Managing investments in volatile markets

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The concept of managing tail risk as part of investors’ overall risk-management objectives is not new, but it has gained a considerable profile as a result of the major tail risk events that characterised the 2008-09 global financial crisis and subsequent market volatility. Both recent history and uncertainty about the future are reflected in changing attitudes to mitigating the impact of tail risk events, including raising levels of protection and reassessing the products and strategies used to protect portfolios.
In order to determine how changing perceptions of tail risk have affected the investment strategies of institutional investors, the Economist Intelligence Unit, on behalf of State Street Global Advisors, conducted a survey of over 300 investors from the US and Europe, including institutions, pension funds, family offices, consultants, asset managers, private banks and insurance funds.
Key findings of the survey include:
Tail risk events are always underestimated
The next tail risk event is expected imminently, stemming from Europe
The benefits of diversification are not clear—but most investors continue to diversify
Investors weigh both effectiveness and value when choosing strategies
Investors are not entirely confident that they are protected from the next tail risk event

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Managing investments in volatile markets

  1. 1. How institutional investors are guarding against tail risk eventsA report from the Economist Intelligence Unit COMMISSIONED BY:
  2. 2. Managing investments in volatile markets How institutional investors are guarding against tail risk events Contents Executive summary 2 About this report 4 Introduction 5 Current expectations of tail risk events 6 What is driving changes in risk strategy? 10 Are we protected? 19 Conclusion 20 Appendix: Survey results 21 © The Economist Intelligence Unit Limited 2012 1
  3. 3. Managing investments in volatile markets How institutional investors are guarding against tail risk events Executive summaryThe concept of managing tail risk as part of investors’ l The benefits of diversification are not clear—but mostoverall risk-management objectives is not new, but it has investors continue to diversifygained a considerable profile as a result of the major tail Almost one-half (47%) of respondents agree that the long-risk events that characterised the 2008-09 global financial held belief that diversification of a portfolio across traditionalcrisis and subsequent market volatility. Both recent history asset classes of equities and bonds would provide some formand uncertainty about the future are reflected in changing of insulation against tail risk events has been disproved. Thereattitudes to mitigating the impact of tail risk events, including also has been a slight decline since the global financial crisis inraising levels of protection and reassessing the products and the number of respondents who use diversification as protectionstrategies used to protect portfolios. against a future shock. Yet, despite evidence of increasing correlations, it is still selected as the most effective mitigationIn order to determine how changing perceptions of tail risk technique compared with other strategies.have affected the investment strategies of institutionalinvestors, the Economist Intelligence Unit, on behalf of l Investors weigh both effectiveness and value whenState Street Global Advisors, conducted a survey of over 300 choosing strategiesinvestors from the US and Europe, including institutions, Given that the rating for fund of hedge fund allocation waspension funds, family offices, consultants, asset managers, the lowest among selected strategies in terms of value, it isprivate banks and insurance funds. not surprising that allocation to this strategy has dropped significantly since the global financial crisis. But respondentsKey findings of the survey include: have increased their use of “other alternative allocation” (such as commodities and infrastructure), managed futures/l Tail risk events are always underestimated CTA allocation and managed volatility equity strategies (orOver one-half (51%) of survey respondents agree that ‘minimum variance equity’), which have higher ratings in termseven those investors who believe that they have a deep of value.understanding of the notion of tail risk almost alwaysunderestimate its frequency and severity. Few respondents l Investors are not entirely confident that they are(14%) believe that most institutional investors have a very protected from the next tail risk eventgood grasp of the frequency and severity of tail risk events. Only 20% of respondents were very confident, with 21% less than “somewhat confident” that they have some form ofl The next tail risk event is expected imminently, stemming downside protection in place for the next significant marketfrom Europe event. But the situation is better than before the crisis—almostAlthough tail risk events are by definition unpredictable, three-quarters (73%) of respondents believe that, as a resultinvestors are very sensitive to their possibility. Almost three- of changing their strategic asset allocation, they are betterquarters (71%) of respondents believe that it is highly likely prepared for the next major tail risk event.or likely that a significant tail risk event will occur in the next12 months, with the cause expected to be related to ongoingEuropean instability.2 © The Economist Intelligence Unit Limited 2012
