(February 21, 2012) — There is no portfolio equivalent of fire insurance that will protect all investors at the same time for a reasonable price, according to a whitepaper by Ralph Goldsticker, senior investment strategist at BNY Mellon Investment Strategy and Solutions Group.
Instead — Goldsticker asserts in the recent report — investors should expect to pay a high premium to incentivize others to take on a disproportionate share of tail risk.
The report states: “When it comes to markets, tail risk is systematic. If your stocks drop by 25% in a market crash, so will everyone else’s. Because in this situation all houses burn down at once, the risk cannot be reduced by diversification. For investors to reduce their tail risk, they must transfer it to others. As a result, the price of tail risk insurance will include a premium reflecting the price that other investors charge for bearing more than their fair share of the aggregate risk. Since no one wants to suffer the effect of a market crash, it’s reasonable to assume that the price will be high.”
The paper concludes that growing concern about tail events has caused the cost of insuring against them to rise. Thus, if the priority for investors is to earn the equity risk premium, and they can tolerate the tail risk, staying the course might be the best alternative.
The paper continues: “It might be that in the new environment, the better solution is to reduce allocations to equities. However, if investors do decide to buy tail risk insurance, we think they should consider buying the minimum amount necessary to match their needs as closely as possible — and not be surprised if it turns out to be quite expensive.”
Another paper by AQR Capital Management arrived at similar conclusions over the high cost of tail-hedging, asserting that insuring against tail risk has proven to be overly costly and a drag on performance. According to the firm’s research, investors should make changes to their portfolio construction and risk management policies in order to more effectively guard themselves against unexpectedly huge losses.
The report stated: “In the wake of 2008, investors are now painfully aware of tail risk – the risk of unexpectedly large losses. Today many institutional investors are insuring against tail risk directly, often by purchasing puts or structuring collars. Unfortunately, experience and financial theory suggest that the long-term cost of such insurance strategies will be larger than the payouts. No surprise, really. The expected return for perpetual insurance buyers is negative, and conversely positive for insurance sellers.”
Consequently, the firm recommended in its report that investors should combine the following five different approaches to most effectively and efficiently reduce tail risk: 1) Diversify by risk, not just by asset, 2) Actively manage volatility, 3) Embrace uncorrelated alternatives, 4) Take advantage of low-beta equities, and 5) Have a crisis plan before you need one.
“We think these approaches lead to better-constructed portfolios for all investors, not just those concerned with tail risk,” the report continued. “For investors who are unable to pursue these approaches, we think the best way to reduce tail risk is to reduce total exposure rather than to buy insurance…Our research suggests portfolios that maintain steady risk (or even reduce risk) when forecast volatility is high may earn higher risk-adjusted returns.”