Tail-risk hedging has returned to the vocabulary of the institutional investor. It’s been feuded over on twitter by finance legends. After hibernating for about a decade, stories have been surfacing about spectacular returns for black swan funds. Several traditional fund managers joined in the action, feasting on huge payouts from asymmetric bets placed earlier in the year. The returns have been eyepopping. Eyepopping returns invariable start the marketing presses.
One of the untold secrets of selling active management is that it really requires more than just performance. It requires a story. Sometimes the story is the clear-cut performance. More often, it is about the color and demeanor of the individuals. In abnormal macroeconomic times, the story morphs to the perceived richness of the opportunity set. In rare occasions, the story overtakes performance and takes a life of its own.
Protecting your portfolio in a fragile world is a story that is currently resonating among those licking their wounds. Such was the case in 2009-2010. Perversely, the cost of this protection was much lower when few bothered hearing that story in 2019. As with many stories, it is often about what did happen rather than what will happen. This may be a function of the availability heuristic, which encapsulates the contradictory nature between selling and investing. Smart allocators develop a refined sense between the two. Ultimately, there is a tension when wrangling abnormal risk to protect one’s portfolio.
As this narrative has permeated our collective ethos, we at Epsilon have been asked by investors how we think about our portfolio’s resilience. Do we use stress tests? If so, how do we calibrate them to account for abnormal events? Have we changed our philosophy towards portfolio construction? Would we add tail-risk hedges to the portfolios? If so, what instruments would we use?
Instead of answering these with recent scars in mind, we often like to reframe the question by looking at a comparably ‘unlikely’ global shock. For example, a solar storm. Let’s imagine that an enormous solar flare erupted from the sun, sending an electromagnetic pulse that fries the majority of semiconductors and hardware circuitry in the world. How does one think about protecting a portfolio after that!?
Well, it would be convenient to not be invested in technology securities, for one. Analysts would scramble to understand the impact to underlying companies’ revenues. They would assess cash on balance, disruption to existing production facilities, replacement demand, the whole nine yards. Securities would quickly re-rate. Sound familiar to today’s analysis of, I don’t know, cruises? Unlike with sectors adversely impacted by COVID, at this level, the question is whether or not portfolio carnage can be mitigated at all.
Doesn’t technology permeate every aspect of life? Even old-line industry are increasingly adopting “technology” into their business practices. Will we as a society return to mideval lifestyles? Will we eschew smartphones and elevators in place of notebooks and mechanical pulleys? While COVID forces us to ask these questions about travel, leisure, and dining, technology, is less of an industry and centrally a function of progress.
We pose this hypothetical for one reason. These types of existential risks move beyond hedging in financial markets and into the bullets, canned foods, and bunker territory of survival. Tail-risk hedging of this order crosses the rubicon to unimplementable territory. It requires counterparties that can payout vast sums of money from such improbable events to make the hedge worthwhile given its extreme probability. When the tail-risk you are attempting to hedge calls into question the solvency of your counterparties, then you’re in a futile situation.
Counterparty of Last Resort
Okay, let’s step back our doomsday scenario to something more manageable. Let’s look at the two most recent calamities for guidance. In both, the United States Federal Reserve acted as the counterparty of last resort. Leading up to the Global Financial Crisis, AIG was in some sense the private sector's insurer of last resort, specifically for the financial system. Given the opacity of their business dealings, their counterparties failed to diversify their counterparty risk, and AIG became a true single-point of failure. That single point threatened to collapse the entire system by virtue of systemic default. The Fed galloped in to halt that domino, to the consternation of many ‘free market’ dogmatists. It did much the same with swap lines to other central banks.
In the COVID crisis, there appears to be less of a single point of failure (such as AIG) than a cascading risk of bankruptcy across swaths of corporates and small businesses. The fear behind this cascade is due to a cessation of capital market lending for companies that rely on it. And so, the Fed came again with even greater force to thaw the rapid freezing of capital markets.
The meme of ‘Fed as insurer of last resort’ has permeated popular culture as well as financial markets. In a sense, if an exogenous shock calls into question the entirety of the system, then the Federal Reserve will change the rules to ensure that calamity doesn’t occur. To this end, the Fed has responded with aplomb and awe-inspiring force in an unprecedented way.
But these ‘doses of antibiotics’ don’t come without their own adverse effects. Some would characterize fed intervention as an expensive way of saving the toe while creating a resistant gangrene which ultimately consumes the leg. The costs of these interventions take decades to see. One could argue that the unprecedented actions by the Fed following Lehman’s collapse and its ensuing accommodative policies (such as extended rounds of quantitative easing) exacerbated the current indebtedness of the corporate sector.
That indebtedness served the corporate sector poorly heading into this global pandemic, likely requiring an even stronger monetary response. Others may even argue that the opacity of the financial system heading into Lehman was (again) caused by a prior Fed’s emphasis on de-regulation. It’s turtles all the way down.
These feedback loops bring us back to tail-risk. Massive volatility shocks are the phenomena that break these cycles. The palliative cures cobbled together in a rush create the next. These imbalances are complex but in some ways self-propagating when our interventions tamp risk for it to resurface in spectacular, unbeknownst ways. What is an investor to do?
The Only Palliative We Know
From our perspective, we do not believe in buying spread wideners on credit indices to protect our portfolio of equities. This isn’t because we are oblivious to these shocks or because we think that our portfolio will always be bailed out by the insurer of last resort. It’s also not because we believe in bunkers, ammunition, and gold.
Instead, when we view these phenomena through the lens of history, it reinforces our belief in investing with the downside in mind. That mentality forces you to avoid ‘bullet to the head’ risks of investing: leverage, liquidity, over-reliance on counterparty solvency. To paraphrase Charlie Munger, we believe that being able to stomach 50% drawdowns a few times every half-millennia is simply a requisite of running a long-term invested portfolio of equities.
As such, creating a superior return stream involves accepting the specter of tail-risk. One can do so if the foundation of one’s portfolio is judiciously managed, with resilience in mind. This will naturally dictate a certain degree of diversification, a certain aversion towards excessive debt, and a philosophy of portfolio construction that isn’t scared to jump into the water as long if it has a good idea of its depth.
Andy Redleaf probably said it best: The source of investment return is the efficient reduction of risk. Investors will be wise to steer clear of sexy solutions to their problems and return to these core principles.
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