Investment Strategy

Why tail hedging matters and what to be aware of

By Matthew Hopkins
Sydney, Australia

Growing investors’ wealth over time is a function of many things but essentially the aim is to access good rates of return, compound them over time as consistently as possible and avoid large losses – especially for those nearing or in retirement who don’t have time on their side.

Easy!

Investment management is full of pithy soundbites as to what investors should do – “buy low sell high” is a favourite, as is “the best way to make money is not to lose money”. Like most sayings there is some truth related to what we should be trying to do, whilst not acknowledging that some of it is quite difficult.

The avoidance of large losses sounds especially obvious, however there is always the potential for losses when seeking returns – the potential for meaningful events is always present in markets (they are run by humans after all) and the impact of those large events (good and bad) has historically had a disproportionate impact on investors’ long-term returns.

When coupled with human tendency to overreact to good and bad news in the wrong way, on average the impact tends to be magnified by bad decision making. We tend to be overconfident when things are going well, and overly cautious when the news seems all bad.

Bad events – the ones that occur outside of our normal expectations are called ‘tail events’, as they exist at the extreme of expected return distributions (they are also often called Black Swan events after the belief that black swans couldn’t exist, until it turned out otherwise).

Do Black Swan events exist?

Everyone is familiar with the great market downturns of 1929, 1987 and 2008. Severe economic shocks create significant downturns that can take years to recover from. However, shocks aren’t limited to equity markets and recessions. During Brexit the pound fell 10%, in 2015 the Swiss Franc jumped 20% over a day - the reality is that any asset class can move by larger amounts than expected.

Financial markets have several characteristics that may lead them to having greater moves than ‘normal’. The biggest impact comes when assumptions about the future change rapidly, and the greater the certainty today the greater the potential impact. They also display serial correlation. This means that rather than prices moving tomorrow based on tomorrow’s new information, they can still reflect what happened yesterday creating an amplifying effect up or down. Think of a downturn where falling asset prices cause loan collateral to fall, which are sold, causing further asset price falls.

Lastly the relationships between markets can change. Different types of assets can offset or diversify their movements but can be dominated by a single factor at other times. Think of inflation rising unexpectedly causing both equities and bonds to lose value together rather than neatly offsetting each other. Defensive labels aren’t guarantees of protection. 

What impact do they have?

The impact can vary depending on the nature of the event and reaction of the investor, not to mention whether the investor is in the accumulation phase or retirement. Large losses obviously impact future wealth adversely, especially in retirement, and avoiding the worst of those losses can have a very beneficial impact on future wealth. Panicking and locking in losses has a disastrous impact.

The table below shows a simple comparison between two hypothetical strategies that are both growing at identical rates and have identical random movements in prices. The only difference is that approximately once every eight years, Portfolio 1 suffers a loss somewhere between 95%-100% of potential losses, whilst Portfolio 2 has its loss capped at 95%. This occurs three times over a 33-year period. The strategy is then simulated 10000 times and the average results shown in the table below.

The results show that even these three small occurrences account for an average ending wealth 11% greater for Portfolio 2, an average return p.a. around 0.4% each year, and slightly lower overall volatility.

The takeout is that tails can impact portfolios far more than what is shown in the simulation, and that it is worth bearing some small cost if the tails can be softened.

 

   Portfolio 1  Portfolio 2
 End wealth  $2,606  $2,903
Return p.a. 9.4% 9.8%
Volatility 6.9% 6.6%

Source: AMP Capital. Example is shown for illustration purposes only.

Tail Hedging

If the risks are real and the benefits clear, then we should then look to mitigate or ‘hedge’ our exposure to these events.

However, insurance in markets is expensive. The cost of limiting losses to 10% or 20% creates an extreme drag on returns which can mean that even if the event occurs, we may still be worse off over time.

To demonstrate this, we have simulated an investor who owns nothing but the S&P 500 and decides to tail hedge against losses at various levels. Every six months they buy a put option that provides them the right or ‘option’ to sell their investment at a level pre-set at 10% or 20% below the existing value. Therefore, if the market falls 50% they can sell to someone else at a price that’s only fallen 20%, hence they are protected.

To help them, we are going to start their investment just before the GFC so they are guaranteed to get a helpful start but they must stay insured or hedged constantly right through the period up until today.

The chart below shows their return experience compared to just holding the market and clearly, they would be far better off in a short period of time, just holding the market and not paying out the ongoing exorbitant cost of the protection.

Tail hedging
p = put option stuck at x% of the current market value. Source: AMP Capital, Bloomberg.

Tail Hedging in practice

We are left with the two clear observations. Firstly, that tail events are real and if we can mitigate them it makes a genuinely meaningful impact on future wealth (not to mention peace of mind). Secondly, we can’t go about implementing tail hedges oblivious to the cost. What we can do is have a process that leads us to the most beneficial outcome. That is to:

  1. Have a process that tries to avoid or penalise tail risk candidates – highly valued and crowded markets, highly leveraged or illiquid securities – these are all conditions that imply a greater risk of experiencing larger losses than those that have the opposite conditions.
  2. Continually assess whether our fund’s exposure to a potential market crash is material. A fund holding a lot of cash is probably not going to need protection.
  3. Incorporate a range of different potential approaches that include options and strategies that seek to profit from a large loss and apply a budget to using these to ensure any potential return drag is not at the expense of achieving our end goals.

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.

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