RMI Applications: Tail Risk Hedging

Note: This article appears on the ETFtrends.com Strategist Channel

By Giralda Advisors

In our preceding article [RMI Applications: Sector Rotation Using ETFs], we outlined one practical application of Risk-Managed Investing (RMI) — specifically, a momentum-based sector rotation strategy designed to mitigate the downside risk of protracted equity bear market declines.  While this strategy may additionally provide some protection against sudden market crashes, it is not expressly designed to do so.  For that element of protection, we believe a complementary RMI approach is prudent. “Tail risk hedging” is the attempt to provide direct protection against unexpected, quickly-developing, potentially devastating drawdowns in equity markets.  Such events, often called “black swan” events, represent very low frequency (i.e., extremely rare) but very high severity risks. In technical terms, they occur in the outer reaches, the so-called tail, of the probability distribution of possible market outcomes and thus efforts to mitigate their financial consequences are termed “tail risk hedging” (TRH).

Winnowing the Field

There is no shortage of techniques available to protect portfolios from tail risk, and there has been a proliferation of products offering these techniques since the financial crisis of 2008/2009.  Most of these products have unacceptably excessive costs in our opinion — due to high fees, underperformance during normal markets, and/or limiting the overall portfolio’s potential for upside growth.  Some lack reliability when protection is required.

Another option — one much more practical for the typical investor — is to look for strategies that can be used over the long term as buy-and-hold investments.  In this regard, we evaluate candidate TRH strategies against the following three criteria:

  1. Sudden appreciation when equity markets suddenly and severely decline, to a degree that meaningfully offsets the decline, and no give-back of that appreciation when equities recover;
  2. Very low carrying cost (direct and indirect) during periods when protection turns out not to be needed; and
  3. Minimal disruption to the rest of the portfolio.

Several common hedges do not make it past these criteria.  For example, equity put options, which some would consider the classic hedge, are generally quite expensive and therefore tend to fail criterion #2.  Also, unless one is adept at market-timing the exiting/monetization of the puts, they typically fail the latter part of criterion #1.  Equity collars generally fail for similar reasons, though their cost (i.e., the sacrifice of upside potential) is more indirect than the explicit cost (i.e., the option premium) of puts.  Self-described “black swan funds” are designed to do well only during severe equity market declines; the portfolio allocations necessary to make them impactful (i.e., the diversion of funds from more productive investments) can result in seriously underperforming portfolios during normal markets, thus violating criterion #3.

In fact, these three criteria result in the elimination from our consideration of a majority of commercially available TRH instruments.

Some Promising Approaches

In our TRH research, we have found two categories of hedges that we believe hold the greatest promise.  They are based on two phenomena that exhibit the appreciation behavior required by our first criterion.  The two categories are equity market volatility and cross-asset-class correlation.  Both tend to spike when equities suddenly decline.  The latter, correlation, is conceptually intriguing but, in our view, is not yet an accessible reality for most investors.  We have concluded that, currently, volatility is the single best source for the timely appreciation that is central to TRH.  There is a variety of ways to access and monetize volatility spikes.

One sub-categorization of volatility is “realized” vs “implied.”  Realized volatility is typically the standard deviation of the S&P 500 Stock Index over some recent number of days or weeks.  It is objective and backward-looking.  Implied volatility is essentially what the market (buyers and sellers of equity options) believes realized equity volatility will be in the future.[1]  It is therefore subjective and forward-looking.  Both versions of volatility can be accessed through investable products, and we believe that, if done cost-effectively, both should be accessed, in a properly diversified TRH mix.

Related: The Tolerable Cost of Risk-Managed Investing

Within the implied volatility sub-category, there are a good number of available investment vehicles that can provide access.  A detailed description of each is beyond the scope of this short article but, typically, the instrument is a derivative, specifically, options or futures.  We mentioned two traditional options-based approaches earlier, namely equity puts and collars but, again, they do not meet our TRH criteria.  There are more cost-effective ways to access similar hedge-like behavior.  Some involve options and futures on VIX, the industry-standardized index of implied volatility.  To help contain the carrying cost of these instruments, signals can be employed to, in essence, turn the derivatives on and off.  Signal-based approaches introduce a new risk into the mix, of course, and that is the risk that your signal may prove to be unreliable.  Signal risk can be managed by diversifying across strategies that employ different signals.