Investors seek tail risk funds to cover 'black swan' events

Fear of extreme events has spawned a number of dedicated tail risk funds since the global financial crisis. Credit examines what the current major risks are and whether institutional investors need to employ specialist funds to hedge them.

John D. Rockefeller once said he tried to turn every disaster into an opportunity. Today, it would seem, everyone is trying their hand. Tail risk is the talk of the markets and increasing numbers of funds are offering ways to hedge against the bleakest scenarios imaginable. With the recent global financial crisis still fresh in the memory – indeed, some commentators would argue it has not yet fully played out – investors are taking more care than usual to insure themselves against losses.

Tail risk, defined as a three-standard-deviation event (in other words three standard deviations from the mean, in theory holding a probability of 0.3%), has refused to leave the agenda.

“You need to hedge against disaster scenarios,” says Hoang Le Huy, head of fixed income and event strategies at Schroders NewFinance Capital, a London-based fund of funds. “Black swan events are at the forefront for a lot of investors right now. It is not something that people take lightly. A lot of tail risk funds were built on the back of the 2008 disaster.”

‘Black swan’ is a term that has come to the fore since the publication in 2007 of the eponymous book by the mathematician and finance academic Nassim Nicholas Taleb. A black swan event is entirely unpredictable, carries a large impact and cannot be satisfactorily explained after the event. (It had been assumed in the West from Roman times that black swans did not exist, until they were discovered in Australia in 1697.) The terrorist attacks of September 11, 2001 and the recent global financial crisis are generally considered examples of black swan events.

Major tail risk events are supposed to have a probability of 0.3% and yet they happen far more frequently than that figure implies. According to a study conducted by Ric Thomas, head of alternative investments absolute return strategies at State Street Global Advisors in Boston, there have been 16 three-standard-deviation events in the last 80 years.

“If the market was normally distributed you would only have seen three, so clearly the market is not normally distributed,” he says. “There are many more left-tail events [negative tail events] than you would expect. In the last 15 years, we have seen the collapse of the Thai baht and subsequent Asian financial crisis, the subprime crisis, the dotcom bubble-and-bust, the Russian default. It seems like there is something every five years, but we do not see a global financial crisis very often. The last time we saw anything significant like that was 1929 through 1933.”

The financial crisis has spurred many investors to set up fresh funds devoted to tail risk hedging. Gaurav Tejwani, head of structured credit at hedge fund manager Pine River Capital Management in London, says the firm was persuaded to roll out its tail risk strategy for external investment as the Greek debt crisis escalated in May 2010. Its dedicated tail risk fund is called the Nisswa tail hedge fund and has $266 million in assets under management.

“That was the trigger point for the fund being spun out, because many investors saw in May they needed protection and that it worked,” says Tejwani. “Our May performance would have been significantly more negative without the tail risk strategy and that only required an allocation in single digits [as a percentage of the fund’s assets-under-management]. So that speeded up the launch. It goes without saying that only when fear comes back into the market do people start thinking about protection.”

Other funds have launched in recent months. In March 2010, Capula Investment Management, a London-based fixed income fund manager, launched a tail risk fund that reportedly has $1.5 million in AUM. Saba Capital Management also opened a tail risk fund in 2010 with around $150 million in AUM, according to media reports. (Capula and Saba Capital both declined to comment for this article.) Bennelong Asset Management launched the Bennelong Tempest Fund on October 1, 2010, with $35 million of AUM, while asset management giant Pimco also launched its own dedicated tail risk fund in 2010.

The opening of these funds reflects both an awareness that most investors failed to protect against systemic shocks prior to the financial crisis and a conviction that the market is not out of the woods yet. Instead, there are several current systemic risks leading fund managers to keep an eye trained on tail risk.

“From a credit perspective, the level of debt held in Europe’s periphery is a particular risk,” says a senior manager in derivatives structuring at a large London-based asset manager. “The other major risk in Europe is short-end central bank rates, which there is lots of speculation about. I am still concerned about the inflation story and investors are looking at opportunities to lighten up in bonds to reflect that. Beyond Europe, the fiscal situation in the US is high on the list of risks and so is the municipal debt situation.”

