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Tail wagging the market…

Investors remain convinced that there are more financial upheavals on the way, so what are the options for protecting your portfolio against future economic catastrophes? If you think of tail risk as being an unexpected, negative market event, then it’s fair to say that the past five years have had more than their fair share of such incidents. From the credit crunch and the collapse of Lehman Brothers to the implosion of the domestic banking sector, investors have seen their portfolios take a hammering. But it may not be over yet. While mathematically speaking there’s less than a 1 per cent chance of such a tail- risk event happening, investors remain convinced that there are more upheavals on the way.

According to a survey commissioned by State Street Global Advisors and conducted by the Economist Intelligence Unit, of some 310 global investors, more than 70 per cent fear another significant tail-risk event will occur within the next 12 months. What this event might be is, of course, unclear, but it ranges from concerns over Europe’s ongoing sovereign

debt crisis to fears of a slowdown in China’s economic growth or decisions on the impending US fiscal cliff. For Irish investors, a key concern over the past few years has been the stability and viability of the euro as a currency. This has led many to seek out safe havens ranging from Swiss bank accounts to gold and German government bonds. But with each option to protect against risk, there are potential downsides, such as currency risk and negative

returns.

“Is putting money in a Swiss bank account that’s paying negative interest any way to protect for the future?” asks Niall O’Leary, head of EMEA portfolio strategists with State Street Global Advisors. Indeed, perhaps the focus should not be on what the next catastrophe might be. As O’Leary asserts: “There will always be something to worry about.” Rather, investors should look to protect their portfolios from the fall-out – whatever that might be. However, while most investors will see the value in having a tail-risk strategy in place, the difficulty arises in opting for one that can actually deliver. “You don’t know if it’s going to work in advance because you don’t know what the tail risk is, says O’Leary. So what are the options for protecting your portfolio against tail risk? Diversification has typically been the first port of call for investors looking to mitigate against risk and volatility, but it might be less effective than you think.

Mitigating

According to the EIU study, for example, more than 76 per cent of those responding have a diversification strategy in place to protect against tail risk. However, before the global financial crisis, this was as high as 81 per cent. “Investors still see it as an appropriate way of mitigating tail risk,” says O’Leary. But he notes that while diversification is undoubtedly important, investors need to be wise to the possible correlation of assets within their portfolios. During the last crisis, for example, risky assets like commodities and property all performed “appallingly”, in line with mainstream equities.

“Risky assets have a very negative return in the event of tail risk, says O’Leary. With such close correlation between asset classes, it can be more difficult to find assets that behave differently in times of stress. In this respect, government bonds have been shown to have diversification benefits, and this is “likely to be the case in future”, notes O’Leary. Risk budgeting is another tool favoured by 55 per cent of investors in the study when looking for “the most effective hedge against tail risk”. It’s a process whereby you assess how much of your portfolio you are willing to lose through measures such as Value at Risk (VAR).

Managed volatility equity strategies, which seek to deliver equity market returns with lower rates of volatility, are also on the rise. Indeed, 58 per cent of respondents to the survey said they now use such strategies, up from 51 per cent pre-crisis. However, they can be expensive, as noted in the survey, with only 39 per cent of respondents asserting that they provide “the best value hedge” against tail risk. For O’Leary however, sometimes it’s worth paying for protection, and likens such strategies to insurance premiums. It’s like home insurance. Be prepared to pay a premium in the expectation that it’s dead money, but that it will keep a roof over your head,” he says. “You don’t not buy house insurance because it’s expensive”.

Distressed

They can also be difficult to access for your typical retail investor, though O’Leary suggests that retail investors option could consider a pooled fund. Some might say that the best protection against market events is keeping your money in cash. This also means that you can step in and buy distressed assets at keener prices in the event of a tail-risk event. But inflation can chip away at your nest egg. “You can’t afford to put everything in cash and earn a negative return,” notes O’Leary, adding, “you have to take on some risk or save a lot harder.” Better, then, to invest in assets that offer a better return but can be converted into cash easily and quickly.

After all, liquidity was the single greatest concern with two-thirds of investors responding to the survey choosing it as a the top barrier to allocating to their tail-risk protection strategies. Why put your money somewhere that might be safe if you can’t access it? But if you feel like the above methods may not be enough to protect your investments, you’re not alone. As the study concludes, there is a concern as to whether or not the tools currently available to investors are adequate. As such, there may be an appetite for new strategies.

Tail risk: what global investors are saying

71 per cent say they fear that a significant tail-risk event in the next 12 months is likely or highly likely

Only a fifth say they are “very confident” that they have some form of downside protection in place; but almost three-quarters say they are better protected for the next tail risk event than they were before this crisis 76 per cent use diversification to protect against tail risk – down from 81 per cent before the crisis 64 per cent say liquidity of underlying investments is the biggest risk to implementing a tail-risk strategy

Source :  EIU, Fiona Reddan

 

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