When you live a single life in this constantly busy metropolis of London, you’re reliant on certain things that are imperative to maintain the on-the-go lifestyle. Good friends who possess great energy, an ‘in’ with the party hosts at the best clubs, flat shoes to run around in (heels are to be kept in a hold-all so one can slip into them moments before making an entrance) and last but by no means least, a functioning freezer. Yes, you did read that right. Being able to go from pack to plate in under five minutes is essential when you’re regularly racing the clock.
So when your trusty freezer that has been working splendidly for the last four years suddenly malfunctions, it’s a shock. Its occurrence is out of the blue and if not entirely devastating, it’s certainly pretty darn inconvenient. In the investment world, we call this type of incident a ‘tail event’. It falls under the realm of possibility but difficult to predict and not a frequent occurrence.
When the equivalent of a freezer breakdown happens in the markets, shares take on the consistency of melted Ben & Jerry’s ice cream, corporate bonds are like defrosted poultry, laden with multiplying bacteria and a source of food poisoning. The portfolio that you have carefully put together loses its structure altering into a soggy, congealed mess. Fortunately there is the equivalent of home contents insurance in the investment world.
The fear of a breakdown, it appears is very much instilled in investors’ psyches after the collapse of Lehman Brothers back in September 2008. Economists and Wall Street, despite their complex multifactor models failed to predict both the event and the extent of the fallout. This was the black swan that Nassim Nicholas Taleb had warned of; the widely held belief that only white swans existed until black ones were discovered in Australia. Many failed to realise that just because they hadn’t seen a black swan, it did not necessarily mean they didn’t exist. Now in the face of the Greek sovereign debt crisis and the possibility of the collapse of the Euro, demand for insurance products to protect investors against any cataclysms is surging.
Besides the sovereign debt crisis in Europe, many believe ‘tail risks’ may come from a mis-step in monetary and fiscal policy leading to hyperinflation from bailing out the global financial system. There are many clever clogs out there who have constructed insurance hedges that allow trading on these very fears. Many of the hedges are designed to increase in value as other portfolio assets (everything from stocks to the Canadian dollar) plummet.
One of these instruments has been getting a lot of attention lately and goes by the name of VIX futures. This is a future on the VIX or Volatility index created by the Chicago Board Options Exchange (CBOE). The VIX has become the default ‘fear index’ since volatility often signifies financial turmoil and can be helpful in evaluating potential market turning points. During the financial crisis of 2008, there was a spike in volatility sending the VIX index level up to 80. During the latter part of 2009, stock markets moved higher and a low volatility level in the region of the teens was reached.
The attractive thing about the VIX is that it has a strong negative correlation to many equities. That is you’re likely to make up part of the losses in one asset class with gains in another. The correlation between US large cap stocks and volatility is -0.65. A simple way to think about this would be imagine stocks went down 100 points, volatility partially offsets this loss by increasing 65 points. Deutsche Bank has created proprietary products with catchy names like ELVIS [replace mental image of the white-suited fat guy singing in Vegas with Equity Long Volatility Investment Strategy] that gain in value with investor expectation of stock market volatility increases. Having the benefit of foresight would be beneficial here as one cannot be entirely sure these products will work in a crisis when correlations all tend towards 1. In this instance, when stocks lose 100 points, so will volatility.
VIX options and futures, as well as credit default derivatives (iTraxx and CDX) and out-of-the-money index puts (on the FTSE, S&P500 etc) are just a few of the ways to hedge at the broader portfolio level in a similar vein as buying home contents insurance covers everything from jewellery to your Jimmy Choos to your Fridge-freezer. But all this comes at a cost. And this cost is rising. According to data compiled by Bloomberg, investors buying options that paid off should the S&P500 plunge were paying 75% more than those speculating on the S&P500 rising.
While these strategies undoubtedly have a place in the investment world, investors should be wary of overpaying for these insurance products. Buying expensive insurance is just like buying any other overpriced asset and a desire to be always hedged using these strategies can prove to be too expensive and not worth the trouble.
There are ways to hedge tail risk using dynamic asset allocation methods. The most obvious and common sense approach is to hold a larger cash balance. There are other traditional asset classes like short term Treasuries and Gilts that can serve as a hedge. A flight to safety during an equity or credit market crisis makes these attractive securities to hold if they are attractively priced. Right now yields are almost inconceivably low and prices too high to consider.
7IM’s investment management team mitigate unforeseen portfolio risk by tailoring cash to their perceived risk levels rather than that dictated to them by market consensus. Continuously monitoring economic developments, working through several different economic scenarios ranging in intensity, and not managing to a fixed model also allows the team to implement sudden and necessary changes in portfolios. Furthermore a layer of risk management is done via currency hedges as movements in currencies increasingly reflect risks in the macroeconomic environment. This of course, is all in addition to benefits of diversification our clients already receive by investing in a range of asset classes from equities and bonds to commodities and timber.
Yes, it is very hard to predict when that freezer will let you down or where the next Lehman is going to come from. But the important thing to remember is that while tail risks may vary in their origin, they can have considerable impact on your portfolios and some level of portfolio contents insurance will prove useful.
And finally….... A black bear has gone to extreme lengths to secure its meal. Attracted by the smell of a peanut butter sandwich, it managed to open the door of a car, climb in and promptly got stuck. The car rolled down a slope into the trees after the creature managed to knock the gear stick into neutral. Expect profit warnings from peanut butter manufacturers who now are prepared for bearish conditions to persist well into the second half of the year!