Trends in Tail Risk Investing

310 investors were asked their views on tail risk in today's market environment in a survey conducted by the Economist Intelligence Unit on behalf of State Street Global Advisors.  They were located in the US and Western Europe and consisted of institutional investors (asset managers and pension funds), family offices, consultants and private banks.  The definition of tail risk is an investment that moves more then three standard deviations from a normal distribution (think bell curve) of returns.  Since the 2008 credit crisis, these events have seemingly multiplied.  Adding tail risk protection is becoming part of more investors' asset allocation model.

Traditionally, most managers diversified across the standard equity and fixed income classes along geographic, capitalization and security type.  There was a reduction of 5% of investors in using this strategy, led by institutional investors.  Slightly more consultants, family offices and private banks are using diversification even though the credit crisis showed that all asset classes correlate to 1.  The other strategy to fall was fund of hedge funds due to poor returns, high management costs and the loss of confidence with the Madoff affair.

Strategy winners were managed volatility equity strategies, managed futures and alternative investments such as real estate, commodities and infrastructure.  Managed volatility was increased across the board by the investors with the largest increase by private banks.  There was a split decision on managed futures with private banks and consultants allocating more and institutional investors allocating less assets.  Risk budgeting was stable overall with the institutional investors decrease in that strategy offset by the increase by private banks.  Direct hedging was unchanged as institutional investors and private banks doing more and consultants and family offices doing less.  The same split occurred with hedge fund investing.

Seven main factors affected investors' choice of tail risk strategy.  They are, in order of importance, liquidity, regulatory issues, risk aversion, transparency, fees, understanding/persistency of returns and lack of understanding of new asset classes.  According to Bryan Kelly, assistant professor of finance and Neubauer Family Faculty Fellow at the University of Chicago's Booth School of Business, the best hedges are debt derivatives and credit default swaps.  However, they are not liquid as they do not trade over central exchanges.  They are not considered safe investments such as AAA sovereign debt or gold for the risk averse.  The cost and fees associated with tail risk assets is another consideration.  Most investors know that it will lower expected returns and be volatile.  Another issue is the mismatch in time horizons.  Many products are short term and are being bought by long term investors such as pension funds.

Since the credit crisis, investing has been influenced more by macro economic events.  This will continue into the near future as we continue to hear about possible regional and global recessions, the breakup of the Eurozone, the US fiscal cliff and unrest in the Middle East.  Investors are trying to find the best hedges as 80% of them agree that managing tail risk is part of their investment planning.  71% believe that an event is likely to happen within one year and it will be worse than in the past.

The source for this article can be accessed here.