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) which would be especially beneficial for superannuation funds with members in retirement who could not afford to take a hit to their investments, according to PIMCO.
Super fund members in the accumulation phase could afford to be invested in growth stocks and still build from the occasional poor performance, but members in or approaching retirement need to have their investments protected, according to Dr Jim Moore, a senior member of PIMCO’s investment solutions group.
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, he said.
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 over the long, 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 are running but can rebound sharply when the markets sell 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.
While these strategies would start to lose their effectiveness if they were widely adopted, we are still a very long way away from that type of saturation, 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.
