Recent market turmoil has highlighted once more that extreme market moves occur more frequently than most statistical models predict and diversification strategies typically break down in these circumstances. This creates a conundrum for most institutional investors, because on the one hand they want and need to take risk to generate excess returns, but on the other hand they do not have the tolerance or the capacity for significant portfolio losses. The traditional approaches have been to either chase the return and bear the risk, or to de-risk and accept the lower rewards. Unfortunately the reality is that most investors follow the first approach when times are good and markets are calm, and move to de-risking mode when markets sell off. The undesirable outcome of this is that risky assets are held when the returns are lowest and the transition to safety occurs when low risk assets are most expensive.
We believe there is an alternative approach in the form of Tail Risk Hedging strategies, which protect investors against extreme market moves and therefore allow them to take advantage of opportunities when markets have sold off.
What is Tail Risk Hedging?
Tail risk hedging strategies aim to protect against extreme market moves. The idea is to give up a little bit of return each year to purchase protection against a market meltdown. The focus is on identifying the key aggregate balance sheet risk factors and determining the cheapest way to protect against these risks. So tail risk hedging is a bespoke strategy.
For example, equity exposure will often be a major risk contributor, but it is important to analyse how equity risk interacts with other balance sheet exposures. Equity put options are an obvious and effective way to hedge equity risk, but is it the cheapest way to buy protection? A few years ago, for example, the credit derivative market was a much cheaper source of equity portfolio hedges than the equity option market. Such inexpensive tail risk hedges can be found in almost all market environments if investors consider multiple asset classes and employ longer time horizons.
Who is Tail Risk Hedging Relevant For?
Tail risk hedging is relevant for all investors that need to outperform a low risk or liability matching fixed income portfolio to meet their objectives. It is therefore relevant for many institutions as many superfunds assume excess returns, many insurance companies need to outperform to meet profit targets and many endowments need to meet ever growing return targets.
Tail risk hedging ensures investors are defensive in the short term, enabling them to survive the catastrophes, and offensive in the long term, enabling them to take advantage of post catastrophe opportunities.
What Can PIMCO Offer?
PIMCO has experience in running Tail Risk Hedging mandates for its clients. These mandates are often based around an annual tail risk hedging ‘budget’ (e.g. 75 bps per year) and a “protection threshold” (e.g. no more than 10% loss in the portfolio). PIMCO’s role is to, on a forward-looking basis:
- Analyse the client’s balance sheet to distinguish key risk factors and determine “normal” and “stress period” betas to these risk factors
- Specify potential tail risk scenarios
- Identify cheap hedging solutions and the optimal mix of hedging instruments
- Implement and maintain the hedging solution (including counterparty risk management)
We believe we are well positioned to work with clients to implement these strategies as a result of our strong risk management mentality and analytics, our long experience in derivative markets and our investment process that focusses on macro trends and risks.