Tail Risk - What It Is and How To Hedge Against It

Tail risk refers to the probability of an extreme outcome from a rare event. Here we'll look at what it is, how it affects portfolio construction, and hedging strategies for it.


Introduction - What Is Tail Risk?

Tail risk describes the likelihood of rare events at the ends of a probability distribution. Specifically, greater tail risk would suggest that the probability of a rare event is greater than what a normal distribution would indicate. We call this having "fat tails." It has been shown empirically that asset returns do indeed tend to exhibit fatter tails than what a perfect bell curve would predict.

In the middle of the bell curve is the expected value, or in investing terms, the average expected return for an investment (or for a portfolio). On either end of the distribution are the rare but extreme outcomes ("returns"). Of course, we can have a "fat tail" on both sides of the distribution for negative and positive outcomes (think major losses and major gains, respectively), but obviously we typically only really care about preparing for and diversifying against the former. These sorts of rare adverse events are known as black swans.

Source: PIMCO

Thus, an ideal portfolio seeks to reduce the left tail to mitigate extreme losses while not altering the right tail in order to avoid hindering outsized gains. In reality, this is usually impossible and the closest thing we can get to that free lunch is broad diversification.

Humans tend to underestimate the likelihood of adverse events. This is called optimism bias. Put another way, investors tend to ignore or underestimate tail risk. This is especially true of young investors who started in the past decade.

As you can imagine, tail risk is an important consideration for the investor with a short time horizon who needs liquidity, for the retiree whose annual portfolio withdrawals are not being replenished (see sequence risk), and for the risk-averse investor who would be inclined to sell in a panic during a significant market crash like we saw in 2008. Severe market shocks can be catastrophic for these investors.

Measuring Tail Risk

It's hard to measure tail risk reliably because black swan events are by definition unpredictable, infrequent, and variable in their degree of detrimental effect. The insurance industry uses value-at-risk ratios to measure tail risk in more predictable environments.

Kurtosis is a metric used to measure the extreme values of tail events, but of course we can only observe this ex post. That said, measuring the kurtosis of a portfolio may at least give us some idea of its future tail risk relative to another. A distribution with fatter-than-normal tails is said to be leptokurtic or having excess kurtosis.

Skewness is a measure of the asymmetry of tail risk. A distribution with a larger left tail is said to have negative skewness. A distribution with a larger right tail is said to have positive skewness. Naturally, investors prefer assets and strategies with positive skewness.

Now let's explore some tail risk hedging strategies.

Tail Risk Hedging Strategies - Ideas, Assets, etc.

As I hinted at earlier, I would submit that one's time horizon should probably be inversely correlated to how much time and effort - and allocation - the investor puts into a tail risk hedging strategy in their investment portfolio. This is because, on average, all else equal, we would usually expect to sacrifice some total return in doing so, at least in the short term.

The first obvious line of defense in your tail risk hedging efforts should be diversification. It's the closest thing we've got to a free lunch in investing. I won't go into too much detail here, but I discussed the why and how of portfolio diversification in a separate post here. In short, assuming the young accumulator is using stocks as the basis of the portfolio, this would mean investing globally across all cap sizes, styles, and equity risk factors.

Expanding out from there, we can entertain diversifying across other assets like treasury bonds and gold. Treasuries tend to exhibit "crisis alpha" when people flock to their safety during market crashes, and they have had a moderate negative correlation to stocks on average. TIPS are inflation-linked government bonds that offer direct inflation protection, when nominal treasury bonds usually suffer from high inflation. Gold tends to be a decent hedge for uncertainty and is usually uncorrelated to both stocks and bonds, potentially lowering portfolio volatility and risk further.

The addition of each subsequent asset usually reduces the portfolio's volatility and maximum drawdown, creating a more efficient portfolio in terms of risk-adjusted return, but typically sacrifices some long-term total return in doing so.

All the aforementioned diversifiers have positive expected returns, albeit lower than stocks. But because these assets can sometimes become positively correlated during market turmoil and crash in tandem, it may be worthwhile in some instances to introduce assets that exhibit what we call negative carry, for which the cost of holding them is greater than their expected return. VIX futures, for example, a direct bet on market volatility per se, seem to be an unattractive negative carry tail risk hedge simply because of their high cost of ownership. I've said elsewhere that I view them as an insurance policy that isn't worth the premium.

An asset with less negative carry, and one that is a more direct hedge than the ones I've listed so far, is put options. Options contracts are derivatives. A put option gives the buyer the right, but not the obligation, to sell the underlying security at a specified price, called the strike price, within a specific time period. For example, if I buy shares of the S&P 500 today but I believe it might crash in the next month, I might buy a put option - called a protective put in this case - that would be expected to go up in value if the market does indeed crash. If the market instead keeps going up, I've simply lost the amount I paid for the option as it expires worthless.

Put options are a direct hedge on the very assets you're holding; they are a near perfect inverse. But we would entertain them as a tail risk hedge due to their possessing what we call convexity - the relationship between their value and the underlying security is nonlinear. In short, in this context, this means that the more significant the crash, the greater the payout from the option, at an accelerated rate greater than that of linearity. Under "normal" market circumstances, buying put options is a drag on the portfolio like in the previous example. Of course, we should expect this; the best hedge shouldn't come cheap. Still, unlike a long volatility play, the cost of this insurance policy is simply capped at the price of the options contracts.

Think of it this way using a simplistic, hypothetical example with made-up numbers. A diversified portfolio making use of put options may chug along at a modest annualized return of 5% for 10 years before earning a 100% return in a year with a severe market crash. Contrast that with a portfolio without put options earning a higher return of 10% for 10 years before suffering a 50% loss in a year with a market crash.

For the investors I mentioned earlier, this insurance policy may indeed be worth it, at the very least helping smooth returns over time. Unfortunately we can't know the future. Specifically, we know market timing is typically unfruitful, and while we can say a severe crash happens on average about every 7 years, we can't say how severe the next one will be and we don't know when it will occur.

Note that because of this, if for some reason you believe we will never again see an extremely severe market crash like we saw in 2008 (a silly belief in my opinion), you should probably not be looking to hedge your portfolio's tail risk, as you would likely be unable to stay the course with it due to tracking error regret from underperforming the market most of the time. A tail risk hedging strategy requires a sufficient understanding of the history of financial markets and a conscious acknowledgement of one's own biases and risk tolerance. This usually invariably comes with experience.

Some funds maintain a small percentage of the fund's assets to put options, which is a way to "diversify your diversifiers," which may be prudent if bonds are entering a headwind.

There are even funds that hold mostly intermediate nominal and real treasury bonds to help pay for a small allocation to a ladder of out-of-the-money (OTM) put options on the S&P 500. I don't want to get too in the weeds on options specifics, but OTM options are cheaper and possess greater convexity. But because of this, we would only expect them to pay out big in a severe crash, not necessarily in a minor market dip.

Exian clients have access to tail risk hedging strategies. Contact us today to see if one is appropriate for you and if your portfolio is properly hedged against black swan events.

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