Photo: Wikimedia Commons
If you’re a serious investors, you should just go read the latest from GMO’s James Montier on buying insurance against “tail risk” — or black swans as some might call it.Immediately he starts off with a great point:
Long ago, Keynes argued that the “central principle of investment is to go contrary to general opinion, on the grounds that, if everyone is agreed about its merits, the investment is inevitably too dear and therefore unattractive.” This powerful statement of the need for contrarianism is frequently ignored, with disturbing alacrity, by many investors.
The latest example in the long line of such behaviour may well be the general enthusiasm for so-called tail risk protection. The range of tail risk protection products seems to be exploding. Investment banks are offering “solutions” (investment bank speak for high-fee products) to investors and fund management companies are launching “black swan” funds. There can be little doubt that tail risk protection is certainly an investment topic du jour.
I can’t help but wonder if much of the desire for tail risk protection stems from greed rather than fear. By which I mean that it seems one of the common reasons for wanting tail risk protection is to allow investors to continue to “harvest risk premium” even when those risk premiums are too narrow. This flies in the face of sensible investing. A safer and less costly (in terms of price, although perhaps not in terms of career risk) approach is simply to step away from markets when risk premiums become narrow, and wait until they widen before returning.
Later he talks about the three main strategies:
1. Cash 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 realisation of those specific events, so the tighter the constraints imposed, the less use the option is likely to be as general tail risk
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).
Definitely read the whole thing, especially for some great charts on tail risk insurance inaction.
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