(August 29, 2012) – Hope for the best and prepare for the worst, so the saying goes, but just how does an institutional investor best prepare for the very, very worst?
Hedge for volatility across multiple asset classes, in order to minimize both the risk of disaster and the carry cost of safeguarding against it, according to Joel McKoan, AllianceBernstein’s chief investment officer for absolute return strategies. For example, an asset manager might pair emerging market investments with gold or US dollar holdings. In the highly unlikely event of a dramatic and widespread loss of confidence in emerging markets, certain commodities and ‘safe-haven’ currencies would likely rise in value.
“There are two main benefits of a multi-asset approach,” McKoan writes in a recent essay. “First, it offers better diversification. Second, it allows a portfolio manager to monetize profits from one strategy and asset class while being able to change to another strategy as valuations shift.”
Beyond currencies and commodities, McKoan also suggests investors consider equity put options, interest rate hedging through bond duration exposure, yield-curve strategies, and credit as low-cost ways to hedge a diverse portfolio against tail-risk. These techniques, he suggests, could mitigate the damage of another 2008-style ‘black swan’ event.
Despite managing well-diversified portfolios, nearly all institutional funds suffered major, if not catastrophic, losses from the most recent financial crisis. “While portfolio diversification has served investors well under ‘normal’ market conditions, it may fall short in periods of extreme market stress,” McKoan cautions. “The challenge is to protect against tail risk at times of crisis, while actively managing any negative carry costs associated with the protection. An effective tail-risk hedging strategy can help investors by buffering their portfolios when extreme events occur. In these markets, the best solution is an agile, active approach that dynamically allocates funds between strategies depending on current market pricing and prevailing conditions.”
Read Joel McKoan’s entire essay here.