3 WAYS TO PROTECT YOURSELF AGAINST TAIL RISK

The latest from James Montier of GMO is a must read as always.  He discusses the rise of tail risk protection and the ways in which investors can protect themselves.  He provides three specific forms of protection:

“We are aware of three general groups of tail risk protection from which investors may choose.

1. Cash – This is perhaps the oldest, easiest, and most underrated source of tail risk protection.  If one is worried about systemic illiquidity events or drawdown risks, then what better way to help than keeping some dry powder in the form of cash – the most liquid of all assets.  (There is much more on the joy of cash to come shortly.)

2. Options/contingent claims – Occasionally, the market provides opportunities to protect against tail risk as a by-product of its manic phases.  A prime example was the credit default swaps that were a result of the demand for collateralized debt obligations.  These instruments were priced on the assumption that there would be no nation-wide decline in house prices, and thus offered a great opportunity (even without the benefit of hindsight) for those who were concerned that such an outcome was more plausible than the market thought. Here, one caveat stands out above all others: one must be cautious of the dangers of over-engineering in this area of tail risk protection.  It is too easy to construct an option that pays out under a very specific set of circumstances, and to do so relatively cheaply.  But, of course, such an instrument tautologically only pays off under the realization of those specific events, so the tighter the constraints imposed, the less use the option is likely to be as general tail risk protection.

3. Strategies that are negatively correlated with tail risk – For the specific type of tail risk (illiquidity events) under consideration here, long volatility strategies are often said to be negatively correlated.  The simplest example of such a strategy is just to buy volatility contracts (bearing in mind the roll return will be negative given the upward-sloping term structure of volatility).  In the recent crisis, a dollar neutral long quality/short junk portfolio acted very much like a long volatility strategy (with the added benefit of an expected positive return, in contrast to most insurance options).”

Options and negative correlation are more complex issues, but for the average investor I would not discount the value of cash.  Some might call that an oxymoron – “the value of cash”, but I have been able to generate enormous alpha over the last 5 years in my personal portfolios via the use of cash.   Knowing when to pull your chips off the table is often your greatest talent.  After all, if you can protect the downside the upside takes care of itself.

I view cash as its own asset class.  It is, in my opinion, the ultimate form of protection.  The power of cash lies in one great form of risk mitigation – your emotions.   Nothing will destroy portfolios like your own emotions.   And you can’t make bad decisions when you’re not in the game. Then again, one has to remember that you’ll miss every shot you decide not to take.  Therefore, being in the game is vital and hence, the use of cash should not be abused in excess. Of course, knowing when to deploy cash and get in and out of the game is a another key element of this discussion.  To me, this is largely dependent on the approach you use and how systematic that approach is.   But that’s a discussion for another day.

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Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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Comments

  1. Does anyone in the world think that the potential for the Greek Austerity vote failing is not an enormous tail risk, considering the chaos which would follow? We are talking about two or three greek politicans deciding that maybe enacting the austerity measures which will ensure a depression there might not be something they want to press ahead with. Yet the bailout mentality which drives the stock market just assumes that Greece will come through this in flying colors and we will have one more month to come up with a solution….which they will never find. What a landscape…

  2. I am an option fan, still sizing and timing can be killers.

    LEVEL TRADE: a (risky) alternative to going long VIX fut
    Those who can trade option on vix could try this:
    – short call sligthly OTM
    – long call firther OTM
    so that delta is worth 0

    in case vix goes to the roof swiftly it will pay. Now, the more you get lose to maturity the more you get close to a losing payoff if vix increase only slightly. Ideally one would have to use 6M maturity and roll it 4M before expiry. That may makes many rolls (bid/offer costs) if your timing is wrong.

    TERM STRUC trade:
    in case of sudden drop, term structure may invert, so get long short term VIX fut and short longer term. Premium = payong short term contago moderated by being paid longer term contango . You are playing backwardation. On absolute basis, steep is important but not as high as before Lybia/Japan. On relative basis the trade looks more attractive.

    SKEW trade:
    buy deep OTM sell closer to the money put so that vega is worth zero at inception + Delta hedge. Problem is that given skew level (please refer to CSFB index and prag cap post about it) it is costly. Especially since your long asset classes, in case of positive outcome may not pay enough to fund those trades. When i looked at what happened with lybia/japan and since 2 or 3 weeks i think market is pretty resilient (pricing bailout ?) BUT skew is still expensive imo. Hence i would disregard skew trade.

    That those trades are all hedging against sudden drop. targeting longer term correction make them more costly. Those are equivalent to shorting banks etc: i.e. question is what is already discounted in the market.That being said Cullen comment about cash is great, and thinking about his post about mistakes you should not make: the most important things is to avoid permanent loss of capital. Trying to profit from tail risk is somewhat risky in itself.

  3. Still watch out where you held your cash, you’d better hold properly selected govt securities since in case of custidian default cash is co mingled. And when we say cash it is cash…remember those money market tilted with cdo etc !

  4. Not knowing what else to do, I have held a large portion of my assets in cash the last few years. I was perturbed at the erosion by inflation. But lately I have realized that cash used for real estate purchase is worth more currently. Cash in a time of asset defation may gain considerable value. What applies to real estate also applies to equities. Another major drop in prices and cash is king!

  5. Montier is living in the 80’s. It “is” different this time as we are no longer in a western centric world. When credit deflation continues into further depression cycles his asset class will be the first to suffer along with many ‘old’ asset classes mentioned by respondants. As the fiat currencies devalue further, and ‘Consumer’ inflation continues further upward, holding Montier’s cash will be deadly to one’s future. All of us need to travel more and witness the ‘real world’.