  4. 4. Managing investments in volatile markets How institutional investors are guarding against tail risk events believe it is likely or highly likely a SIGNIFICANT TAIL RISK EVENT will occur in the next 12 months Other alternative Managed volatility allocation equity strategies Managed volatility Other alternative equity strategies allocation Single strategy Managed futures/ hedge fund allocation CTA allocation Fund of hedge Diversification across fund allocation traditional asset classes Direct Fund of hedge hedging fund allocation Source: Economist Intelligence Unit survey of US and European institutional investors © The Economist Intelligence Unit Limited 2012 3
  5. 5. Managing investments in volatile markets How institutional investors are guarding against tail risk events About this reportIn June and July 2012 the Economist Intelligence Unit, l Vineer Bhansali, managing director and portfolio managercommissioned by State Street Global Advisors, surveyed at Pimco310 institutional investors in the US and Western Europe to l Mouhammed Choukeir, chief investment officer at Kleinwortinvestigate their views surrounding tail risk: what specific risks Bensonthey are concerned about and why, what strategies they havein place to mitigate the impact of tail risk, what they believe l Tim Hodgson, senior investment consultant at Towersother investors know about tail risk and whether tail risk Watsonevents will happen more frequently and be more severe than in l Bryan Kelly, assistant professor of finance and Neubauerthe past. Family Faculty Fellow at the University of Chicago’s Booth School of BusinessRespondents were drawn from the UK, France, Germany,Italy, Switzerland, Benelux (Belgium, the Netherlands and l Sunil Krishnan, head of market strategy at BT PensionLuxembourg) and the US. Investors were grouped by type— Scheme Managementinstitutional investors (such as asset managers and pension lNorman Villamin, chief investment officer at Couttsfunds), family offices, consultants and private banks—and size(assets under management of less than US$1bn and greater The report was written by Kristina West and edited by Monicathan US$1bn). Woodley of the Economist Intelligence Unit.In addition, in-depth interviews were conducted with sixexperts from asset-management firms, private banks,consultancies, pension funds and academia. Our thanksare due to the following for their time and insight (listedalphabetically):4 © The Economist Intelligence Unit Limited 2012
  6. 6. Managing investments in volatile markets How institutional investors are guarding against tail risk events Introduction Market perception of tail risk cost. However, Europe is not the sole cause of concern for global markets. Although tail risk since the financial crisis events are by definition unpredictable and unquantifiable, questions need to be asked about “Tail risk” is a term that has been used broadly for what is being done to educate investors about the extreme shocks to financial markets, although it historical frequency and severity of these risks is technically defined as an investment moving and how investors can best guard against them more than three standard deviations from the while allowing room for performance gains. mean of a normal distribution of investment returns. Since the 2008-09 global financial crisis, There is a concern among the institutional the occurrence of a number of both large and investors surveyed that even those who are smaller tail risk events, including the eurozone familiar with the notion of tail risk almost always sovereign debt crisis, the March 2011 tsunami underestimate its frequency and severity. Despite in Japan and unrest in the Middle East, have this concern, investors have clearly been shocked many investors into the realisation that sufficiently hurt by recent tail risk events that protecting portfolios against such events must they are reconsidering their traditional methods become a more integral part of their investment of protection. strategy. In this report, we explore the expectations of tail At the time of writing, a US-based credit-ratings risk events over the next 12 months, look at how agency, Moody’s, is predicting that Greece is investors have already changed their portfolios to likely to leave the euro zone and that Spain may reflect this, and consider the trade-off between the seek a full bail-out, which “would set off a chain cost and effectiveness of strategies used to protect of financial sector shocks”, and that policymakers a portfolio. could only contain these shocks at a very high © The Economist Intelligence Unit Limited 2012 5
