Extreme events potentially lurk around every corner these days it seems, so it’s no surprise that the topic of tail-risk hedging has resurfaced with a vengeance as investors seek better downside protection.
But rather than asking how to protect their investment portfolios against extreme risks, asset owners should perhaps first ask themselves whether it's worth the effort to do so.
The Thinking Ahead Institute reckons the top-three extreme risks that could have a big impact on economic growth and asset returns are, in declining order of importance: global temperature change, global trade collapse and cyber warfare*. The institute, part of investment consultancy Willis Towers Watson, set out these potential outcomes in a report released last week, Extreme Risks 2019.
The current US administration has likely helped push the first two up the agenda, given President Donald Trump’s trade wars and his withdrawal from the Paris climate change agreement.
US public pension funds are certainly showing concern about the environment, Jay Kloepfer, head of capital markets research at US consultancy Callan, told AsianInvestor last month.
“For the first time in a long time we’re having explicit discussions about tail-risk hedging – though we haven’t seen any implementation yet – and of hedging in general,” he said.
But some in the industry are asking whether it makes sense to do much at all – or if asset owners are ready to do what is really needed.
Peter Ryan-Kane, Hong Kong-based founder and head of independent investment consultancy Perk Advisory, suggests tail-risk hedging is an "urban myth".
“In my experience, as an investor and consultant,” he told AsianInvestor, “I’ve not seen a portfolio take a large-enough position in a so-called tail hedge asset to actually have a meaningful impact in the portfolio if they suffered a very bad experience in the bond or equity markets.”
“The two things you’re trying to hedge are the Bloomberg Barclays Global Aggregate and MSCI World [benchmark indexes] – those two big betas,” Ryan-Kane said. “Anything that is going to be really materially uncorrelated with those has to be an asset with no bond or equity characteristics.”
Hence often a tail-risk hedge will be an asset that is illiquid or has high transaction costs, or a complex derivative, he said. “So once you net off the entry and the exit from your tail-risk return, you’ve mitigated it even less.”
For example, putting just 5% of a portfolio into gold – a common tail-risk hedge – will not help if interest rates go up by 200 basis points or equities fall by 20%, he added.
However, to allocate 15% or 20% to a physical asset that yields zero, costs money to store and has high transaction costs and very little liquidity, Ryan-Kane said, “I think you’ve got to join the preppers** in Virginia and dig a burrow somewhere in order to justify that to your investment committee”.
Ultimately, his advice to clients considering a tail-risk hedge has been that if they don't feel the risk-return characteristics of their asset mix suits the prevailing environment, then the best solution for them is to change the asset mix.
Willis Towers Watson also flags the difficulty – and expense – of protecting against extreme events. For one thing, cash has held its value through long periods of both delation and inflation, but there's no guarantee it will do so in the future, it said in the report.
In respect of derivatives, added the firm, “it is worth mentioning that cost and usefulness are often in opposition. The cost of derivatives protection can often be reduced by specifying more precise conditions – but the more precise the conditions, the greater the chance that they are not exactly met and hence the ‘insurance’ does not pay out.”
As for holding a negatively correlated asset, there is no single asset that will work against all possible bad outcomes, added the firm. “Further, there is no guarantee that the expected performance of the hedge asset will actually transpire in the future.”
To that end, Willis Towers Watson said, there is no ‘single answer’ for portfolio construction, thus recommending “a combination of diversity, risk management, dynamism, best-in-class alpha and innovation”.
* The three outcomes were defined, respectively, as: Earth’s climate tips into a less-habitable state (hot or cold); a worldwide protectionist backlash against cross-border trade; and the internet being weaponised that causes severe damage to virtual systems vital to the economy and even to hard infrastructure.
**Survivalists preparing for catastrophe.