Tail-Risk Management Integral to Investment Plan

The majority of investors view tail-risk management as an important part of their investment plans, but barriers remain for adopting risk-mitigation strategies.

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.

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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%).

 

(Cont...)

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.

 

Survey Cites Need for Adviser Services

The Merrill Lynch Affluent Insights Survey found families cautiously optimistic and regaining control of their financial lives.

The investment adviser released findings from its report examining the values, financial priorities and concerns of affluent Americans. The latest findings from this series, which began in 2009, focus on two areas: adjusting to the new normal, and the greatest concerns for their future and for their families.

Forty-four percent of affluent Americans view the current economic climate as a new reality, and many are taking steps to gain greater control of their financial lives in this environment, including reining in spending and lowering debt. The survey also finds a notable shift toward less conservative investing.

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While health care costs and funding retirement remain top concerns, many families have the added challenge of financially supporting a parent or adult-age child.

For three years, health care costs have remained a top concern. More than three-quarters of respondents (77%) are highly concerned, and a more substantial majority (83%) of those over the age of 65 reported this as a concern.

Respondents’ second and third greatest financial concerns relate to retirement and include ensuring their assets will last throughout their lifetime (68%) and being able to afford the lifestyle they want later in life (55%). Four out of five (80%) respondents worry that they will be unable to accomplish certain financial goals before retirement, such as saving enough to sustain their lifestyle during retirement (42%), being able to pay off or invest more in their current home (27%) or affording a dream home (24%).

 

(Cont’d…)

Half of affluent Americans cited the need for help in addressing financial considerations, such as structuring their investment portfolio to generate the income they'll need to live on during retirement (45%); determining the level of investment risk appropriate for financial goals (36%); and prioritizing goals (24%) and devising a plan to achieve them (29%)

The conversation starting point should be someone’s goals, not the numbers or allocation of investments, said Andy Sieg, head of global wealth and retirement solutions for Bank of America Merrill Lynch. “Having a more meaningful discussion about concerns and aspirations also inspires trust and helps to achieve desired outcomes today and in the future,” Sieg said.

The outlook for 2013 by affluent Americans can best be described as cautiously optimistic, with 30% feeling optimistic and 45% feeling hopeful about their financial situation during the year ahead. About a third (35%) said they believed their financial situation might improve in the coming year, and 41% said they expected it to remain about the same.

Among respondents with a positive outlook for the year to come, 45% cited the ability to take advantage of investment opportunities as the top reason they believe their financial situation will improve next year. Additional reasons include:

 

  • Greater discipline in their spending habits (36%)
  • Having less debt (32%)
  • Opportunities for career advancement (26%)

(Cont’d…)

Among those who believe their financial situation will not improve in 2013, 61% cite the impact of ongoing market volatility on their investments as a key barrier (54% of men, 68 of% women), followed by the fact that their dependents, be they children, parents or other family members, continue to be a drain on their finances (23%).

When asked to define their tolerance for risk, 30% describe themselves as conservative investors, gravitating toward lower-risk investments and savings vehicles, such as mutual funds, bonds, and savings and money market accounts. This is down from 36% of investors who identified themselves as conservative a year ago, and down significantly from 50% two years ago (July 2010). This shift toward less conservative investing can be seen most among affluent investors under the age of 50. Today, 23% of younger investors ages 18 to 34 describe themselves as conservative, compared with 52% two years ago; while 23% of those ages 35 to 50 describe themselves this way, compared with 45% two years ago.

One in four (25%) affluent Americans have found that their family and friends are speaking with them more openly about their financial situation today than they did before the recession, especially those ages 18 to 34 (49%). In addition to discussing financial matters among a trusted network becoming less of a faux pas, forming financial decisions at home is becoming more of a team effort. Today, nine out of 10 married couples (89%) involve their spouse in financial decisions. One-third (34%) consult with their spouse or partner about all financial decisions, including everyday expenses and purchases; 24% consult with them only about purchases over $1,000; and 21% only consult with them about major expenses or purchases, such as a new car or affording a vacation.

The survey was conducted via phone by Braun Research in August on behalf of Merrill Lynch Wealth Management. The nationally representative sample consisted of 1,000 affluent Americans (ages 18 and over) with investable assets in excess of $250,000. At least 300 affluent Americans were also oversampled in five target markets including Atlanta, Chicago, Dallas, Detroit and South Florida.

For more information about the Merrill Lynch Affluent Insights Survey, and for a report of its complete findings, visit www.ml.com/affluentinsights.

 

 

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