  7. 7. Managing investments in volatile markets How institutional investors are guarding against tail risk events 1 Current expectations of tail risk events Chart 1 As the markets remain volatile, it is not surprising that investors are asking themselves and each What do you feel will be the most likely cause of a tail risk event other: what next? Considering that, in the space occurring in the markets in the next 12 months? Select up to three of two years, Greece’s credit rating has slipped (% respondents) from A1 to C (in effect junk) by Moody’s, there is a real concern over what might happen in the The global economy falls into recession 36% next two years and what effect it could have on financial markets. With almost three-quarters Europe slips back into recession 35% (71%) of survey participants believing that it is highly likely or likely that a significant tail risk The eurozone breaks up 33% event will occur in the next 12 months, and only 12% considering it unlikely or highly unlikely, Greece exits the euro 29% managing tail risk has become a major factor in portfolio management. The US slips back into recession 21% The problem with trying to devise a strategy for Major bank insolvency 20% managing tail risk is that it is always those risks US politicians remain that are not forecast that have the potential to deadlocked over tackling 17% cause the most damage; in one sense, widespread the huge fiscal deficit acceptance of a risk event potentially dampens its Chinas economy slows significantly 15% impact, or even means that it ceases to be a tail risk event, depending on one’s definition. Risks Country bankruptcy 10% such as Greece defaulting and/or exiting the eurozone, for example, although still holding the An oil price shock 9% possibility of causing a significant shock, are now largely expected by the investment community, Large company bankruptcy 9% and most will have factored this into their Monetary stimulus leads to new investment decisions as and where necessary. asset bubbles, creating renewed 9% financial turbulence As Mouhammed Choukeir, chief investment Economic upheaval leads to widespread social and 9% officer at Kleinwort Benson, comments: “Europe political unrest is the current eye of the storm, but it is not really Tensions over currency a tail risk now as it is known. The US or Japan manipulation lead to a 8% rise in protectionism defaulting would be, and Japan has a huge Political extremism burden of debt.” or violence 6% Source: Economist Intelligence Unit. Concerns over Europe are still looming large on the minds of investors, with worries over the6 © The Economist Intelligence Unit Limited 2012
  8. 8. Managing investments in volatile markets How institutional investors are guarding against tail risk events global economy and the possibility of the US them harder, especially as they are on the cusp returning to recession coming further behind, of a bond market credit event. In addition, UK albeit still with a significant percentage of respondents bucked the trend with their concern votes (see Chart 1). The implications of these about tensions over currency manipulation expectations are potentially twofold: the leading to a rise in protectionism, at 17%, investment community is aware and preparing compared with 9% for Europe overall. According for major risks, and, although Europe remains at to Mr Choukeir, this is likely due to concerns that the centre, other concerns are also being taken a weak euro would make the pound stronger and extremely seriously. less competitive. However, looking at the responses by Similarly, in percentage terms family offices were geographical location uncovers some more than twice as worried as private banks over interesting variations. It might be expected the global economy falling into recession, while that US respondents would be more concerned consultants were by far the most concerned than respondents in Europe about a return to about a potential economic slowdown in China. recession in the US, and that is true, but not by a wide margin: 23% of respondents in the However, these concerns are clearly US versus 19% in Europe. But 28% of Italian interconnected. “We believe that stability in respondents also flagged this as a major Europe’s economy is key,” says Norman Villamin, concern, which may be a result of Italy being chief investment officer at Coutts. “[We need] more levered to US growth than other European to avoid a US$15trn economy presenting a countries, and so a recession in the US would hit drag on the rest of the global economy. With Chart 2 What do you feel will be the most likely cause of a tail risk event occurring in the markets in the next 12 months? (% respondents) Top five - USA 48% 37% 28% 25% 23% The global economy The eurozone Europe slips back Greece exits The US slips back falls into recession breaks up into recession the euro into recession Top five - Europe 40% 32% 30% 29% 22% Europe slips back Greece exits The eurozone The global economy Major bank into recession the euro breaks up falls into recession insolvency Source: Economist Intelligence Unit. © The Economist Intelligence Unit Limited 2012 7
  9. 9. Managing investments in volatile markets How institutional investors are guarding against tail risk events Chart 3 What do you feel will be the most likely cause of a tail risk event occurring in the markets in the next 12 months? (% respondents) Top five - family offices 44% 39% 34% 25% 20% The global economy The eurozone Europe slips back Greece exits The US slips back falls into recession breaks up into recession the euro into recession Top five - consultants 52% 31% 26% 24% 22% The global economy Europe slips back The eurozone China’s economy The US slips back falls into recession into recession breaks up slows significantly into recession Top five - institutional investors 35% 34% 31% 30% 21% The global economy The eurozone Europe slips back Greece exits Major bank falls into recession breaks up into recession the euro insolvency Top five - private banks 44% 37% 31% 24% 22% Europe slips back Greece exits The eurozone The US slips back Major bank into recession the euro breaks up into recession insolvency Source: Economist Intelligence Unit. Europe as a key trading partner to emerging It is certainly evident that not everyone is economies, including China, a relapse back into reacting to the threat in the same way. Sunil recession by not only the euro zone’s periphery Krishnan, head of market strategy at BT Pension but also Europe’s core, like Germany, would have Scheme Management, says: “We try not to focus immediate knock-on effects to an already fragile too much on very severe or unlikely events Chinese growth outlook.” which are out of our risk distribution. It is more8 © The Economist Intelligence Unit Limited 2012
