Investing and Opinion and Banking & Finance

SKARBECK: Latest investment tool to tame risk is no panacea

June 18, 2011

Ken Skarbeck InvestingA popular investment strategy circulating among institutional investors is called “tail-risk” hedging.

The idea behind tail-risk hedging is to provide protection to a portfolio against a disastrous event that would wreak havoc on the markets—a so-called “black swan” event made famous by Nassim Taleb’s book “The Black Swan: The Impact of the Highly Improbable.”

To visualize tail risk in mathematical terms, recall the bell-shaped curve under which the majority of probable outcomes tend to occur. On the tail end of each side of the curve are “outliers” that, although rare in occurrence, can happen statistically. Recent examples of these infrequent risk events could be the 2008 credit crisis and Japan’s March earthquake and nuclear disaster.

A variety of techniques are used in tail-risk investment strategies such as buying and selling far out-of-the-money options on the Chicago Board Options Exchange Market Volatility Index and derivative trades using credit default swaps. Gold and other commodity strategies also may be employed.

As tail-risk hedging amounts to a form of insurance, the costs can be high and the payoff uncertain. These hedge funds and structured products that purport to hedge for tail risk charge high fees. And buyers of these products need to be educated on how the returns are generated.

For example, in some tail-risk funds, during years where markets behave normally, losses can run up to 15 percent while waiting for a significant market dislocation. One tail-risk manager estimates his fund loses money on 95 out of 100 trades.

If an outlier event does sink the market, perhaps the fund rockets up 50 percent to 100 percent. However, this assumes the fund was properly positioned to capitalize on the characteristics of that particular black swan event.

It is also interesting that the popularity of tail-risk investing didn’t soar until after the credit crisis. Isn’t that similar to buying earthquake insurance after the earthquake? Market forces dictate that the price of hedging rises when markets are volatile and investors most need it, while it declines when markets are rising.

The interest in tail-risk products is being driven by the consulting industry, which is still trying to explain how prior big ideas—like market-neutral hedge funds and portable alpha—suffered big losses during the market downturn. Portfolios constructed with “non-correlated” investments were promoted to make money in both up and down markets, but the credit crisis exposed that risk-reduction strategy as fantasy.

Perhaps the biggest issue confronting institutions that want to hedge against a tail-risk event is that no one knows for sure what the next crisis will be and what kind of investment strategy will protect against it. Of course, the sellers of these strategies claim it is worth the cost to hedge tail risk and a typical allocation is 1 percent of investable assets to protect against a black swan event. Some products for retail investors that may hedge for tail risk include leveraged inverse exchange-traded funds.

Before investing, participants should consider the psychological mind-set required to stay invested in a tail-risk strategy while suffering continuing losses when markets are rising with no apparent calamity in sight.•

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Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. He can be reached at 818-7827 or ken@aldebarancapital.com.

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