An Asset Allocator’s Approach to Tail Risk Hedging

John Liu

The global financial crisis of 2007–09 permanently altered institutional and individual views on risk as investors became acutely aware of the dangers of tail risk in the financial markets. In the years since the crisis, institutional investors have applied different methodologies to manage tail risk in their portfolios. This chapter will discuss the main methodologies and approaches from an asset allocator’s point of view. One of the key difficulties asset allocators face is to properly model and measure tail risk exposure in a portfolio. A simple but useful intuitive model will be introduced: the two-state regime-switching model. This model is used to discuss asset allocation approaches for managing tail risk in portfolios. The risk and reward characteristics, and allocation benefits of tail risk hedging are examined along with analysis of implementation and benchmarking issues. Lastly, a roadmap will be presented for investors to evaluate portfolios and hedge tail risk. This chapter is based on the author’s experience of setting up and running tail risk hedging programmes at a university endowment and a public employees retirement fund in the US, as well as subsequent experience