The financial crisis convinced many investors of the value of protecting against tail risk, the possibility of unforeseen events changing the direction of a portfolio. Over $40 billion is now invested in tail risk funds. These funds trade against the prevailing market wisdom, buying put options and other instruments that lose money when the markets are rallying but are designed to pay off by as much as 100 percent or more when markets crash — hence their post-crisis popularity. With rising demand for options, however, the costs of tail risk hedging have risen for most fund managers and their investors, leading to concerns that the costs are compounding losses.
Warren Wright, CIO of Diversified Global Asset Management, a $5.7 billion fund of funds in Toronto that he co-founded in 2004, has been investing in tail risk strategies as portfolio insurance since the firm’s inception. In 2007, however, DGAM started its own tail risk portfolios. Wright, along with David Hay, a managing director and portfolio manager, and Michael Robillard, a portfolio manager, have produced returns that have been close to market expectations for a tail risk fund, but with lower costs. This year about 10 percent of DGAM’s overall portfolio is invested in the tail risk strategy. Returns have been flat, in keeping with relatively calm markets, while the conventional non-tail-risk hedge funds in the firm’s portfolios are up six to seven percent year to date. Wright spoke with Alpha about how the fund of funds has minimized its costs of tail risk protection by cutting out the hedge fund manager as middleman.
What made you decide to stop investing in hedge funds that specialize in tail risk strategies and run the strategy yourselves?
As an investor in someone else’s fund you don’t have control over timing of your liquidity, and you’re paying performance fees on beta. We manage our tail hedge internally in order to have better control of the composition, sizing and timing of the tail hedge positions.
A year after you started your own strategy the financial crisis hit. How did that change things?
In the spring of 2007, we focused on areas of the structured credit markets that we believed were over-leveraged and prone to market crisis. We also bought significant protection through credit default swaps on a variety of financial institutions, believing that these entities were highly vulnerable to a de-leveraging event. We sold off most of this tail protection in the second quarter of 2008. Then we switched our focus to equity volatility. In 2008, our tail hedging strategy gained 300 percent.
But what happened after 2008 was like B.C. and A.D. Portfolio insurance was cheap before the financial crisis; now it’s a much more complex task to hedge against downturns. The volatility of volatility is high, and you have to take advantage of volatility spikes. Post-2008, we’ve taken a three-pronged approach. First, we take on what we call “correlative” hedges, usually using out-of-the-money options that are intended to be highly convex in big moves in markets; that is, their price rises when the market falls. The second type of hedge is a functional, or linear, hedge. Here we use at-the-money options or futures and swaps to reduce exposures to particular market risks. Finally, we use macro hedges to take advantage of macro-oriented asymmetry in markets. For example, we bought protection on the euro before and during the European debt crisis.
How does this portfolio insurance component fit with your overall investment strategies?
When markets are in crisis, both volatility and correlations tend to rise. In order to protect your portfolio during times of crisis, it is important to have some strategies that benefit from increases in volatility or correlation; that’s the key premise behind our tail hedging strategy.
Because we’re tailoring our tail risk insurance to customized portfolios, we have to first specify our portfolio expectations under different market scenarios and ask how much of the expected return we are willing to spend to chop off our left tail — the risk of a downturn — or enhance our right tail, the risk of an unexpected rise in the markets. This requires a disciplined approach. We have to constantly measure performance against expectations and set a budget for the “insurance” premium we are willing to pay to protect our portfolios against adverse market events.
I think volatility has come down over the past year mostly because markets are really range-bound. The expectation that central banks will provide liquidity may put a floor in markets. However, ongoing deleveraging by developed economies will likely limit global growth and put a ceiling on markets. So the expected returns for most portfolios are lower, which means there is less natural return to pay for tail risk insurance.
Then there are times when our underlying managers reduce risk in the face of market uncertainty, thus leaving the portfolio under-exposed to opportunities in the right tail. To this end, we may also buy upside protection or calls for the portfolio. For example, in August 2011 when the stock markets plunged, our tail hedge returned 125 percent. We sold our put options and spent some of the proceeds on call options.
What instruments work best as tail hedges now?
S&P put options, the traditional instrument for tail risk hedging, are always the baseline, but from there we see where we can get better asymmetry in markets. David Hay and Michael Robillard scour the market for cheaply priced insurance. We buy a range of instruments across asset classes, including equities, credit, rates, commodities, foreign exchange, etc. The key is to look at the cost of protection across all markets, recognizing the tension between premium and convexity. How correlated are equity, debt, commodities and currency with one another, and where do you get the most profit from each dollar spent on protection?
Is it worth the effort and the costs to do all of this yourself, rather than leaving it to a hedge fund manager but paying 2 and 20?
When you outsource the hedging role to an external manager you relinquish control of the timing, sizing, strategy, and monetization of the hedge. There is no certainty that they will perform as advertised or that they will monetize the hedges at the appropriate time. Further, your might have to wait for the next redemption date in order to get liquidity.
Managing the strategy ourselves takes more work and requires strong governance at our level. We have to have the right people, and we have to have good relationships with the Street. We’re paying for our own infrastructure. But we think it allows us to build better portfolios. We don’t charge our clients extra for the tail risk strategy; it’s part of our overall fee. But we find the benefits of the approach far outweigh the costs. We now have the ability to better customize the hedge to specific risks, and greater control over the sizing, timing and composition of the hedge. We’ve significantly reduced the fees associated with the process. And most important, we can monetize the hedge during a crisis period and use the liquidity to play offense when most others are playing defense.