Nassim Nicholas Taleb co-founded Universa Investments, which specifically concentrates on tail risk, with former trader Mark Spitznager in early 2007. Taleb is especially focused on the risk of inflation or deflation, and frequently likens the policy challenge facing developed economies to flying an airplane. According to this analogy, there was a plane crash in 2008 and the federal governments of the world chose not to replace the pilots but to give them a larger, more complicated plane to fly. These pilots now have to navigate between a mountain in front of them and an ocean beneath them (representing inflation and deflation), while having to land on a tiny strip of runway.

“Universa believes the biggest risk in the system is debt because it led to the financial crisis, and all that has happened since is that the debt was socialised. It has not gone away,” says a source close to the fund. “That leaves the solution of extreme inflation. Otherwise, there is the risk of extreme deflation, which makes it impossible for governments to inflate their way out of debt.”

Sting in the tail

Taleb is not alone in foreseeing extreme market problems. Thomas at State Street argues the debt problems in Europe, Japan and the US municipal market are of special concern. He views three ways out of these problems: defaults, further quantitative easing (QE) or a soft landing. But he views a soft landing as the least likely because of the fine tuning it would require.

“If there are defaults, then it gets ugly and if there is QE then you could have an inflationary problem,” he says. “You already have commodity prices going up dramatically and that is completely as a result of excessive monetary easing around the globe. So these will lead to either deleveraging or deflationary problems.”

Fundamentally, the problem of excessive debt in the developed world remains unresolved. Moreover, so long as one of the main solutions proposed by governments is QE, then the danger of a major financial downturn cannot be discounted, Thomas argues.

“Most global financial crises are preceded by excessive monetary easing,” says Thomas. “That was the case through the Great Depression and through 2008. There was an excessive amount of monetary easing; we are also seeing that today and it is not a stable condition. At some point we need monetary authorities to be a little less accommodating.”

In the short term, Bennelong Asset Management is also focused on the “worrying debt maturity profile” of European sovereigns and their banks; Asian inflation; and the potential damage that an “unexpectedly stronger dollar may have on global risk asset prices”, says Paul Henry, London-based co-chief investment officer at the firm. Over a medium- to longer-term horizon, high levels of US federal debt and the expiry of QE2 are considered a major risk; as are overheating in China, potential stresses in the Japanese bond market and currency, stricter capital controls in the emerging markets, and further austerity measures in Europe.

Fear of systemic market downturns is leading some asset managers to turn to dedicated tail risk funds for insurance. Although fund managers have their own hedging strategies, the current climate of heightened risk, coupled with the rising interest in tail risk generally, makes such funds more attractive. “The mandate of our tail risk fund is extremely opportunistic, allowing us the flexibility to look globally and across asset classes when structuring positions. These may be difficult for an institutional fund manager to access in-house, both in terms of their mandate restrictions and/or skill set,” says Henry. “In terms of our overall approach to tail risk, we are quite macro-focused, drilling into where we see the key risks in the market and then optimising the risk/reward payoffs for exposure to a particular risk or theme.”

According to Jeroen van Bezooijen, senior vice-president and product manager at Pimco in London, credit investors could benefit from using a diverse range of tools to manage tail risk, especially since buying protection through CDS can become prohibitively expensive during periods of heightened volatility.

“Buying CDS alone means you would just be throwing away all or at least most of your excess return,” says van Bezooijen. “Investors hold credit to earn excess returns over triple-A government bonds, and tail risk hedging should aim to protect these portfolios against large drawdowns. This needs to be done in a clever way so that only a modest amount of the excess return is spent on hedging.”

Many such tail risk funds focus on equity products. For credit investors, that need not be a problem except that it does add a further level of risk to their hedging strategy, since it assumes correlation across credit and equity markets if the insurance is to pay out in a generic credit market crash. In extreme downturns, an elevated level of correlation is reckoned all but inevitable.

