Tail risk management is the talk of the town. After the calamity of 2008-9, everyone wants to hedge against the black swan event, the nightmare scenario. In the first leg of a two part investigation, Theo Casey sets off to discover whether such an ambitious hedging aim can be achieved at a bearable cost.

“First of all, forget the Vix.”

“Um, OK... really?”

“Yes. It’s just not appropriate for this type of hedging. Second of all, you can’t launch this thing for nine months.”

“Er, no. The Casey Hedged Equities Fund goes live this week.”

It’s a lot to take in.

On the other end of the phone is a PhD-toting City expert well known in a growing niche – tail risk management. Though he prefers not to be named, he was certainly forthcoming about his methods during our consultation.

He’s helping me launch a long equity fund that will be protected against a sharp equity market downturn.

Allow me to explain:

1. Tail risk management (TRM) is hedging of one’s investment portfolio against highly improbable market downturns – so-called black swan events.
2. I am not a fund manager and the Casey Hedged Equities Fund (Chef) is not a real hedge fund. It is a working model designed so I may demonstrate how TRM may apply to the wider investment community.
3. Yes, a prominent bank’s degree-laden analyst really did say that Vix futures and options – those based around the archetypal volatility index – are a bad hedge.

But first, let’s explain how we got here.

Five times worse than you thought

“When a homeowner purchases insurance against a catastrophic event that might destroy the roof over their head, they do not regret having paid the premium...”

So begins Pimco managing director Vineer Bhansali’s rationalisation of TRM.

Almost every person I speak to feeds me a variant of this spiel.

It’s a ridiculous comparison. And not because it’s overly dramatic. It’s not nearly dramatic enough.

In the past 10 years, investors have collectively incurred two 50% declines in global equity markets. And that’s just the headline.

Research by Welton Investment into tail risk (to be precise, left tail risk, as it’s the downside, which appears on the left side of the bell curve, that TRM seeks to protect against) show these terrible events are five times more likely than investors expect. “These estimation errors can have a very significant impact on investment returns,” concludes Welton, with impressive restraint.   

This is serious stuff. Hence, serious action is necessary to restore faith in asset managers’ ability to protect clients’ money.

One TRM approach is simply to buy out-of-the-money puts on the index, such as the S&P 500. This is often characterised as the Black Swan Protection Protocol.

However, this is not as cheap a solution as it once was. Interest in buying puts on the S&P has risen. Société Générale strategist Dylan Grice notes that the pre-crisis average implied volatility – a principal component of option pricing – was around 12%. Since the crisis it has been more like 26%.

“Some of the skew we are seeing is a direct response to the increase in tail risk hedging activity,” believes Aaron Yeary, partner at Pine River Capital Management in Minnetonka.

Given the lack of affordability in these options it’s little wonder that the Vix – derived from S&P 500 implied vols – might not be a perfect fit for TRM. However, it’s not only the overcrowding effect that makes Vix futures and options a bad hedge...

Why the Vix doesn’t work

Professor Robert Whaley, a pioneer in options thinking, created the Vix in 1993.

It’s come an awful long way. With the aid of Goldman Sachs – which, in concert with Whaley, re-engineered the methodology in 2003 – derivatives on this indicator have flourished. Trading in Chicago Board Options Exchange Vix futures and options tops 100,000 contracts a day.

The reason the Vix is so closely associated with TRM is because of one particularly impressive statistic – a violent inverse correlation with almost everything else.

According to figures from Deutsche Bank’s recent TRM white paper, the Vix has a strong negative correlation with US stocks, international stocks, bonds and inflation-linked securities. So when those assets go down, the ‘fear gauge’ goes up.

Sounds ideal – What more could one ask from a tail hedge?

A longer curve, apparently.

“Contracts on the Vix only run six months forward,” our PhD points out. “As is typical in most assets, near-dated options are the most volatile. So one wants to buy longer-dated contracts.”

It’s a fair point. The Vix appears to have one gaping design flaw... its options only run to March 2011.

It comes back to cost. The higher the vol, the greater the cost of buying an option. And given that I am trying to hedge against something that is very unlikely to happen – at least in the next six months – I don’t want to pay very much for it.

