Market shocks are more common than you think, and Bhansali thinks he has a way to guard against them.
Video: Lawrence Jones interviews PIMCO managing director Vineer Bhansali about his strategy for hedging against 'tail-risk.'
Like many great ideas, this one came together unexpectedly at a meeting between old colleagues. The story of the development of PIMCO's tail-risk hedging strategy began as a casual chat between two highly respected scholars of finance: Vineer Bhansali and Mohamed El-Erian.
Bhansali, head of PIMCO's 14-person analytics team, was in Boston delivering a conference paper. El-Erian, who had worked at PIMCO, was president and CEO of Harvard Management Co., the firm charged with managing Harvard University's endowment. Bhansali met up with his former colleague to discuss a novel hedging approach he was developing at PIMCO. As it turned out, El-Erian was doing something similar at Harvard.
The approach, called "tail-risk hedging," aims to protect portfolios that deploy the strategy from rare and systemic shocks. Popularly referred to as "black swans," these events can greatly damage investor results. They are the dramatic losses that appear on the far left end--the "tail"--of the probability distribution curve of investment returns. Their chances of happening are supposed to be minute, but some in finance and economics believe that the shocks occur more frequently than commonly thought, and people are developing ways to hedge against the risks posed by these shocks.
Bhansali first implemented tail-risk hedging several years ago in a hedge-fund-like strategy he was running at PIMCO for an insurance company. The client became more interested in how Bhansali was hedging away the portfolio's tail risk than in the overall hedge fund. The client asked Bhansali to create a distinct tail-risk hedging portfolio. Soon after, many other PIMCO clients became interested in disaggregated hedging portfolios of this kind. Of course, the current financial crisis has only intensified the demand.
Meanwhile, El-Erian returned to PIMCO in January 2008. (He is now CEO and co-CIO.) His return intensified efforts to expand the strategy. PIMCO now uses the tail-risk hedging approach at open-end mutual funds PIMCO Global Multi-Asset Fund PGAIX and PIMCO RealRetirement target-date funds. The strategy is also being used at many of the firm's institutional and separate account mandates. All in all, the tail-risk hedging part of PIMCO's business has grown into several billion dollars in assets under management.
Lessons from Science for Investing
Bhansali's views on the management of investment risk and its mitigation have been informed by his unconventional background. He obtained a Ph.D. from Harvard in theoretical particle physics. In his early years as a professor, Bhansali's reputation for high-level mathematical abilities and his rigorous thought process attracted the attention of New York investment firms, which were always looking for "rocket scientist" researchers to develop highly complex trading strategies. One of his callers, from Goldman Sachs, was Fischer Black, who is best known for his work on options pricing and the Black-Scholes equation. Black recruited Bhansali for a position on his research team. Bhansali turned him down to continue teaching physics.
Many more solicitations later, however, Bhansali relented and took a position at Salomon Smith Barney/Citigroup as a derivatives specialist. "I figured that if I did that for a few years, I could always return to academia," he says.