Hedging downside tail risk

The first step in portfolio construction is to find the optimal allocation across asset classes that, on average, provides the highest return for a given level of risk.

Traditional portfolio theory shows that returns tend to follow a so-called bell curve distribution, with the most probable returns concentrated around the centre, or the mean return. Less probable returns narrow away towards the edges of the curve where the least probable, but more extreme, returns lie.

Managing risk

While it is important to manage overall risk in a portfolio, tail risk on the left hand side of the curve is arguably the most important as it corresponds to heavy losses. Although it is less likely, these events tend to be more severe in terms of frequency, duration and magnitude of losses than theory would suggest.

Financial markets do not tend to behave “normally” and periods of market stress tend to occur more frequently and globally than investors may expect and theory suggests. It therefore has the potential to wipe out a portfolio’s value and with it prevent investors meeting their objectives.

What tends to be forgotten is that even in a bull market, corrections happen, as highlighted in the alternatives article in Market Perspectives last month, an average correction of 10% each bull year in equity markets. Such downsides are not restricted to equities. Bonds can also experience significant yield volatility, for instance the taper tantrum of 2013, on the surprise tapering of quantitative easing by the US Federal Reserve, and spreads rocketing last year at the height of the pandemic.

Thus, long-term investors may want the risk/return profile of a portfolio to be asymmetric and the left tail thinner. There are three potential avenues that might be considered to achieve this.

Hedge funds to protect left tails

First, options can be used to manage portfolio risk exposure. Buying puts provides insurance and may take out the whole of the damaging left side of the tail of the curve. However, there is a premium to pay for this “left tail”, which is either a cost to the investor or offset by selling calls and giving up some of the potential upside return. It creates asymmetry but at a significant cost.

Second, futures allow a dynamic asset allocation approach to be used. Buying and selling futures contracts can help to shift portfolio asset class allocation in order to participate in any upside and protect against severe losses. Such a strategy is less expensive and more flexible than options.

However, it requires regular portfolio monitoring and a framework embedded into the portfolio. For many focused on investing over a long-time horizon and without constant changes, this could prove tasking and the timing of a correction might still be difficult to judge.

Preferred approach

The final avenue, and our preferred choice, is to externalise the management of tail risks and consider hedge funds with systematic asymmetric returns: low beta strategies such as market neutral, macro multi-strategy or low net long-short equity may all help to reduce the left tail in a portfolio.

By actively selecting managers with robust processes and proven investment methodologies, investors could make the step up from efficient diversification to hedging tail risk and an asymmetric return profile.

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