Warding off the black swans

Tail risk hedging strategies could improve investment performance by around five or six per cent in black swan events such as the global financial crisis (GFC), according to PIMCO.

Very poor annualised market performances such as those seen during the GFC that appear in the left tail of a statistical bell curve occur more often than a standard model would predict due to correlations among risk factors, meaning “left tail events” tend to occur around once every four to five years, according to Dr Jim Moore, a senior member of PIMCO’s investment solutions group.

Just one left tail event could reduce 10-year gains by one-third to one-half, meaning a successful tail risk hedging strategy is crucial to preserving asset performance in the long term, Dr Moore said.

The hedging strategies included credit default swaps and the tranched layers in the credit default swaps, which had a lot of leverage versus premium spent. Equity options were one of the most obvious but also most expensive.

Other hedges included bond options and currency options, for example the Japanese Yen tended to sell off slowly when risk assets were running but could rebound sharply when the markets sold off, Dr Moore said.

These hedging strategies would require budgeting between 50 and 100 basis points per year which was functionally similarly to buying an insurance strategy, he said.

“You need a comprehensive long term view that factors in both the macro environment, the regulatory environment but also realising that there’s the likelihood of catastrophic losses and it’s incumbent to think about managing for them ahead of time as opposed to trying to clean up after the fact,” Dr Moore said.