How to address tail risk?

Strategies intended to mitigate tail risk include owning fixed income bonds, trend-following or other CTAs, long/short equity funds, and various volatility strategies including tail risk. Developed market government bonds are perceived as being too richly valued to repeat their historical role as portfolio insurance. Tail risk strategies and trend-following CTAs alike are path dependent in different ways: a “slow bleed” scenario of equities losing 0.50% per month for many years might not be positive for tail risk approaches, though it could be better for trend-following CTAs, which now manage assets estimated at $350 billion. Conversely, a sudden pullback in stocks could cause losses for those CTAs that are trend-followers and are long of equities at present. Jeppe Blirup, Fund Manager of Copenhagen-based Alternative Equity Partners A/S, says he is happy with his current allocation to a tail risk hedge fund and that it helped keep the performance flat during the sell-off in Q4 2018. Blirup mentioned it’s important to not underestimate the benefits of tail hedging in a portfolio context as correlations are unpredictable in a downturn and tend to move up meaningfully. Long/short equity hedge funds typically carry more equity market correlation in volatile markets than meets the eye.

Blirup is focused on finding activist short hedge funds who have an identifiable edge and zero or negative correlation to the equity market.

“Tail risk strategies are a way to immunise your portfolio against high consequence events that could put one out of business. They also allow the modification of a portfolio return distribution, and through paying away premium in benign environments, monetising in risk-off environments, allows one to systematically sell high and buy low,” argues Anthony Limbrick, Principal, Portfolio Manager and Head of Quantitative Research at London-based 36 South, which creates and manages asymmetric portfolios using long-dated options designed to mitigate tail risks.

Goldman Sachs Asset Management (GSAM)’s Co-Head of Research, Portfolio Management and Portfolio Construction, Alternative Investment Strategies, Federico Gilly, agrees, arguing that, “public equity remains the main return driver in portfolios. An option strategy can reshape the equity distribution so that you can weather 2008 type events and continue to hold equities as permanent capital, without being forced to liquidate assets at the bottom.” GSAM manages $18bn in risk premia and hedge fund strategies, of which half is option-based.

For Cantor Fitzgerald’s Dublin-based Associate Director of Investment Services, Ian Halstead, tail risk hedges are the logical conclusion of a fairly standard mean-variance portfolio optimisation exercise, which seeks a higher return to risk ratio by ascending the efficient frontier. Halstead advises charities who have continuous funding needs, which makes it important to reduce drawdowns that could cause a hiatus in funding. His basic calculus is that, “to pay 0.60% per year in order to reduce drawdowns by about 6% in a crisis event represents a good trade off”. Halstead allocates to a basket of tail risk managers including some that have a higher “bleed” in normal market conditions, as these managers may offer a higher payout and therefore be a more efficient use of capital.

Structural or tactical allocations?

If there was broad consensus over the need for some form of volatility and tail risk exposures, there was more debate over whether hedges should be structural and strategic fixtures in portfolios, or more tactical ones, timed or sized according to the perceived market climate and opportunity set.

Halstead feels that tail risk hedges cannot be timed on a monthly or quarterly basis, and should be strategic.

By contrast Max Townshend, Head of Portfolio Construction at London-based Local Pensions Partnership (LPP), finds it difficult to make “a structural case for long volatility, though we are trying to become more tactical and market aware, and improve our tactical and GTAA expertise. It is an incredibly difficult exercise to measure and forecast tail risk.” This is partly since it would vary between LPP clients (UK local authorities) – and the overriding obstacle anyway is that LPP does not want to ask them for pension contributions.

Schroders’ Head of Risk Managed Investments and Structured Funds, Mike Hodgson, has created a volatility-controlled global equity strategy, which sizes equity exposure inverse to volatility. It has more exposure – and even leveraged exposure – to the MSCI World when volatility is low and also buys put options, giving end investors equity exposure with the comfort of an absolute limit on downside risk.  The put options are bought on a regular basis to create an “evergreen” solution with a smoother return profile. “We are seeing growing interest in this type of strategy embedding downside protection, particularly from pension funds who perceive their higher than expected recent equity returns as windfall gains,” he says.

Zem Sternberg, CIO of New York-based electronic options trader, Lake Hill Capital Management, believes it makes sense to be allocated to the right systematic volatility approach over a multi-year period. “It is perceived as a risky business involving complicated structures, payoff diagrams, academic papers, and formulas, which are incomprehensible to almost everyone.  In fact, formulas used by insurance companies and casinos can be applied to option trading to generate consistent returns. We are looking to use simple rules that provide 90% probabilities of profiting over a five-year time frame, to stack the odds in our favour,” he says.

