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Tail-Risk Hedging--Dos and Don'ts

Know what risks you are getting into when hedging tail risks.

Terry Tian, 03/29/2012

Wall Street never falls short of providing products that cater to an investor's perceived need. Tail-risk-hedging products are the latest invention. But what exactly is tail risk, and is it something that needs protecting against? If so, how does one go about it?

The Mysterious Tail Risk
People tend to use the word "tail risk" to describe rare events that have tremendous negative impact, such as equity market crash, surge in interest rates, government default, sustained inflation, wars, and natural disasters. In statistical terms, tail risk is usually defined as the probability of asset or portfolio value moving more than three standard deviations from its mean, assuming returns are normally distributed. In a normal world, a tail-risk event has a 0.13%, or a 1 in 769, probability of occurrence. In reality, however, these events occur much more frequently.

For example, the historical mean and standard deviation of monthly S&P 500 stock market returns between February 1926 and February 2012 (1,033 months) is 0.94% and 5.53% (annualized), respectively. The mean less 3 times the standard deviation is negative 15.65%. Therefore, a tail-risk event would be a monthly loss of more than 15.65%. These large monthly losses should have occurred only once (1.34 times, to be exact) over the 1,033 months, assuming monthly stock market returns are normally distributed. If this is the case, any rational investor should not worry too much about hedging such a rare event that is almost impossible to happen again in his lifetime. In fact, such drawdowns have occurred 10 times since 1926, indicating that tail-risk events occur about 7.5 times more often than the normal distribution would suggest.

Why Should Investors Care About Tail Risk?
While investors should theoretically be invested for the long term, a portfolio can be destroyed by tail events in the short term. If the tail event occurs close to retirement or just before a major cash outlay (such as the purchase of a house or college tuition), the effects can be irreversible. For example, a 60/40 portfolio (of the S&P 500 and the Barcap US Aggregate Bond indexes, respectively, rebalanced quarterly) lost 34.5% between Oct. 7, 2007, and March 7, 2009. This loss was recovered during October 2011, two and half years later. During that time, some investors needed to make withdrawals to survive unemployment or other unexpected cash outlays, putting them even further behind their retirement or other goals.

It is impossible to hedge against every type of tail risk out there, but investors should at least think about protecting against equity risk. After all, in a typical 60/40 portfolio, the 60% equity portion has historically generated about 90% of the volatility. Logically, however, even with this clear definition, one important question still remains unanswered: How to do it?

Tail-Risk Hedging—the Wrong Way
The intuitive solution of equity tail-risk hedging is to invest in something that will pay off handsomely when the stock market crashes--just like buying insurance to protect against catastrophic accidents in your personal life. A number of financial products that are negatively correlated with the stock markets can serve the purpose, such as equity put options, long volatility exchange-traded funds, inverse stock index ETFs, and bear-market funds. Unfortunately, these products do not work the same way as your life insurance.

Life insurance usually asks for monthly premium overtime and pays off automatically upon death, which is inevitable at some point in the (hopefully) distant future. Portfolio insurances, however, can cost much more upfront and may never generate any profit. Looking back through the rear mirror, investors are often amazed to see the big payoff of portfolio hedges during distressed times, but what they failed to consider is that the value of those insurances tends to fall sharply when the crisis passes, leaving the long-term returns very disappointing. If investors try to manage hedging costs by buying low and selling high, there's a good chance that they will mistime the market, taking off their insurance exactly before the even worse crash happens.

Terry Tian is an alternative investments analyst at Morningstar.

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