With bond yields at historic lows, particularly in the US, pension funds have been searching for new forms of downside protection to reduce tail risk, boosting demand for certain types of hedge funds in the process. In the US, too, where demand is invariably met by a quick supply of new products, specialist ‘tail-risk funds’ have started to pop up.
According to Max Darnell (pictured), chief investment officer at currency and global macro manager First Quadrant, tail-risk hedging is clearly a hot topic but it should be viewed in the broader context of a fund’s whole portfolio. The cost of hedging is also an increasing concern in today’s markets, he says.
Tail-risk hedging is defined by the desire to avoid, or at least minimise, large short-term downdrafts in the value of the investment portfolio, sometimes thought of as ‘black swan’ or unpredictable events.
First Quadrant published two papers on the subject, in September and October, the first of which was written by Darnell, who was the firm’s director of research before taking on the CIO role in 2002. In it he says decisions to hedge tail-risk are just one example of investors engaging actively in asset allocation.
“Downside risk comes in many forms and tail-risk hedging focuses only on a subset of those.”
Darnell argues that there is possibly too much focus on big short-term impacts to the detriment of considering the likely effects of a prolonged period of weak economic conditions or big themes such as new companies or industries rising to replace previously dominant ones over time.
“Managing against the risk of longer-term cumulative depreciation in asset values should, whether one thinks these scenarios are relevant or not, be moved to the centre of this discussion alongside concerns about shorter-term adjustments,” he says.
While he is not opposed, in principle, to investors allocating a certain amount to a specialist tail-risk fund, he questions whether they will have the discipline to reallocate whatever gains are made through that fund to buy back into the asset classes which they are designed to protect after their values have fallen.
Jeppe Ladekarl, First Quadrant’s a director on First Quadrant’s global macro team, says the world is in an environment where more tails can be expected. Two obvious areas are in fixed income and currency markets.
“Retail investors, in particular, do not expect to get capital losses in fixed income,” he says. “But because of the duration (bet) they will probably get that. If you buy a bond for $80 and hold it, you can get $100 in eight years. That’s the pull to par. But if you hold it in mutual fund form you will experience the full mark to market effect of changing interest rates, potentially leading to portfolio sales as rates go up. In the hold-to-maturity portfolios of banks you don’t see the same mark to market effects on a daily basis. That’s exactly what the banks are banking on, if you can excuse the pun, with their portfolios.”
With currencies, some people think that a static hedge, such as the commonly used 50 per cent level, is a “benign choice” but it actually carries a huge risk, Ladekarl says. Over time the losses and gains from currency will wash out but after a big rise or fall, when cheques have to be written to cover the hedge, investors then do not have the dry powder to take advantage of the cheaper underlying asset prices.
Before joining First Quadrant last year, Ladekarl was the principal portfolio manager for currency and global tactical asset allocation for the World Bank’s pension and endowments department.
“Our everyday risk management considers geo-political issues,” he says. “This is not confined to emerging markets, on which the world has become more dependent, although they have less time-tested infrastructures … People should be worried about political stability in Europe, too, three years down the track.”