David Dredge, CIO, of volatility manager Singapore-based Convex Strategies, also has a long-term perspective. “I measure a good year not by the cost of insurance, but by the amount of ongoing insurance, which is intended to grow. I am always recycling monetisations into greater convexity, to grow the potential payout over time.” He claims if volatility is traded efficiently, a long volatility strategy can sustain returns through a complete economic cycle and outperformed equities over extended periods.

But timing the size of a volatility allocation is crucial for some managers. According to Blirup, “long volatility is quite a macro bet and you need to evaluate the business cycle. As the strategy pays off in a recession scenario, it should be exited or sized at basis points, otherwise you end up giving back all the profits.”

Simon Lai, Deputy CIO of the John Lewis Partnership Pensions Trust is also somewhat tactical. “A good hedging outcome is more dependent on when to put it on and when to take it off, than the implementation of a hedging strategy itself,” he says. “One must be disciplined to crystallise gains from a hedge: for instance, we built in a trigger to unwind our hedging strategy based on market drawdown. The trigger was breached just before Christmas 2018 and as a result the hedge was halved, which seemed an impeccable ‘timing’ decision, but without having to make that decision on the spot.”

Savvy structuring

Even in the context of a steady allocation to volatility strategies, tactical trading of instruments can be important to optimise costs and payoffs.

Gilly argues that the allocation itself needs to be actively managed. “Market microstructure and imbalances can be optimised to reduce the negative carry of buying put options – and moreover the halving of bid/offer spreads on S&P 500 options between 2016 and 2019 makes it worthwhile carrying out daily rebalancing of weekly and monthly S&P 500 options.” He also pays attention to the slope of the VIX curve when adjusting hedging programs.

Limbrick points out that, (perhaps counterintuitively for those not conversant with the Black Scholes formula for option valuation), “a call option might prove profitable in a down market: if the forward dividend yield falls faster than interest rates, and volatility increases, then call option could become more valuable”.

Is 2019 the right time to ramp up volatility exposures?

Limbrick is of the opinion that, “long dated implied volatility across multiple asset classes – as measured by 36 South’s proprietary GIVIX index – remains cheap on a 13-year view and should mean revert upon some kind of risk-off event, even if not a tail risk event. Additionally, CBOE VIX short positioning is near extremes, which has historically presaged a risk off event.”

Eric Peters, CEO and CIO of Greenwich, Connecticut-based One River Asset Management, which offers a range of absolute return strategies including long volatility, agrees that: “we have just had the longest economic cycle in history. It is clearly more attractive to buy volatility when it is cheap than when it is expensive.” He sees potential for markets to ratchet up to a higher volatility regime. “Equity volatility as measured by the VIX has stayed above 20 for three five-year periods: 1986-1991; 1999-2003, and 2009-2013. In 2018 it may have felt like a big spike versus 2017, but the average was not even above 20.”

Christopher Cole, Founder and CIO of Austin, Texas-based volatility manager, Artemis Capital, agrees. “Let’s put this all in perspective:  volatility averaged 20+ for 6+ years between 1997 and 2004 and 3+ years between 2008 and 2011.  In January the one year average of volatility just went north of 17.  We haven’t even started analysing periods of volatility dating back to the 1920s, 1970s, and late 1980s but I think you get the idea.  If history is any indicator, we have a long way to go before the ‘volatility regime shift’ plays out to completion.”

Chris Rodarte, London-based Portfolio Manager of alternative asset manager, Pine River Capital, sees value in Asia. “Asian volatility has come under pressure at the front end. Persistent retail selling of volatility, in Japan and Korea, has depressed it as those selling protection over a five to 10-year time horizon get an enhanced coupon and rarely lose out because the triggers are a selloff of 50% or more.”

Lai may have taken some protection off the table late last year but he remains alert to market risks, noting that: “the equity rally has made a significant contribution to returns, and we are now late in the cycle. We therefore expect some kind of correction, crisis or drawdown over the next three years, and aim to preserve funding ratios.”

Politics

Most speakers emphasised economic and financial risks, but Bobby Vedral, founder of MacroEagle, political adviser and former Global Head of Market Strategies at Goldman Sachs, views politics as an increasing source of volatility and alpha: “for instance, when the Saudis needed to get Trump on board in the face of outrage over the death of Khashoggi, it was a good time to go short of oil”.

“Inflection points are the key thing to watch out for in political cycles and we have identified a clear trend towards nationalist and populist parties in European elections. The country first, anti-establishment vote is key in developed markets, while anti-corruption is relevant in emerging markets,” he adds.

Vedral makes a more startling prediction. “Because central bank independence was an invention of the last political cycle, it is likely to be reversed. This will lead to higher inflation and yields and contribute to correlation breakdowns.”

