Fat Tails

Originally published in the December 2011 issue

Extreme outcomes in markets have led to investors demanding innovative solutions to cap risk and minimise drawdowns. Some forms of so-called tail risk protection like put options are simple and have been used by investors for decades.

Now, however, institutional investors, notably pension funds and life insurers, are demanding more comprehensive and finely calibrated types of tail risk protection. It is demand from this quarter that AXA Investment Managers, now managing $5.4 billion, is targeting with its recent launch of a series of funds of hedge funds that will aim to protect investors from shock market events and longer-term trends. The move follows the success of some similar investment strategies during the volatility that has characterised markets in 2011.

“The objective of the tail risk funds is to provide strong inversely correlated returns to equities and equity-related assets in times of high stress,” says Francisco Arcilla, who joined as Global Head of AXA Funds of Hedge Funds from EIM in October. “In normal market conditions, it offers a plus or minus low single digit return with some additional alpha generation. The aim of the strategy is to be de-correlated.”

Low volatility orientation
The portfolio manger of the Tail Hedge strategy is Ryan McRandal. He is being backed by the mainly London-based fund of funds’ 37 staff, including a dozen investment professionals. The business takes a multi-strategy approach to hedge fund investing, focusing primarily on low volatility strategies. It runs mostly customised mandates for internal AXA funds related to its insurance business as well as external customers like pension funds and other life insurers. The fact that AXA allocations are the biggest share of the fund of funds business underpins the genuine alignment between the giant insurance parent and external investors.

Arcilla comes well prepared to the new role at AXA IM. At EIM, he had risen to become Co-Head of Investments and a member of the Global Investment Committee. Prior to taking on that role Arcilla served for nearly three years as Deputy Chief Investment Officer and Head of Investor Solutions.

His move to EIM followed over a decade of trading a variety of markets. This provided Arcilla with experience, which included a stint at KBC Alternative Investments, of trading emerging markets, foreign exchange, credit and fixed-income derivatives. In the latter role he was a managing director for Santander. Before honing his skills as a trader and money manger, Arcilla worked briefly in investment banking at Merrill Lynch which he joined after studies in finance at the London Business School and the HEC School of Management.

Concept of tail risk
The classical definition of tail risk is of a form of portfolio risk that arises when the possibility that an investment will move more than three standard deviations from the mean is greater than what is shown by a normal distribution. Typically in investing when a portfolio of investments is put together, it is assumed that the distribution of returns will follow a normal pattern.

With this assumption, the probability that returns will move between the mean and three standard deviations, either positive or negative, is 99.97%. This means that the probability of returns moving more than three standard deviations beyond the mean is 0.03%, or virtually nil. However, the concept of tail risk suggests that the distribution is not normal, but skewed, and has fatter tails. The fatter tails increase the probability that an investment will move beyond three standard deviations.

Typically investors, including some tail risk hedge funds, have bought inexpensively priced, long-dated put options, giving them the right to sell a security in the future. Such positions are well out of the money and substantially discount the current market price. The position can be funded by receiving premia for selling short-term put options, which transfer to the buyer the right to sell at a price relatively close to the prevailing market price. The limited time duration means that the payoff before expiration is limited. The drip feed of small losses the strategy can create in stable market conditions gives way to a large profit when markets sell off sharply.

AXA IM’s approach
The tail hedge fund that AXA IM is running, currently managing over $400 million, is designed to be de-correlated and provide a return when equities do poorly or collapse. But it isn’t a fund of so-called black swan funds that use the equity puts strategy outlined above.

Instead, AXA IM’s fund does two things. One is managing exposure at the asset class level. Instead of positioning using derivatives focusing solely on equities, AXA IM uses exposure and active management of derivatives among a variety of other asset classes such as rates, foreign exchange, credit and commodities. Positions are always recycled to ensure that the payout profile can be maintained.

“What is slightly different is that investors usually use equity derivatives to hedge equities exposure,” says Arcilla. “Instead, at AXA IM, we think there is always an asset class that gives better convexity and cheaper implementation.”

Rotating positions
The second thing AXA does differently is on the manager level. AXA looks to rotate the positions in the portfolio according to how the prospects of the different managers look. The focus is on dynamic management and knowing which managers to source as well as the returns they will generate in a time of market stress.

“Around 90% of the funds we invest in aren’t available in the hedge fund market,” says Arcilla. “We have either tailored them to our own specifications or there is a special share class. In some cases there are constraints and we sometimes invest alongside the managers.”

The Tail Risk strategy has run for clients since November 2010 but is still in an early stage for the fund of funds product. It has returned approximately 12.74% for 2011 to mid-November. Though there is a fund structure, investment is done through managed accounts so preserving a one-to-one relationship. It is invested with fewer than 10 managers, though this figure is likely to rise as the product gains more investor custom.

AXA IM is in the process of getting the fund of funds version of the strategy approved for distribution in the near future. A commingled version of the strategy, drawing on the group’s risk control and risk management process, is expected to be launched in 2012.

Also on the drawing board is a fixed income tail risk product for investors seeking a customised vehicle in that area. Arcilla notes that the 30-year bull market in bonds means that a number of investors will be looking to find protection. He also envisages other products in tail risk protection being generated.