Do Institutional Investors Need Tail Risk Insurance?
Standard Life Investments Euan Munro discusses how it is possible to build portfolios for institutional investors that will withstand challenging economic environments and negate the need for expensive tail risk.
Do specific types of institutional investors tend to buy tail risk insurance more than others? How do they gauge their level of need for such products? How does this insurance factor into the total cost of the product for the end investor? What other factors should investors consider?
Euan Munro is the head of multi-asset investing at Standard Life Investments.
The subject of tail risk insurance has led to spirited discussion among a broad group of investment managers since the financial crisis. “Portfolio insurance,” “tail protection” or “tail hedging” are all terms that describe steps taken in an investment strategy to limit losses on a portfolio of investments in a time of unusual stress or crisis.
Managing that category of portfolio risk is an important issue. The industry has lined up to debate the finer points regarding which form of tail risk insurance is best to take on, as well as how and when to do so. This has given shape to a new orthodoxy about managing such risks, one whose premise is that such risks, and the accompanying insurance, are both necessary aspects of a properly managed portfolio.
All of which makes asking whether we really even need tail risk insurance something close to heresy. Heresy it may be, but the fact is that the new orthodoxy encourages a bipolar mindset in investment managers. It leads them to do something risky on the one hand, in part because they know that they can pay for protection with the other. And it comes at a real price: Tail risk insurance is expensive.
There is another alternative approach to risk management, and its fundamental premise is not to let any single type of risk become dogmatically “existential” to the fund. Instead, the portfolio should be seen as a vehicle wherein the investment positions across multiple asset classes and various global markets work sympathetically with one another in a wide variety of most-likely scenarios. Given that no manager really knows what will happen in the future with any precision, the manager contemplates multiple scenarios and allocates the portfolio’s assets accordingly. Its positions are designed to pay even when the market is down – and without the cost of buying risk insurance.
In the new orthodoxy, then, we are held captive by the belief that severe market stresses will happen that can’t be forecasted. The popular solution is to buy tail risk insurance to limit the downside for investors. That leaves us in a predictable place: with popular assets again, but also portfolios that are expected to lose money in normal circumstances, yet still have to be “protected” against losses in times of stress.
The first problem with this is cost. Buying insurance against an obvious risk such as a fall in the U.S. stock market is protection against a great likelihood. The chances of this happening over the next few months are almost even, which makes equity market insurance expensive. For example, to buy an option to sell a $100 million U.S. equity portfolio at today’s prices for the next year would cost more than $10.7 million. In other words, this form of tail risk insurance would need the equity market to rally by more than 10.7% before the portfolio can even start to make money.
The second problem is that the new orthodoxy has difficulty matching the investor to the risk that should be of the most concern. Investors with different goals must be mindful of the various kinds of tail risk events. For example, some institutional investors with funding requirements for long-dated liabilities should fear a collapse in interest rates much more than a large drop in the stock market. And so, not being focused on the right risk leaves a portfolio owning the wrong form of protection.
A Different Approach
It is possible to build portfolios that will be resilient in many different economic environments, negating the need for expensive tail risk. This can be done by deploying a diverse variety of investment strategies across global markets, combining classically risky strategies, such as positions in equity and credit markets, with positions in government bonds and currencies.
For example, if a portfolio owns high-yield credit and equity market exposure, then there’s an obvious tail risk in the event of a serious wobble in risky assets. Rather than spending a fortune on equity market puts, the manager could sell the Canadian dollar versus the U.S. dollar. But, of course, that can only be done with a view on the prospective and relevant macroeconomic shifts. Global growth over the past decade or so has been around 5% and is unlikely to continue at this level. Therefore, in a scenario where global growth is less robust than in the prior decade, the Canadian dollar is likely to be overvalued and would be expected to decline slightly. However, in a strong “risk off” market, the commodity linkage of the Canadian dollar would cause it to drop more rapidly and thus give some protection to the portfolio.
The theory and practice of all of a portfolio’s positions working sympathetically with one another is thus important. Those positions should strive to make money if the global economy evolves in line with the manager’s central economic forecasts. If that is achieved, there is no insurance premium to be paid. At the same time, all the positions in aggregate can be combined for their contribution to total returns in a variety of alternative economic scenarios. Why? Simply because being even approximately right about a central economic forecast would be fortunate. The portfolio cannot therefore be wedded to only one scenario or outcome. Managers, consultants and institutional investors must contemplate multiple outcomes.
This article was first published in Fund Fire on 15th May 2012