The term “tail risk” derives from the notion that the possible outcomes of an investment are distributed along something like a classic Bell curve. I write “something like” advisedly: it is now a matter of consensus that a true bell or Gaussian curve describes a much more predictable world than that in which we live, a world in which a “storm of the century” actually would occur only once a century, not once every four years or so.
A tail risk, then, is the risk of the sort of disaster that ought to be quite rare on Gaussian presumptions; the risk that an actual upcoming event will fall on the left side of the curve. On the other hand, an event that falls on the far right side of the curve would be, by definition, a very welcome one.
State Street Global Advisors hosted a webinar Thursday morning on the management of tail risk, based largely on a survey of institutional investors and consultants, both in the United States and in Europe.
The key points offered on the subjects of tail risk and portfolio management by Niall O’Leary, head of EMEA Portfolio Strategy SSgA, and Monica Woodley, managing editor, Economist Intelligence Unit, at the webinar, were as follows:
- That institutional investors and consultants are very sensitive to the fact of tail risk, and are no longer confident that diversification among traditional asset classes is a sufficient approach to the management of this risk;
- That portfolio changes are underway reflecting this heightened sensitivity;
- That in the universe of investors, understandings and expectations as to the costs and effectiveness of the various measures that can be employed to manage tail risk remain quite fluid; and finally
- That SSgA has its own views about how these understandings and expectations might solidify in the near future.
The underlying survey included four different types of respondent: institutional investors (34percent of the whole), private banks (27 percent), family offices (20 percent), and consultants (19 percent).
The Next Big Storm
By definition, tail risk events are unpredictable. Nonetheless, everyone seems to have an opinion about what the next tail risk event will be.
Survey respondents were asked what they expect the most likely catalyst of the next tail event will be, on the presumption this occurs over the next 12 months, and they were allowed to give up to three answers. The four most popular hypotheses for membership in the Big Three were: global economic recession; European recession; Eurozone breakup; Greek exit from the Euro.
There are substantial differences between the way the U.S. respondents looked at the world and the way Europeans did so. The possibility that the U.S. itself will slip into a new recession setting off the next fat tail was on the minds of the U.S. respondents, identified as one of the big three by 23 percent of them. This was not, though, a major concern for the Europeans. On the other hand, the possibility that a major bank insolvency, a Lehmann-style event, will prove the next catalyst was on the minds of Europeans, identified as one of the big three by 22 percent of them. This does not seem to worry Americans, who may regard such concern as the classic mistake of fighting the last war.
Hedging: or selling to those who hedge
Intriguingly, too, consultants see the world in ways quite different from their client base.
For example, as you can see above, consultants are much less likely than are institutional investors to see an imminent breakup of the Eurozone. They are much more likely to be worried about a hard landing in China.
But some fat tail is surely out there, waiting for you, whatever its precise form. What to do? As O’Leary and Woodley observed, simply increasing the level of diversification among your traditional assets is not a plausible strategy, since there is evidence of increasing correlation of those asset classes. Shakespeare’s Venetian merchant was confident of his own good fortune, because he had several different ships at sea. But, as it turned out, all his ships sank; leaving him it seemed at the mercy of his lender.
Measures that have helped Antonio better as a hedge against the next big sea storm include risk budgeting techniques, property or commodities investments; managed vol equity strategies, and managed futures/CTA allocations.
The choice among these options is one SSgA finds investors are struggling with in our day.
Further, if you’re trying to sell such products to institutions, you should keep in mind that although they are naturally concerned about the obvious points, effectiveness and cost, their list of concerns is a far longer one. You’ll have to address at a minimum their questions about liquidity, transparency, the likely response of (or level of understanding among) regulators, and the robustness/persistency of the returns your product can provide.