Tail-Risk Management Integral to Investment Plan

Since the financial crisis, investors have started to rethink tail-risk mitigation strategies, Niall O’Leary, head of EMEA portfolio strategy for State Street Global Advisors (SSgA), said during a webinar. Tail risk is an extreme shock to financial markets that shows up as infrequent observations in the far left tail of a return distribution. It is technically defined as an investment that moves more than three standard deviations from the mean of a normal distribution of investment returns.

Investors are not entirely confident they are protected from the next tail-risk event, O’Leary said, adding that research from the Economist Intelligence Unit on behalf of SSgA shows institutional investors think they almost always underestimate the frequency and severity of tail risk.

According to the research, 71% of respondents think it is likely or highly likely that a significant tail risk will occur in the next year. The Eurozone crisis, prospect of recession and the slowdown in China are prominent concerns. With tail risk, however, O’Leary said the unexpected events are the ones with the most potential to cause damage.  

Research indicates significant geographical differences between institutional investors’ views of the next tail-risk events. U.S. investors predict the next event will be the global economy falling into recession (48%); the Eurozone breaking up (37%); Europe sinking back into recession (28%); Greece exiting the Euro (25%); and the U.S. slipping back into recession (23%). European investors think the next tail risk will be Europe slipping back into recession (40%); Greece exiting the Euro (32%); the Eurozone breaking up (30%); the global economy falling into recession (29%); and major bank insolvency (22%).

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According to the survey, investors have several strategies in place to protect against tail-risk events. “A number of approaches have fallen somewhat out of favor [after the crisis],” O’Leary added. Before the crisis, 81.4% of investors diversified across traditional asset classes to mitigate tail risk. Now, that number has fallen to 75.7%. Conversely, investors have increased their usage of alternative allocations such as property and commodities (57.5% before the crisis, versus 65.1% now).

Survey respondents noted the following as effective hedges against tail risk (ranked most to least effective): diversification across traditional asset classes, risk-budgeting techniques, managed volatility equity strategies, direct hedging-buying puts/straight guarantee, other alternative allocation (e.g., property, commodities), managed futures/CTA allocation, single strategy hedge fund allocation and fund of hedge fund allocation.

“Investors are concerned about tail risk … but their take-up has been slow,” O’Leary said. Survey respondents noted the following barriers in allocating to their tail-risk protection strategy: liquidity of underlying instruments (64%); regulatory adherence/understanding (54%); risk aversion (49%); transparency of underlying instruments (46%); fees/cost (42%); understanding the investment returns/persistency of returns (33%); and lack of general understanding of new asset classes (28%).

Despite challenges, things are looking up after the crisis: 73% say they believe that because of changes in their strategic asset allocation, they are better prepared for the next major tail-risk event than they were before the crisis.

“The vast majority of investors … feel that now, despite what they’ve experienced in recent years, they are better protected against downside risk going forward,” O’Leary said.