Managing Risk in Your Portfolio with Tail Risk Hedging

2020 has been a tumultuous year. The recent economic and market turmoil has highlighted the fragility of the market and how extreme market conditions can occur even when most experts and statistical models predict stability. In such circumstances, the most diversified portfolios can also break down. This creates a conundrum for investors. Typically because on one hand, investors need to take risks to generate higher returns, but on the other hand, they do not have the risk tolerance for such significant risk levels or losses.

Generally, there are two approaches to investing. One is to chase returns and bear high risks while the other is to minimize risk and accept low rewards in return. In most cases, investors follow the first approach when the market is in a good condition. Whereas they switch to a minimum risk mode as soon as the markets sell-off. This eventually causes risky securities to be held during their lowest returns and the shift to a secure portfolio occurs when low-risk securities are the most expensive.

However, it is possible for investors to find an optimal way of investment, balancing their rewards and returns. One of the most effective methods that can protect investors against extreme market volatility is tail risk hedging. Tail risk hedging strategies allow investors to tap lucrative opportunities during low market situations. In March 2020, the Coronavirus pandemic affected economies globally and led to a huge market decline not seen since the financial crisis of 2008 or the Great Depression. It was during this time when tail risk hedging strategies came to the limelight again after 2008.

Here is what you need to know about tail risk hedging and how this strategy can help in managing your portfolio’s risk:

What is a tail risk loss

There are times when the market goes abnormally up or crashes abysmally. On days when the market is positive, the investor garners a significant profit with no loss. But, on the days when the market crashes, the investor stands to lose a lot. Sometimes, a market low or a crash can last for several days. Even though it is not possible to predict these market movements with precision, the induced losses can certainly be massive. This risk of loss is known as tail risk.

Mathematically, the distribution of returns of an investment portfolio is defined through mean and standard deviation. In a normal investment portfolio, the risk and return fall between mean and three standard deviations. This implies that the returns can be negative or positive but will fall in a clearly marked 99.7% range. However, when the distribution of returns occurs in an undefined territory and is more skewed, it is accompanied by tail risk. Generally, this happens when there is a shift of more than three standard deviations in the return distributions. Traditional portfolio strategies are found on the basis that market returns observe a normal distribution. However, the concept of tail risk specifies that the distribution of returns is not normal. Instead, it has a fat tail (a risk that is more than three standard deviations from the current price).

Tails are the end portions of the distribution curves that depict the statistical probabilities of different outcomes. In the investment world, these distribution curves show the possibility of achieving different investment returns over a defined time. However, in reality, markets do not behave so normally and there are periods of financial distress. These periods create ‘fatter’ tails than a normal curve.

In more general terms, tail risk is an unforeseen event, which has the potential to bring the investor a big loss. For example, for a real estate investor, the COVID-19 pandemic could have ceased the rental income for months. For an online business, the sudden regulations or intentional disruption of digital streaming can disrupt the entire network and cause massive monetary loss.

That said, it is not possible to predict events accurately in life or their impact on the stock market, in particular. However, it is possible to manage these tail risks by buying a financial instrument known as insurance. In the stock market, these insurances are particularly known as put options and form a critical part of the tail-risk hedging strategy.

What is tail risk hedging

Tail risk hedging aims to protect investors against extremely volatile market conditions. Tail hedges can potentially help investors reduce their losses in adverse market situations. There are different ways that investors can use to employ tail risk hedging. One way to do this is to restrict your asset allocation in unstable sectors. Another method is to maintain your existing asset allocation and apply strategies like equity puts, credit protection, currency and interest rate options. These strategies may also better equip investors to hold on to their long-term vision and stick with their positions during tough times. In some situations, tail hedges can help create a potential for investors to opportunistically invest in risk assets even during times of market distress.

The ultimate objective is to give up a portion of your return each year to secure protection against a market meltdown. Investors have to focus on their key risk factors and find the cheapest way to protect against such risks. For example, in a general investment portfolio, equity is a major risk contributor. However, it is important to assess how equity securities interact with other components. Equity is one option to hedge against risk, but it is not the cheapest one available. Earlier, the credit derivative market was a more economical source of hedging risk rather than an equity options market. Similarly, investors can opt for multiple asset classes and take longer time horizons to create an inexpensive tail risk hedge.

In the stock market, if an investor buys a cheap put option with a strike far from the trading price, the investor is following a tail risk hedging approach. In such a case, when the market suddenly slopes downwards, the value of these cheap put options witnesses a surge in their prices to many multiples of their initial price. This will help the investor offset the losses, which the market crash may have otherwise caused. Hence, by leveraging proper risk management techniques through the purchase of assets that potentially profit from an adverse market situation, investors can reduce their losses significantly.

When investors hedge against drastic, potentially-loss incurring market events, they assume the short-term costs. Investors can also look to diversify their portfolios to hedge against tail risk. For example, if an investor holds ETFs (exchange-traded funds) aligned with the S&P 500 Index, the investor can hedge the tail risk by buying derivatives on the Chicago Board Options Exchange (CBOE) Volatility Index. The CBOE index is negatively correlated to the S&P 500 index. So, if in case the value of the S&P 500 ETFs falls, the loss can be minimized with the gain from the CBOE index.

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Who is likely to benefit from tail risk hedging

All investors that need to beat a low-risk or liability matching fixed-income portfolio to ultimately meet their financial goals, will likely benefit from tail risk hedging. This is particularly helpful for institutional investors, such as insurance companies that need to outperform to meet their profit goals, endowment companies that need to meet their constantly rising return targets, and superfunds that rely on excess returns.

What are the disadvantages of tail risk hedging

Even though the idea of tail risk hedging that aims to profit from a market down is alluring, it is critical to remember that tail risk hedging and other similar trading or risk hedging strategies have their flaws. Some of the most important drawbacks of tail risk hedging are:

• The tail risk event has a statistically very low probability of occurrence and it may also never happen.
• The investments secured in put options to protect the portfolio may backfire if the market trends upwards or worse, it trends sideways.
• The hedging strategy involving put options (the most common and preferred tail risk hedging tactic) is complicated and difficult to manage. If not managed properly, this tail risk strategy can incur additional losses rather than minimize them.
• The sudden inclination towards tail hedging strategies shows fear among investors. This in turn, fuels the market to behave more abnormally.

Owing to these disadvantages, several experts do not recommend adopting tail risk strategies, unless there is sound professional help. Even then, tail risk hedging has gained a lot of popularity and has also benefitted from the work and writings of famous authors.

Is tail risk hedging worth it

Typically, sound tail risk hedging will have some near-term costs. However, owing to its significant benefits, it can enhance the investor’s return potential by mitigating losses when a market storm hits suddenly. Moreover, tail risk hedging can aid in providing liquidity even during a crisis. This helps investors buy assets at a much lower price as other investors suffering losses are forced to sell. Further, tail risk hedging is ideal for investors who wish to take greater risks elsewhere in their portfolio. In all, tail risk hedging strategies have the potential to add value even during a financial crisis. This value addition is usually more than the value added by the tail risk hedging strategies in the long-term.

To sum it up:

Tail risk hedging can be a great strategy, potentially enabling investors to pursue their objectives without requiring them to adjust their risk or return expectations after a market downturn. That said, there are numerous ways investors can employ tail risk hedging. However, given the complexity of management, active involvement, and implementation in hedging, it is advisable to consult with a professional financial advisor to leverage this tactic for a protective shield during tough times.