Cash Offers Best Tail-Risk Protection, Says New Paper

(July 25, 2011) – A flexible allocation allowing timely moves into cash gives an asset owner the best tail-risk protection, a new paper by James Montier, a London-based portfolio manager with GMO, has contended.

Institutional investors concerned about protection from black swan events often overlook the values of a flexible cash allocation, Montier argued. Other hedges like options/contingent claims and strategies that are negatively correlated with tail-risk simply do not provide the same level of protection.

Cash is “the oldest, easiest, and most underrated source of tail-risk protection,” claimed Montier in the paper, titled “An Ode to the Joy of Cash.” “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.”

Other strategies designed to minimize tail-risk do not provide protection from what Montier called “general” tail-risks, such as inflation. “This is one of the failings with many products being marketed as tail-risk protection; they are long volatility strategies rather than ‘general’ tail-risk protection portfolios.”

Tail-risk protection, he cautioned, is “not a magic bullet.” Crucial to the successful execution of a tail-risk hedge is timing. But if “the ‘when’ of tail-risk protection” is correctly handled, Montier explained, then an allocation to cash offers the best protection against black swan events.

A flexible cash allocation provides the best tail-risk strategy because it minimizes what Montier called “Valuation Risk” and “Fundamental Risk.” Valuation risk is the risk connected with overvalued assets. According to Montier, cash is a much better investment than sticking with overvalued assets. “In our view it is better to hold cash and deal with the limited real erosion of capital caused by inflation, rather than hold overvalued assets and run the risk of the permanent impairment of capital.” With fundamental risk, or the risk of “write-downs to intrinsic value,” cash is a good hedge because it “is a more robust asset than bonds, inasmuch as it responds better under a wider range of outcomes.” Thus, an allocation to cash can increase a portfolio’s resistance to varied fundamental risks.

Cash, Montier concluded, is “a severely underappreciated tail-risk hedge” and one that institutional investors would be wise to consider.

Click here and here to watch Nassim Taleb, bestselling author of “The Black Sawn” and “Fooled By Randomness,” talk in-depth about black swan events.