  10. 10. Managing investments in volatile markets How institutional investors are guarding against tail risk events appropriate to watch the markets on a regular by printing money, causing their currencies to basis, to keep contact with our trustee board depreciate and creating protectionist tensions and to focus on events that could hurt us rather over exchange rates. than major, unlikely events. We form views on the probabilities priced into the financial markets.” To manage both the expected and the unexpected, over 80% of survey respondents In anticipating the likelihood of a tail risk event, believe that managing tail risk should be an investors need to be aware of which asset class integral part of any comprehensive investment will be hit hardest by such an event. According plan. This view is most strongly held by to Vineer Bhansali, managing director and respondents from the US and Italy (83% in each portfolio manager at Pimco: “The currency country), while the Germans seem less convinced markets are currently most exposed, then the (60%). Of different investor types, institutional debt and equities markets. Governments are investors and consultants are the strongest trying to protect their own equity markets, so believers (87% and 86% respectively), while the stock downside risk will be more controlled. just 63% of respondents from private banks If all countries are working for themselves, the believe that managing tail risk is integral to an shock will come in the inter-country space.” Many investment plan. governments are stimulating their economies © The Economist Intelligence Unit Limited 2012 9
  11. 11. Managing investments in volatile markets How institutional investors are guarding against tail risk events 2 What is driving changes in risk strategy? The widespread impact of tail risk events to date The survey found a significant decline in fund of has resulted in a large proportion of investors hedge fund allocation, with a 9-percentage-point reconsidering the products that are available drop from pre-crisis figures, and a clear reduction to mitigate the impact of these events, beyond in diversification across traditional asset classes traditional diversification techniques. These (of 5 percentage points). Gains were seen in include option-based strategies, alternatives or “other alternative” allocation, which includes managed volatility equity approaches. commodities and infrastructure (7 percentage Chart 4 What strategy(ies) did you have in place before the global financial crisis to protect against tail risk events? What strategy(ies) do you have in place now? (% respondents) Now Before crisis Diversification across 76% traditional asset classes 81% Risk budgeting 68% techniques 69% Managed volatility 58% equity strategies 51% Managed futures/ 48% CTA allocation 43% Direct hedging - buying 39% puts/straight guarantee 40% Fund of hedge 30% fund allocation 39% Single strategy hedge 33% fund allocation 32% Other alternative allocation 65% (e.g. property, commodities) 57% Source: Economist Intelligence Unit.10 © The Economist Intelligence Unit Limited 2012
  12. 12. Managing investments in volatile markets How institutional investors are guarding against tail risk events points), managed volatility equity strategies (7 The overall figures that show a decline in the percentage points) and managed futures/CTA use of diversification across traditional asset allocation (5 percentage points). classes are misleading. Use of diversification has actually increased for all investor types except The poor performance of fund of hedge funds in for institutional investors, with the decline 2008, when they generally failed to provide the in use for that group so severe (from 89% to downside protection expected, led to a greater 67% of respondents) that it dragged down the focus on the value of the strategy as a tail-risk- overall average. mitigation approach. During good times, the two layers of charges (one for management of the Institutional investors may be just the first to overall fund and another for the individual funds recognise—and act on the fact—that traditional held) could be easily overcome with investment diversification is no longer effective for managing returns, but in a low-return environment, tail risk. The increased use of diversification management costs tend to be more heavily across traditional asset classes by most investor scrutinised. Indeed, out of the eight mitigation types is puzzling, considering that just 14% strategies covered in the survey, fund of hedge of respondents disagree with the statement funds was seventh on the list of best value. that the long-held belief that diversification Chart 5 What strategies do you feel provide the most effective hedge against tail risk? (% respondents) 