By Peter Shepard, Managing Director, and John Burke, Vice President, MSCI Research.
Did hedging tail risk pay off?
As investors take stock of the fallout from the coronavirus and recent market volatility, some have begun exploring tail-risk-hedging strategies as a way to protect against further drawdowns. What are the potential costs and benefits of hedging against tail risk?
We simulated a series of portfolios employing tail-hedging strategies and compared them against hypothetical all-equity and stock-and-bond portfolios.
“Tail risk” refers to the possibility of a large event that would be highly unlikely in a standard bell-curve distribution. But financial markets are “fat-tailed,” and such events are actually relatively frequent. The 100-year storm comes more like once per decade.
Tail-hedging strategies typically involve buying derivatives, such as deep-out-of-the-money put options, that are expected to pay off when these events occur. But this insurance costs money. Like other kinds of insurance, many tail-hedging strategies require regularly spending and losing money in order to avoid the worst losses. Other strategies, like a collar, pay for the downside insurance by selling away upside.
The market prices of tail-risk-hedging instruments potentially provide information about two related questions: What likelihood of another large drawdown have markets priced in? And how expensive is it to insure against such a drawdown?
Paying for it all
The chart below shows how the option-implied “risk-neutral” probability of a large drawdown has changed over time, starting before the 2008 global financial crisis and extending to the current coronavirus crisis. It shows the implied probability of a 20% or greater drawdown of the US equity market over the subsequent three months, as inferred from the prices of out-of-the-money put options.
Source: MSCI.
Option-implied risk-neutral probability of a 20% or greater drawdown over the subsequent three months for the US equity market.
The rising implied probability of a drawdown coincides directly with the rising price of tail-risk insurance via the same options. While it may seem like the best possible time to have insurance, it is also an expensive time to buy insurance.
And while tail-risk insurance is especially expensive now, the chart below suggests that the cost of tail hedging has typically been high. The chart compares the simulated performance of US equity alongside alternatives to reduce tail risk: a zero-cost collar tail-hedging strategy and simple reductions of risk exposure with a 70%/30% stock/cash or bond allocation.
The tail-hedging strategy directly insured against tail risk, while the 70/30 strategies reduced tail risk through a reduction of risk exposure more generally, and the 30% bond strategy further benefited from a flight to quality in the Treasurys when equity declined. The alternative strategies all avoided the worst of equity’s losses, but the tail hedging came at a much steeper cost.
Source: MSCI.
The performance of other tail-hedging strategies showed a similar pattern, as shown in the table below. Unless they could have been timed to go into effect just before a crisis, the protection they provided was more than offset by their cost. Simple strategies to reduce risk overall had similar or smaller drawdowns, while the high costs of maintaining tail insurance eroded performance.
Source: MSCI.
Historically, tail-hedging strategies are designed to add value during a crisis, but at what cost? Investors who avoided the full risk of a stock-market drawdown likely lost out on the full upside. There is no free lunch.
(The views expressed here are those of the authors and do not necessarily reflect those of ETF Strategy.)