One alternative is buying variance swaps – a longer market than that of the Vix – all of nine months to expiry.
And that is why I can’t launch the Casey Hedged Equities Fund for nine months.

First, I must build up a base of cheap options at the long end of the curve. In nine months, the June 2011 contracts I buy today will expire. That will cover the first month of my fund’s life when I eventually launch it.

Next month, I will buy the July 2011 – and so on ad infinitum. I will have a stream of options bought long-dated (hence dormant and cheap) that will subsequently be near-dated (hence more sensitive to market movements and potentially expensive).

Hire an expert?

This systematic option buying is simple and elegant.

However, the Casey Hedged Equities Fund is all about stocks. I don’t have the capacity to hire options traders to carry out this task. This type of infrastructure will be costly. Perhaps I can palm off responsibility to a third party?

Should I go to the sell side or the buy side? Big banks or independent funds? There’s a divergence in thinking between the two.

Funds appear to sell off-the-peg tail risk management solutions – systematic tail risk programmes – whereas investment banks tend to offer more tailored products.

I couldn’t tell you which is the better bet, as neither camp has much proof of concept. Most of these solutions have been brought to market in the wake of the credit crunch.

However, it is clear to me that TRM is going to be an expensive endeavour.

Moreover, I’ve got to buy a high performance system. Given that my fund, as is typical, can only invest 2% or 3% of assets in any other fund, that’s all the capital I’ve got to play with for my hedging.

Ninety-seven per cent of the assets will be long equity. And that position will be severely damaged in an equity sell-off.

So the return I’m looking for on the 3% of assets that are hedging my tail risk

must be especially potent to first offset the accumulated cost of TRM and second, compensate for losses in the main body of the fund. The payoff on the hedge must be sharply geared to be worth my while.

It’s a big ask.

I talk to relative value specialists Pine River Capital Management. Aaron Yeary, whom we heard from earlier, explains how Pine River views TRM: “As a matter of course, we hedge tails, just in case there are massive dislocations in broader markets.”

But this hedging is a weary business – Yeary admits it is “not alpha-generating”.

The fund, with about $200m under management, charges a fixed fee for TRM. “Even with a fee, this is a cheaper solution than a fund could produce in-house,” says Yeary.

Pine River invests mainly in liquid equity and credit index products – the S&P 500, variance swaps, the CDX and iTraxx credit default swap indices, and so on.

“We try to find the cheapest convexity across the market,” Abhishek Bhutra, Pine River’s co-head of structured credit, tells me. “We’ll buy credit if equity is expensive, because you can’t source cheap insurance where it doesn’t exist. Our approach is systematic and designed to find the most convex volatility products.”

In simple terms, Pine River goes out looking for instruments whose prices change in a non-uniform way as the price of the underlying changes. What the firm wants is things that might make a modest payoff if there is a small sell-off, but a whopping payoff if there is a cataclysm.

However, Yeary and Bhutra are not giving much away about where to find these diamonds.

Mining deeper for value

Instead of buying an off-the-peg hedging strategy, another potential solution is to find an even more specific, and hence cheaper, hedge.

“Our clients are hedge funds, asset managers and pension funds – so we provide a wide variety of products to match varying demands.”

That’s Stéphane Mattatia, head of engineering and advisory in SocGen’s global equity flow department. He believes the French bank’s solutions deliver that asymmetric payoff – more bang for your buck.

The first solution circumvents the problem of cost we encountered earlier using the simplest form of the Black Swan Protection Protocol approach.

Instead of buying call options on the Vix or put options on the whole S&P 500, focus the search on the cheapest options. A family of puts on the best performing stocks among a basket. Those options also have a low volatility sensitivity, making them relatively cheap.

SG looks for the best performs at the end of the trade, rather than at inception.

Why would we want to hold the best performers as a hedge? Remember that a tail event is one in which correlations rise steeply. These positions, though they have a strong historical performance, are predisposed to being just as volatile when the market falls. Hence, you’re still playing all the market’s volatility, just through a cheap proxy.

Two wrongs make a right

The second solution is cheaper still. It achieves this by making the hedge still more specific.

Take this analogy. Bookmakers at William Hill give odds of 300/1 that Chelsea will beat Everton 6-0 on December 4. That translates to a £3,000 return on a £10 bet.