“You can put on indirect hedges as a credit investor as well as the usual CDS and options,” says van Bezooijen. “One of the characteristics of these crises is that they are systemic events and macro events, so correlation between asset classes increases. There is some positive correlation between credit and equity in normal market circumstances, but if you go into the tails then that correlation increases and the deeper the sell-off, the more correlated equity and credit get.”

According to this argument, using both indirect hedges and more direct approaches, like purchasing CDS and options, allows fund managers to cut the costs of insuring their investments. Correlation may not always be immediate, but as soon as it appears, investors look to protect themselves. Indeed, Universa’s tail risk fund tends to attract more credit investors as soon as they see beta hitting their markets.

But an even more fundamental strategic question for tail risk funds is whether they should identify particular risks to hedge or only insure their clients against a more broad-based market disaster. Some economic and financial problems, of course, are deeply politicised. This is especially true of Europe at the moment, and tail risk funds would be unwise to make too many assumptions about political developments. Instead, most look to hedge against not the first victim of a downturn but the more generalised ripple effect that ensues across markets.

“You can try to be a macroeconomist and predict where the next catastrophe is coming from but that is incredibly hard. We believe in the long run you cannot do that,” says Tejwani at Pine River. “Some of these tail risks are, by definition, unpredictable. We are more worried about a scenario where even a relatively well-hedged strategy loses money. In those situations, you see various long-only or short-only funds which you thought were diversified and hedged suddenly start to look highly correlated.”

No room for manoeuvre

Moreover, hedging against minor or ring-fenced risks can be expensive and begin to undermine the profit potential of investment portfolios. For tail risk protection, liquidity is vital and this is harder to achieve if your hedges are especially targeted.

“You want to stay in the most liquid, most actively traded option markets. You can stick to exchange-traded options, because if you actually hit a crisis then you are in the best position to also monetise these hedges,” says van Bezooijen. “If you go into things that are more structured, bespoke and exotic, then you pay higher transaction costs but it also might be harder to get out when a crisis hits. What use is a tail risk hedge if you cannot actually get the money out when you need it?”

Van Bezooijen says the specific composition of its tail risk portfolio will vary depending on pricing; but says it will usually entail some combination of equity puts, credit options, CDS index tranches and call options on low-yielding currencies.

According to van Bezooijen, an example of a trade that worked well in the financial crisis involved super-senior tranches on CDS indexes such as iTraxx and CDX. “You could buy protection in 2006 and early 2007 for four to five basis points. When the crisis hit these spreads widened to over 80bp, so as a buyer of protection you got a healthy payoff to offset losses on a credit portfolio. If the crisis and subsequent sell-off had not happened, you would only have paid away a handful of basis points on buying protection,” he says.

Meanwhile, Universa limits itself to exchange-traded products and will usually focus on put options, whether in futures, bonds or equities. But that is not to say tail risk funds can afford to ignore the specific composition of their clients’ portfolios; in Universa’s case, the choice between futures, bonds or options will reflect the client’s underlying holdings. Thus, individual tail risk funds tend to appeal to managers of particular kinds of portfolios. Moreover, tail risk funds cannot simply hedge and then take a long lunch. Management needs to be both broad in terms of asset class and active in terms of daily trades.

“For a given cost or budget, we try to find the most asymmetric trades across equity derivatives as well as credit derivatives,” says Pine River’s Tejwani. “We have constraints so we cannot put all our money in one market, but we have the flexibility and the ability to actively move it and that is where we can add value. We are not trying to predict where the next crisis will come from, but we can see whether tail insurance is definitively cheaper in equity or credit markets and likewise going across various instruments globally.

“You cannot imagine a black swan situation not affecting either equity or credit markets. So our strategy effectively behaves like an out-of-the-money option [i.e. a fund with no intrinsic growth value in normal market circumstances]. It sounds extremely simple to construct a fund that performs well in a tail risk scenario, but in practice it requires constant management. It is not something where you do an occasional trade and then forget about it. We often have multiple trades every day,” he adds.

