(March 5, 2013) – It is an appealing notion, in a post-2008 world: tail risk hedging for defined contribution (DC) plans.
But plan sponsors looking to insure against the catastrophic personal retirement losses all-too-common in the financial crisis could do more harm than good pursuing that strategy, a study has found.
Two finance researchers working in Australia used historical data to simulate the impact of both active and passive tail risk hedging on DC investor cohorts stretching from 1928 to 2010. Anup Basu of the Queensland University of Technology and Griffith University Professor Michael Drew found that for two-thirds of the investor cohorts, the strategy would have done more harm than good for their bottom line.
“Overall, our findings indicate that historically holding hedged positions would have proved very costly for most DC plan investors,” the authors wrote. “Whilst buying tail hedges would have proved beneficial in some cases, the misgivings about these strategies among long horizon investors are not unfounded. Extreme or tail risk events, by very definition, are events with low probability of occurrence … Since the timing of these events is unpredictable, the investors are required to remain hedged all the time.” Even when groups in the model encountered these extreme events, the authors found that in many cases the protections were not worth their long-term cost.
This was particularly true of passive hedging strategies, except for the DC cohort covering the Great Depression years. On average, Drew and Basu found that active hedging would have resulted in nearly 10% greater wealth at retirement for equity investors as opposed to passive hedging.
(The study modeled passive hedging by allocating 1% of the portfolio to buying tail hedge every year regardless of price. The active approach spent the same portion [1%] on out-of-money put options, but purchased at certain price levels based on market conditions.)
Annual returns averaged 14.49% for the study’s sample groups of unhedged DC investors. Applying active hedging to the simulation brought that figure to 14.10%, and the passive approach pulled it down further to 13.6%.
Even for the cohort of DC plan members approaching retirement during the financial crisis—which Drew and Basu call “a ferocious tail event”—hedging still would not have been worth the decades of drag on returns, according to the study: “Undoubtedly, both active and passive hedging produced higher returns than the unhedged strategy during this crisis event. However, the investors with unhedged strategy still retire with a higher wealth than those adhering to hedged strategies. This shows that the pay-offs from hedging during the crisis in 2008 (and earlier crash between 2000 and 2002) were not large enough to recover the cost of hedging over twenty years.”
Read Anup Basu and Michael Drew’s paper, “The Value of Tail Risk Hedging in Defined Contribution Plans: What Does History Tell Us,” here.