Another manager forecasting higher volatility is Madrid-based Diego Parrilla, Managing Partner of absolute return manager, Quadriga Asset Managers, whose latest book, The Anti-Bubbles: Opportunities Heading Into Lehman Squared and Gold’s Perfect Storm, challenges the fashionable view that central banks have written a put under financial markets, and that fiscal policy has no limits, which has its most extreme manifestation in Modern Monetary Theory.

Parrilla contends that: “QE has created a credit bubble just as bad as in 2008, as complacency fuels a desperate search for yield. The term ‘Lehman Squared’ was coined to describe lending too much at the wrong price and the wrong time – and now we are doing the same thing with QE, QQE, LTRO etc. Credit and carry risk have increased, as seen in artificially low interest rates and very tight spreads for investment grade, high yield and emerging market debt such as 100-year Argentina bonds, as well as the depressed volatility index and liquidity risk, not to mention private credit seen in shadow banking. My mother has been forced to move from an unlevered AAA rated government debt to a levered position in a BBB-rated bond in order to meet her target returns.” Therefore, long volatility exposure is one of Parrilla’s recommendations.

Equities or multi-asset?

Some managers, such as Pav Sethi, Founder and Chief Investment Officer of derivatives and volatility manager, Gladius Investment Group, are emphasising equity volatility because, “the VIX does correlate best to S&P 500 beta, which is where institutions have most exposure”.

Most volatility strategies seem to be exclusively equity focused but of course volatility can be traded across a range of asset classes, including interest rates, bonds, currencies and commodities, and investors may need to rethink their assumptions about correlation patterns among asset classes. Argues Peters: “Under current correlation assumptions pension funds are 50% funded and need to make 7-8% per year to avoid insolvency, but a correlation breakdown could render them only 35% funded”. Parrilla also suggests that “correlation patterns have contributed to an artificially low value at risk for most portfolios, but investors should beware false diversification, which results in imbalanced portfolios. If traditional diversification does not work, gold could rise to USD 3,000 or USD 5,000 over the next few years as investors embrace the anti-bubbles.”

Dredge, who also keeps an eye on gold, points out that, “the equity VIX index is a tiny sliver of the global volatility market and is traditionally the most expensive. It has been an inefficient hedge for most shocks since 2008, as the cost versus the payout is not nearly as high as for other hedges such as short subprime, or even Korean FX volatility. In the 1970s, gold volatility averaged 70%. A whole bunch of other markets have different profiles, which provides a good argument for cheaper, cross-asset volatility strategies.”

Correlation can also be exploited to the advantage of investors. Limbrick stresses that, “a multi-asset approach has the advantage of using correlation to mitigate costs. You get swings and clusters of value in different asset classes, including extreme contango and backwardation. For instance, a three-five year in-the-money Nasdaq put option briefly had positive carry a few months ago, and there was extreme backwardation in longer-dated equity exposures.”

New York-based hedge fund manager, IONIC Capital Management’s, Principal and Portfolio Manager, Daniel Stone also trades cross asset long volatility. He argues that, “ARP programs have shifted from being equity-centric to focusing on opportunities in interest rates, currencies, and commodities. In 2018, equity volatility spiked, causing pain for equity-oriented programs, which caused these programs to pivot and diversify exposure into other asset classes. When central banks acted in lockstep, relative interest rate and forward FX rates were not moving, which begat low implied volatility.” That could change. “Interest rate volatility could pick up and has already seen some moves higher in realised volatility at the back end of the curve. We are surprised that long-dated options on long-dated interest rates at the 10, 20 or 30-year level, command very little premium over short-dated options.”

Rodarte has also noticed, “a spike in US Treasury volatility with the MOV index measuring it up 38% from its all-time low”. He adds, “a muted VIX combined with yield curve inversion has been a harbinger of recession before”.

GAM’s London-based fund of funds Investment Manager, Susanna Wallis, has some concerns on fixed income relative value trading: “It has worked but leverage has grown and returns have compressed. We now find volatility trading of credit more interesting.”

A lonely voice foreseeing lower volatility was Geneva-based volatility manager, Dominicé & Co Asset Management Partner and Head of Asset Management, Pierre De Saab, who is “basically bullish of equities given low interest rates, and would not be surprised to see the VIX drift below 10,” though he does not expect it to fall as low as in 2017. That said, he also expects a dislocation or correction of some kind this year.

New York-based Brandon Berry of exchange Eurex concurs that “the path of least resistance is probably for markets to go higher, because upside volatility is cheap”.