However, if you introduce further specificity, the odds change markedly. The odds for Chelsea beating Everton 6-0 and for Didier Drogba scoring at least one goal are 550/1. That’s a £5,500 return on a £10 stake. It’s an 80% cheaper bet. Which is unusual, as nearly every time Chelsea has won 6-0, Drogba has scored.

It’s a consequence of introducing conditions to the payout.

On paper it’s an even less likely event, but the probability of the condition being met is high in the context of a tail event.

“You rarely encounter a crisis in isolation,” says Mattatia. “So if your nightmare scenario is a double dip and you expect further flight from equities to bonds, don’t just buy a put on the S&P 500. Buy a put on the S&P 500 with a barrier that it will only pay out when 10 year bond yields are below a certain level. Or a put on the S&P that only pays out when gold rises 10%.”

Mattatia summarises: “This hybrid, cross-asset strategy benefits from extreme correlation levels between asset classes, and high leverage. However, you’re only protected once certain conditions have been met.”

These approaches rely on correlations rising at times of extreme market pressure. But that’s a fairly safe bet. When panic strikes, correlations head towards one as everything falls in unison.

Why the Vix does work

Viewing the slides of a recent SG presentation on tail risk, I stumble upon something spectacular.

“Short 2M 1x2 40/20 Delta. Net Payout Ratio 36:1”

Crumbs. This is John Paulson territory. No, not the Master of the Universe turned Lehman-scuttler. The one who made $1bn by shorting subprime.

A payout ratio of 36 times my stake is exactly the kind of asymmetric return Chef needs to hedge its 97% equity component.

How is this achieved?

“Using the Vix,” says Mattatia.

Perhaps I was too hasty to mourn the passing of the volatility index.

“The idea,” he says, “is to buy an out of the money call on the Vix – which is expensive. However, you can finance this position by selling call spreads. If you have a sharp drop in the market, the Vix spikes. It spikes so much that the call pays so much that it outweighs the cost of the short call spread.”

Taken out of R2D2 language, what “Short 2M 1x2 40/20 Delta” means is I sell a two month call spread on the Vix, with strike prices of 20 and 40. At the same time, I buy a two month call on the Vix at 20.

The premiums roughly finance each other, so the position is cheap to hold. If the Vix goes above 20, my counterparty will exercise its call, but I am hedged with my call. If the Vix goes above 40, I have a call that hedges my equity losses.

Two or three months, to quote Vix expert Jeremy Wien, is usually the “sweet spot” for hedging because the front month is very volatile and decays out quickly, while longer options will not give you the reactivity you need.

We have an active solution, offering a great payout. However, there is a discord between TRM and the active approach I am pursuing.

Overwhelmed by choice

“You never stop learning,” warns Mattatia. “We must be humble, as tail risks come, by definition, by surprise.”

Finding specific hedges for tail risks is grey, not black swan thinking.

One cannot foresee which risk will be next to shake up the market. There is no universal tail risk hedge. As a consequence, one should pursue a diverse range of tail risk hedges.

Tired out by a long week of shopping around, I flop down with a cup of tea and consider my notes. What should the Casey Hedged Equities Fund do?

1. Don’t DIY An equity fund has neither the requisite options expertise nor the capacity to hold the complex array of contracts needed to manage its own tails.

2. How will I explain this to my clients? If I hedge, my fund will underperform its peer group, unless my rivals also manage their tails. Educating the clients on why Chef lags and how TRM differs from traditional diversification will be a headache.
3. Correlation is an opportunity Taking advantage of the likely spike in correlations – both between markets and within them – will allow me to buy cheaper hedges.

While TRM is conceptually attractive, the practicalities are daunting.

One fund manager with a growing presence in this field notes that the conversion rate to using TRM among his existing clients is not high.

No one can deny the need for tail risk management, but its cost and complexity are evidently offputting.

Alas, the alternative is that managers lose their clients’ money, again.

With 10 years of proof that tail events do happen, ignoring the risk is surely not an option.

On the other hand, the path to action lies through a wilderness, full of thorns, pitfalls, and perhaps the odd predator.

Theo Casey is a Futures & Options Intelligence columnist