Bennelong’s Tempest Fund uses options and swaps that have a known limited downside to hedge against specific events and more general market downturns. “There is a shorter-dated component to the strategy [maturities of less than six months], which aims to capture short-term pullbacks in risk asset markets,” says Henry. “These positions allow the fund to benefit as asset prices move towards the tail risk event. More longer-dated options and credit default swap positions are structured to pay off in the event of more extreme price movements.” 

The fund currently has derivatives positions in equities, currencies, commodities, credit, fixed income and inflation/deflation structures varying in duration from 10 days to 30 years. The fund is currently positioned to benefit from any significant increase in inflation or positive shift in yield curves.

“In terms of more specific positioning in the fixed income and credit space, the fund is currently invested in long CDS protection across a variety of European sovereign, European financial and Japanese corporate debt as well as owning call options on five-year and 10-year swap curves,” says Henry.

Optional extras

Thomas at State Street points to four possible tail risk protection strategies. Among these, the use of options or the adoption of “trend-following futures-based” (or managed futures) strategies are two approaches that may make sense for credit investors. The problem with the first approach, according to several fund managers, is that it can be expensive to use put options or CDS, not least because so many fund managers have adopted this approach since the crisis. Indeed, it is because this approach is unsatisfactory that many investors park a small percentage of their AUM with a tail risk fund instead of trying to hedge against tail risk themselves. One example of an investor outsourcing the hedging of tail risk to another firm is SFCS Capital, an investment management boutique that uses Universa for this purpose.

“Simply hedging is not as straightforward as it seems,” says Claude Bovet, head of alternative strategies for SFCS Capital in Vancouver. “Buying out-of-the-money puts to protect the left tail would cost roughly 10% a year. Universa is able to give us the tail protection at a net gain over the year on average and this is guaranteed not to fail or blow up.”

In terms of day-to-day tactics, Tejwani says tail risk fund managers need to be focused on where insurance is cheaper to buy: stress-testing their book to various shock scenarios and to, for example, a typical ninetieth percentile move in credit or equity. That helps them choose between the two asset types. As of late January, Tejwani says the fund prefers equity markets slightly because they offer convexity a little cheaper than credit markets. But he thinks that may be a factor of equity markets responding to problems in Europe slower than credit markets, as was the case in 2008.

Some tail risk fund managers will start with the portfolio make-up of its clients and pick hedges appropriate to these risks. Pimco takes such an approach but still only focuses on extreme scenarios, believing those are the only ones where the protection is worth paying for.

“If you just want to protect against negative return effects and modest volatility, then you pay away so much in protection costs that it is not really worthwhile,” says van Bezooijen. “The strategy is really focused on cutting off these black swan left tails.”

Lower costs

Although the market has been heavily focused on tail risk, recent declines in equity volatility make the purchase of tail risk protection cheap, at least relative to the last three years.

“The volatility index, Vix, is the lowest it has been since April 2007 and it is approaching the lowest levels of all time,” says the source close to Universa. “Universa is attracting clients as a result, and the low level of Vix actually allows clients to take greater risk in their main investments. It is like 2008, when Universa’s investors had liquidity when no-one else did. But tail risk protection also means they can stay long the market; when the market goes down 5% or 10% they tend to actually be adding risk.”

Some funds are too large to be able to fully hedge their portfolios against tail risk given the limited depth of options markets, according to the source. Universa itself has been associated with sovereign wealth funds in China and the Middle East, among the largest investors the world.

The survival of many of the new tail risk funds may be down to the resilience of fund managers and their clients. Tail risk funds are supposed to make losses in ordinary years but investors and fund managers, always hungry for capital appreciation, may lack the patience to sit out the good (or, in the case of tail risk funds, bad) years.

Some do at least offer protection against right-tail risk too, a term used to describe unexpected – and unwanted – market upturns. Nevertheless, if the anticipated next downturn has still not materialised two or three years hence, it could be that some of them start to disappear altogether. Many will be praying for black swans.