Humans have a tendency to overlook the low-probability, high-impact events. Since their occurrence is extremely low, why bother, right? This is referred to as optimism bias. In other words, investors frequently overlook tail risk. This is especially applicable to young people who tried investing in the past couple of years.
As you may think, tail risk strategies are of utmost importance for a lot of people. Investors with a fixed time frame that requires liquidity, seniors whose annual portfolio transactions are not being replenished, and inexperienced investors who might be inclined to sell in the frenzy of a major market collapse – such as the one we saw in 2020 – can all benefit from them. Market shocks turn out to be disastrous for these investors in the majority of cases.
Because of the recent market downturn, there’s been a lot of attention paid to tail hedge strategies and their stellar performance during the Covid-19 pandemic. The concept of tail risk hedging is gaining traction once again, and the demand for hedging strategies and portfolio insurance solutions has exploded.
Assessing Tail Risk
Because tail events occurrences are, by definition, unpredictable, infrequent, and vary as far as negative impact goes, measuring tail risk is a rather difficult task. In more predictable areas, the insurance sector (think of auto insurance, for instance) uses value-at-risk ratios. In this case, however, the following measurements are used:
- Kurtosis is a statistical measure that assesses how much a distribution’s tails deviate from the tails of a normal distribution. In other words, kurtosis determines whether a distribution’s tails comprise extreme values. That being said, calculating a portfolio’s kurtosis can provide some insight into its future tail risk in comparison to another.
- The asymmetry of tail risk is measured by skewness. Negative skewness is defined as a distribution having a greater left tail. Positive skewness is defined as a distribution that has a larger right tail. Investors gravitate towards assets and strategies that have positive skewness.
The normal distribution is the most common type of distribution. However, you’ll see a lot of negatively skewed distributions. In the United States, for instance, household income is negatively skewed with a lengthy left tail. Actually, in general, most markets have hidden left skewness that is larger than a lot of people realize.
Tail Risk Hedging Strategies
For investors and traders trying to ward off tail risk and limit their exposure to it, finding affordable and liquid tail risk hedges is crucial.
Tail risk is not limited to capital and insurance markets. Climate disruptions, cyberattacks, supply chain breakdowns, energy breakdowns, pandemics, terrorism, and other disasters are all catastrophic risks that businesses must be aware of.
Most investors, especially the long stock and bond markets ones, have been accustomed to good times rather than bad times over the last decade or so.
However, it is critical to consider downside risk and measures to assist you in getting through difficult times in excellent nick. A single severe drawdown might entail years of hard work to get your investment portfolio back to where it was.
Now, the real question is: Is there a universal tail risk strategy that can properly hedge any and every portfolio against tail events?
Yes and No. When it comes to tail hedges, strong customization is advisable. Sure, there are tried-and-tested strategies that can hedge multiple types of portfolios, but keep in mind that hedging strategies come in a variety of forms. Oftentimes, they can be too expensive, or the opportunity cost can be too high.
However, a combination of good strategies can outperform a single good strategy. This is especially relevant for portfolios that focus on risk management — for example, lower left-tail risk, lower drawdowns, and higher return per unit of risk.
Tail risk hedging can also mean investing in assets that have minimal correlations to the larger financial markets in the hopes of making a profit even if tail risk events occur and cause severe price volatility.
Let’s take a look at some of the most common tools that hedging strategies use.
- Modern Portfolio Theory (MPT)
Modern portfolio theory, which employs diversification to construct groups of assets that reduce volatility, is one of the most important techniques.MPT establishes an efficient frontier for an expected amount of return and a given amount of risk using statistical metrics.
To create an optimal and balanced portfolio, the theory is based on the correlation between various assets, as well as the degree of volatility that these assets have. MPT has been employed in the risk management strategies of many financial organizations. The ideal parameter to aim for is a curved linear relationship between risks and returns. Investors have varying risk tolerances, and MPT can help them choose the right portfolio for them.
- Put Options
Options are yet another useful tool. Put options are frequently purchased by investors wanting to hedge an individual stock with good liquidity against the chance of a tail event. Puts gain value as the value price of the underlying security decreases. The cost of purchasing put options is what intimidates the people who could really benefit from this strategy.
Options are subject to time decay and lose value as they approach expiration. Vertical put spreads can help you save money on premiums by limiting the amount of protection you get. This method only covers a single stock, and investors with diversified portfolios cannot afford to hedge each position individually.
Index options can help investors hedge a larger, more diversified stock portfolio. Larger stock market indexes – the S&P 500, for instance – are monitored using index options. These broad-based indexes cover a wide range of industries and provide useful indicators of the overall economy.
Stocks have a tendency to be correlated; this means that they tend to move in the same direction, and even more so when market instability is high. To reduce risk, investors might use put options to hedge. Bear put spreads are one risk-mitigation approach. Index put options provide protection to a greater number of sectors and companies.
- Volatility Index Indicator
The volatility index (VIX) indicator is also a common hedging tool. The VIX index is used to measure the volatility of a basket of put and call options related to a certain index or to an exchange-trade fund (ETF).
The most influential index is the CBOE Volatility Index ($VIX), which measures implied volatility for a basket of out-of-the-money put and call options for the S&P 500. Because it rises during periods of increased volatility, the VIX has been labeled the “fear gauge.”
A score below 20 suggests moderate volatility, whereas a level beyond 30 indicates high volatility. The VIX is measured by exchange-traded funds (ETFs). As a volatility-specific tail risk hedging strategy, investors can use ETF shares or options to go long on the VIX.
Keep in mind that while it is a frequently used hedging tool, it is a rather misguided one, so watch out for this one. We’ll discuss why in another article, so stay tuned!
The Best Tail Risk Hedging Strategy for You
While most of these tail risk tools can prove to be extremely useful, they cannot eliminate all market risk. This is exactly why you need an expert that can help you avoid a less-than-ideal strategy that ends up costing too much, without providing your portfolio with appropriate protection!
When thinking about protecting your investments and other assets from market volatility and Black Swan events, you’ll definitely want to find a strategy that ticks as many boxes as possible.
It might be difficult, however, to develop a tail risk hedging strategy that would protect you from significant market economic downturns without devoting a lot of effort and resources. We would, however, be delighted to help you find a tail risk hedging strategy that caters to the specific needs of your portfolio. Remember, a hedged portfolio is just as important as a good one!
Leave us a message and start designing your hedging strategy today!