61% 55% 53% 50% 43% 39% 38% 37% Diversification Risk budgeting Managed Direct hedging - Other Managed Single Fund of across traditional techniques volatility buying puts/ alternative futures/CTA strategy hedge asset classes equity straight allocation allocation hedge fund fund strategies guarantee (eg property allocation allocation commodities) Source: Economist Intelligence Unit. Chart 6 Which strategies do you feel provide the best value hedge against tail risk? (% respondents) 53% 50% 47% 40% 39% 37% 29% 28% Other alternative Diversification Risk budgeting Managed Managed Direct Fund of Single allocation across traditional techniques futures/CTA volatility hedging - hedge strategy (eg property asset classes allocation equity buying puts/ fund hedge commodities) strategies straight allocation fund guarantee allocation Source: Economist Intelligence Unit. © The Economist Intelligence Unit Limited 2012 11
  13. 13. Managing investments in volatile markets How institutional investors are guarding against tail risk events would provide some form of insulation against wariness around the black-box approach of these tail risk events has been disproved. Compared types of strategies. to the other strategies covered by this survey, diversification is still seen as the most effective Different strategies for different and the second best for value. (Unsurprisingly, investors institutional investors rated diversification as Looking at the survey results by investor type, the less effective than the other investor groups, overall figures mask a few significant differences although they did have the highest levels of use and shifts in strategy by some investors. Private of diversification before the global crisis, at 89%, banks have been the most active in changing compared with 80% of family offices, 77% of their approach to managing tail event risk— private banks and 76% of consultants.) shifts were seen in seven of the eight strategies Other strategies that have seen an overall covered by the survey, with only their use of increase in use also rate highly for value or diversification holding steady. The biggest effectiveness. Other alternative allocation increase was of other alternative allocation and is considered the best value strategy, while use of managed volatility equity strategies (up managed volatility equity strategies are the by 14 and 13 percentage points respectively) and third most effective. The rise in use for managed the biggest decrease was in fund of hedge funds, futures/CTA allocation is surprising, given its down by 11 percentage points. lower ratings for effectiveness and value in the survey. CTAs did, generally, bear up well in Institutional investors also made substantial terms of performance in 2008, and so the survey changes, with only their use of other alternatives data may indicate some ongoing uncertainty or holding steady. The largest increase was use Chart 7 What strategy(ies) did you have in place before the global financial crisis to protect against tail risk events? What strategy(ies) do you have in place now? (% respondents) Family offices Now Before crisis Diversification across 84% traditional asset classes 80% Risk budgeting 71% techniques 72% Managed volatility 54% equity strategies 51% Managed futures/ 43% CTA allocation 44% Direct hedging - buying 26% puts/straight guarantee 38% Fund of hedge 28% fund allocation 31% Single strategy hedge 16% fund allocation 30% Other alternative allocation 77% (e.g. property, commodities) 71% Source: Economist Intelligence Unit.12 © The Economist Intelligence Unit Limited 2012
  14. 14. Managing investments in volatile markets How institutional investors are guarding against tail risk events Chart 8 What strategy(ies) did you have in place before the global financial crisis to protect against tail risk events? What strategy(ies) do you have in place now? (% respondents) Consultants Now Before crisis Diversification across 79% traditional asset classes 76% Risk budgeting 79% techniques 79% Managed volatility 59% equity strategies 55% Managed futures/ 60% CTA allocation 48% Direct hedging - buying 31% puts/straight guarantee 45% Fund of hedge 24% fund allocation 31% Single strategy hedge 24% fund allocation 29% Other alternative allocation 64% (e.g. property, commodities) 53% Source: Economist Intelligence Unit. Chart 9 What strategy(ies) did you have in place before the global financial crisis to protect against tail risk events? What strategy(ies) do you have in place now? (% respondents) Institutional investors Now Before crisis Diversification across 67% traditional asset classes 89% Risk budgeting 63% techniques 71% Managed volatility 55% equity strategies 50% Managed futures/ 39% CTA allocation 44% Direct hedging - buying 44% puts/straight guarantee 36% Fund of hedge 28% fund allocation 41% Single strategy hedge 39% fund allocation 34% Other alternative allocation 58% (e.g. property, commodities) 57% Source: Economist Intelligence Unit. © The Economist Intelligence Unit Limited 2012 13
