Is Fat Tails Insurance Worthless?
Regular Zero Hedge readers know about our fascination with fat tail insurance, which is particularly relevant in modern day central planning when nothing is as it should be and everything is as the central bankers determine it is, at least until such time as the general market calls their bluff and we see the kinds of six sigma dislocations that marked trading for months on end after the Lehman bankruptcy. Probably the best most recent example is our overview of the 5 black swans that keep Dylan Grice up at night, and the way to hedge against them (incidentally, these were Long-term deflation, a Chinese Hard Landing, Asset Bubbles, Hyperinflation, and of course, a Bond Market Blow-up). And while one should always be hedge against prevailing conventional wisdom, because more often than not the crowd is wrong, and with very disastrous consequences, GMO's James Montier, in a just released white paper asks the fundamental question (whose affirmative answer could put purveyors of fat tail insurance such Nassim Taleb's Universa fund out of business), whether fait tails insurance is even necessary if everyone is protecting for the very same selection of "black swans" (therefore confirming that the hedged against events are anything but a black swan). Specifically, in Montier's words: "Tail risk protection appears to be one of many investment fads du jour. All too often those seeking tail risk protection appear to be motivated by the fear of missing out (not fear at all, but greed). However, the surge of tail risk products may well not be the hoped-for panacea. Indeed, they may even contain the seeds of their own destruction (something we often encounter in finance – witness portfolio insurance, etc). If the price of tail risk insurance is driven up too high, it simply won’t benefit its purchasers." His solution for the best tail hedge: cash. "In many situations, cash is a severely underappreciated tail risk hedge." And somewhat more philosophic: "When it comes to timing tail risk protection, a long-term value-based approach and an emphasis on absolute standards of value, coupled with a broad mandate (a wide opportunity set, or, investment flexibility, if you prefer) seems to offer the best hope." Too bad that one must also factor for career risk, which usually means that everyone does end up doing precisely the same trade no matter what, which ultimately brings everyone back to square one.
While Grice's paper on the nuances of actual hedging to various strategies is far more detailed, here is how one approaches this topic in Montier's world:
We are aware of three general groups of tail risk protection from which investors may choose.
This is perhaps the oldest, easiest, and most underrated source of tail risk protection. 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. (There is much more on the joy of cash to come shortly.)
2. Options/contingent claims
Occasionally, the market provides opportunities to protect against tail risk as a by-product of its manic phases. A
prime example was the credit default swaps that were a result of the demand for collateralized debt obligations.
These instruments were priced on the assumption that there would be no nation-wide decline in house prices, and thus offered a great opportunity (even without the benefit of hindsight) for those who were concerned that such an outcome was more plausible than the market thought.
Here, one caveat stands out above all others: one must be cautious of the dangers of over-engineering in this area of tail risk protection. It is too easy to construct an option that pays out under a very specific set of circumstances, and to do so relatively cheaply. But, of course, such an instrument tautologically only pays off under the realization of those specific events, so the tighter the constraints imposed, the less use the option is likely to be as general tail risk protection.
3. Strategies that are negatively correlated with tail risk
For the specific type of tail risk (illiquidity events) under consideration here, long volatility strategies are often said to
be negatively correlated. The simplest example of such a strategy is just to buy volatility contracts (bearing in mind
the roll return will be negative given the upward-sloping term structure of volatility). In the recent crisis, a dollar-neutral long quality/short junk portfolio acted very much like a long volatility strategy (with the added benefit of an expected positive return, in contrast to most insurance options).
Why Montier is skeptical: in one phrase - tail risk herding, driving up the price of hedges.
Tail risk protection is not a magic bullet. The cost of tail risk insurance becomes very evident when compared to the more conservative equities plus cash strategy considered in the sample above. This highlights one of the most important lessons of the exercise: tail risk protection requires timing … the “when” of tail risk protection, if you will. In the sample above, running permanent tail risk insurance similar to that of Strategy 4 leads to what might be called deferred drawdowns, made clear in Exhibit 3.
Obviously there is much more to Montier's thinking which can be found in the full letter below, although we would make one caveat: in tail risk insurance, like in everything else, it only pays to put a trade on if one is early, and, needless to mention, if the trade is the proper hedge against the specific risk. If either of these two are off the table, the naturally the costs will be prohibitive. Alas, in this day and age when alpha is all too often ignored at the expense of levered beta pursuits, in which the investing community has realized the banker trick that it only pays to be wrong if everyone is wrong (and thus will need a government bailout if all fail at the same time), do not expect much original and independent thought. After all - in a regime of centrally planned Bernanke put-ism, the only thing that matters is economies of scale. Whether one is right or wrong, when there is no risk of failure, is completely irrelevant.
Full Montier paper:
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