on whether the cost to protect against such future outcomes is worth the benefit(s). Oftentimes an investor may be better off adjusting their asset allocation in lieu of derivatives to achieve the intended benefit.
Nick Fazzie, CFA
Nick J. Fazzie, CFA
Nick is an Investment Officer with Hirtle Callaghan and is responsible for servicing and implementing the firm’s Investment Strategy decisions within client accounts. Prior to joining Hirtle, Callaghan & Co., Nick worked with Aberdeen Asset Management. Nick received his B.S. in Accounting and M.B.A with a concentration in finance from University of Delaware. Nick is a CFA charterholder and a member of The CFA Society of Philadelphia. In addition, Nick holds his Series 65 license.