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
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:
- Tail risk management (TRM) is hedging of
one’s investment portfolio against highly
improbable market downturns – so-called black swan
- 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
- 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
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
So begins Pimco managing director Vineer
Bhansali’s rationalisation of TRM.
Almost every person I speak to feeds me a variant of this
It’s a ridiculous comparison. And not because
it’s overly dramatic. It’s not nearly
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.
The bad news about stockmarkets
The following table shows that severe rolling
quarterly losses occurred 5.3x (169÷32) more
frequently than expected.
|Severe quarterly S&P 500 losses
||Actual returns (no of quarters)
||Expected returns (no of quarters)
||Tail risk events (no of quarters)
Past performance is not necessarily indicative of
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
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
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
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
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
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
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
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
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
However, it is clear to me that TRM is going to be an
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
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
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
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
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
"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
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
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
How is this achieved?
"Using the Vix," says Mattatia.
Perhaps I was too hasty to mourn the passing of the
"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
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
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
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?
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.
- 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.
- 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
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
Theo Casey is a Futures & Options Intelligence