-
""

Hedging downside tail risk

05 March 2021

5 minute read

By Jai Lakhani, CFA, London, UK Investment Strategist

With financial markets pricing for a vaccine-driven recovery this year, volatility is likely to remain elevated given pandemic developments and how soon the economy returns to health. What can investors do to manage portfolio 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.

""

Market Perspectives March 2021

Encouraging hopes of a vaccine-driven recovery are keeping investors in good spirits.

""

We give you versatility and a choice of services

Barclays Private Bank provides discretionary and advisory investment services, investments to help plan your wealth and for professionals, access to market.

Investments can fall as well as rise in value. Your capital or the income generated from your investment may be at risk.

This communication:

  • Has been prepared by Barclays Private Bank and is provided for information purposes only
  • Is not research nor a product of the Barclays Research department. Any views expressed in this communication may differ from those of the Barclays Research department
  • All opinions and estimates are given as of the date of this communication and are subject to change. Barclays Private Bank is not obliged to inform recipients of this communication of any change to such opinions or estimates
  • Is general in nature and does not take into account any specific investment objectives, financial situation or particular needs of any particular person
  • Does not constitute an offer, an invitation or a recommendation to enter into any product or service and does not constitute investment advice, solicitation to buy or sell securities and/or a personal recommendation.  Any entry into any product or service requires Barclays’ subsequent formal agreement which will be subject to internal approvals and execution of binding documents
  • Is confidential and is for the benefit of the recipient. No part of it may be reproduced, distributed or transmitted without the prior written permission of Barclays Private Bank
  • Has not been reviewed or approved by any regulatory authority.

Any past or simulated past performance including back-testing, modelling or scenario analysis, or future projections contained in this communication is no indication as to future performance. No representation is made as to the accuracy of the assumptions made in this communication, or completeness of, any modelling, scenario analysis or back-testing. The value of any investment may also fluctuate as a result of market changes.

Barclays is a full service bank.  In the normal course of offering products and services, Barclays may act in several capacities and simultaneously, giving rise to potential conflicts of interest which may impact the performance of the products.

Where information in this communication has been obtained from third party sources, we believe those sources to be reliable but we do not guarantee the information’s accuracy and you should note that it may be incomplete or condensed.

Neither Barclays nor any of its directors, officers, employees, representatives or agents, accepts any liability whatsoever for any direct, indirect or consequential losses (in contract, tort or otherwise) arising from the use of this communication or its contents or reliance on the information contained herein, except to the extent this would be prohibited by law or regulation. Law or regulation in certain countries may restrict the manner of distribution of this communication and the availability of the products and services, and persons who come into possession of this publication are required to inform themselves of and observe such restrictions.

You have sole responsibility for the management of your tax and legal affairs including making any applicable filings and payments and complying with any applicable laws and regulations. We have not and will not provide you with tax or legal advice and recommend that you obtain independent tax and legal advice tailored to your individual circumstances.

THIS COMMUNICATION IS PROVIDED FOR INFORMATION PURPOSES ONLY AND IS SUBJECT TO CHANGE. IT IS INDICATIVE ONLY AND IS NOT BINDING.