Relative value and dispersion

The simplest relative value strategy – implied versus realised volatility – has basically worked 90% of the time over the past two decades. De Saab points out that 2018 was the first year in twenty (bar 2008) when the realised volatility of the S&P 500 was above the average level for the VIX.

But 2018 proved a boon for other types of relative value trades, such as dispersion. Will Bartlett of San Francisco-based volatility manager, Parallax Volatility Advisors, follows a global relative value approach to equity including mainly equity indices, with some volatility and equity hedging. He observes that, “the strong performance of dispersion in 2018, was a welcome change from prior years. A change in the composition of flows – with demand for hedging idiosyncratic exposures and skew in single name put options – has made index dispersion trades more attractive.” He expects “the next volatility spike will likely be credit-driven and will impact single stocks. We see potential opportunities at the longer end and think that exposure to as many volatility products as possible provides the best relative value lens. The longer-dated OTC market is somewhat lowly correlated to the shorter dated one.”

Liquidity

Investors always need to heed liquidity, and Halstead points out that structural imbalances – a limited number of buyers and sellers – mean that options are not super liquid. Limbrick is of the opinion that, “liquidity matters most during the left or right-hand tail event under which investors might want to monetise some of their tail risk protection. When that happens, it is highly likely that the counterparties who have sold crisis protection would want to exit their positions – and therefore, the liquidity profile of tail risk protection could even be negatively correlated to the rest of the market.”

Bartlett has, in contrast, had bad experiences with liquidity. He repeated what he said at the 2018 volatility and tail risk event – that February 2018 saw no quotes available on OTC volatility or variance swaps, and has seen liquidity deteriorate for many years. Since he started trading volatility in 1996, “the number of firms making markets in options has plummeted from hundreds or thousands to basically just two large firms today, so nobody knows what will happen in the event of a flash crash. There is now far less liquidity in all markets traded, and even less than 10 years ago.”

Wallis contends that, “most hedge funds learned their lesson from 2008, but daily dealing UCITS funds trading OTC volatility contracts may have a liquidity mismatch problem”.

Which vehicle?

Volatility can be traded through funds with multi-year, annual, quarterly or monthly lock-ups; liquid alternative funds with weekly or daily dealing, or even ETFs that offer intraday liquidity and tend to be passive (though in theory an actively traded volatility ETFs could be created).

Argues Dredge, “volatility does not work well as a passive strategy”. For active volatility managers, passive vehicles with daily liquidity are probably most relevant as their enforced rebalancing in response to inflows and outflows can upset the supply and demand equilibrium of volatility instruments. Though levered VIX ETPs saw $2bn of outflows in 4Q, 2018, they are now seeing assets flowing back in, including into levered products, with some indicators suggesting record short positioning.

But alternative risk premia (ARP) products may now be equally or more significant. De Saab suggests that “of $200 billion in ARP, $20 billion may be in short volatility risk premium strategies, which is a very important factor in decision making as ARP type strategies have essentially replaced supply from the VIX ETP market”. Wallis reckons that, “60 or 70 UCITS ARP products are managing $21 billion while ’40 Act liquid alternatives products in the US may be managing as much as $150 or $200 billion – and virtually all of them are selling volatility in one way or another”.

The dynamics of ARP strategies may differ somewhat from pure play, one trick pony, short volatility ETFs however. “Their profit and loss is less visible as most investors may not have granularity on the profit and loss breakdown of what their programs are doing. ARP programs can also change weights of different risk premia, rebalancing from one to another, which may allow them to maintain some exposure to short volatility for longer. They can also move more opportunistically between markets, and trade indices from different angles, such as skew and term structure, and use the increasingly popular dispersion trade – which may be crowded, judging by a Bloomberg education event,” says De Saab.

London-based fund of funds manager Alessandra Poles, Volatility and Rates, Alternative Investment Strategies, Aberdeen Standard Investments, reflected on her experience with volatility strategies. “A number of our portfolios have had a structural allocation to tail risk strategies since 2012. Initially, this was implemented through bank strategies that had quite a high negative carry and pay off. It became clear that choosing such strategies implied the need to be relatively right on timing of a volatility event, otherwise the bleed can be substantial. As a consequence of that experience, the decision was taken to switch allocations to hedge fund tail risk strategies with carry profiles that were more sustainable over the medium-term for our portfolios, with lower but still attractive levels of potential pay-offs. Although the weight of these funds in most portfolios has been drifting down somewhat in recent years, partly naturally and partly as a conscious decision, this remains an active strategy for us and something that we think adds value to portfolios. We are also in the process now of developing a Global Risk Mitigation strategy in partnership with a bank as we think we can bring to bear our experience in both volatility and risk premia investing to this area that is of interest to clients.”