(November 27, 2011) — A recent paper by AQR Capital Management asserts 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 states: “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 recommends in its report that investors should combine five different approaches to most effectively and efficiently reduce tail risk. Those recommendations are: 

1) Diversify by risk, not just by asset

2) Actively manage volatility

3) Embrace uncorrelated alternatives

4) Take advantage of low-beta equities

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 continues. “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.”

This is consistent with a risk parity approach, of which AQR is a prominent vendor. 

However, many investors still voice concerns over a risk parity strategy. For example, while Australian superannuation funds are overwhelming exposed to equity risk at a time of volatility and low return, risk-balanced investing approaches are not widely practiced, a fact vigorously debated and critiqued at the aiCIO Chief Investment Officer Summit in Sydney. Alastair Barker, investment manager at the AU$42 billion AustralianSuper, explained that the fund did not use risk parity approaches in its strategic asset allocation because of its high-conviction assumptions.

“I think the fundamental tenant of the risk parity thing for me is that you’ve got to have a belief that whatever it is you’re investing in, if you’re going to lever it, you’ve got to be pretty convinced that it’s going to return, and if you’re not absolutely convinced in the environment, than it’s really difficult to justify,” Barker said. “That’s just trying to put it into a common language that I can put to my investment committee.”

On the other hand, Tim Unger, head of investment strategy, Australia, Towers Watson, said that the returns environment of the past few years was leading superannuation funds to reconsider their risk management and to start looking at risk- balanced strategies as a possible solution. Damian Lillicrap, head of investment strategy, at the AU$32.4 billion QSuper, said that the fund does pursue risk balanced strategies in its asset allocation.

“The risk parity direction is a direction that we see that we should be doing a lot more of,” he said. “We have stepped toward that in our fund under the last two years. We went away from the fixed interest benchmarks and starting investing in longer duration securities.”