  15. 15. Managing investments in volatile markets How institutional investors are guarding against tail risk events Chart 10 What strategy(ies) did you have in place before the global financial crisis to protect against tail risk events? What strategy(ies) do you have in place now? (% respondents) Private banks Now Before crisis Diversification across 78% traditional asset classes 77% Risk budgeting 65% techniques 57% Managed volatility 64% equity strategies 51% Managed futures/ 53% CTA allocation 38% Direct hedging - buying 47% puts/straight guarantee 42% Fund of hedge 38% fund allocation 49% Single strategy hedge 43% fund allocation 32% Other alternative allocation 65% (e.g. property, commodities) 51% Source: Economist Intelligence Unit. of direct hedging, up by 8 percentage points, diversification across traditional asset assets (up while the largest decrease—besides the use of by 47 percentage points) and other alternative diversification, as previously mentioned—was of allocation (up by 33 percentage points), while fund of hedge fund allocation, which was down Benelux swung towards single-strategy hedge by 13 percentage points. Consultants, despite fund allocation (up by 15 percentage points). But displaying less appetite for change, showed changes by European investors must be viewed in significant drops in the use of direct hedging, terms of the number of respondents, in addition by 14 percentage points, while increasing their to percentage terms. The most significant swing use of managed futures/CTA allocation and other in Europe as a whole was an 11-percentage- alternative allocation (by 12 and 11 percentage point drop (23% change) in fund of hedge fund points respectively). allocation. Family offices also showed significant drops in Some of these trends can be attributed to the use of direct hedging (12 percentage points) cultural differences. For example, German and single-strategy hedge fund allocation (14 firms showed a preference for traditional asset percentage points), as well as a small increase allocation, particularly over strategies involving (6 percentage points) of other alternative hedge funds and CTAs, where regulation may allocation. be an issue. German companies also have a higher fixed-income allocation than some Filtering investors by geographical location, the other markets, and are therefore impacted less US showed only small losses and gains in the by drawdowns. They still see diversification of popularity of different strategies, as did the UK. traditional assets as the best way to deal with However, Germany showed a huge swing towards tail risk.14 © The Economist Intelligence Unit Limited 2012
  16. 16. Managing investments in volatile markets How institutional investors are guarding against tail risk events Chart 11 What stategy(ies) did/do you have in place before the global financial crisis/now to protect against tail risk events? Biggest three changes in strategy by country/region (percentage point change) Increase in popularity of strategy Decrease in popularity of strategy USA UK Germany Other alternative Managed volatility Diversification across 8 allocation (eg property 12 equity strategies 47 traditional asset classes commodities) Other alternative 11 Direct hedging - buying 9 allocation (eg property 40 Managed volatility puts/ straight guarantee equity strategies commodities) Other alternative 8 Fund of hedge fund 6 Diversification across 33 allocation (eg property allocation traditional asset classes commodities) Benelux Europe (overall) 27 Fund of hedge fund 11 Fund of hedge fund allocation allocation Single strategy hedge Managed volatility 15 fund allocation 8 equity strategies 15 Diversification across 8 Diversification across traditional asset classes traditional asset classes Factors influencing strategy selection— quarters of respondents), while private banks regulation and risk are the most concerned with transparency (cited Although the effectiveness and value of by 54%). individual tail-risk-mitigation strategies evidently play a part in their selection (or The natural hedge, according to Bryan Kelly, avoidance) by investors, their use is also assistant professor of finance and Neubauer influenced by regulatory factors, the perceived Family Faculty Fellow at the University of safety of the instruments used to hedge Chicago’s Booth School of Business, is often (including their liquidity) and their availability. complex derivatives, but this approach does come with its share of problems. “There is a Almost two-thirds (64%) of survey respondents fear of debt derivatives and mistrust of the CDS highlight the liquidity of the underlying [credit default swap] market,” Dr Kelly says. investment as the top barrier to allocating to “People are trading some instruments—they their tail-risk-protection strategies, and almost have to lay off downside risks. Equity options one-half (46%) point to the transparency of the remain liquid and stayed up in the crisis, so underlying instruments. Liquidity is of particular people can still function in the exchange-traded importance to family offices (selected by three- markets.” © The Economist Intelligence Unit Limited 2012 15
  17. 17. Managing investments in volatile markets How institutional investors are guarding against tail risk events Chart 12 What barriers do you see or did you have to overcome in allocating to your tail risk protection strategy? (% respondents) Lack of general understanding of new asset classes Understanding the investment returns/persistency of returns 64% 54% 49% 46% 42% 33% 28% Liquidity of underlying Regulatory Risk aversion Transparency of Fees/costs instruments adherence/ underlying understanding instruments Source: Economist Intelligence Unit. Regulations such as the European Markets golden opportunities to invest. Having cash Infrastructure Regulation (EMIR) in the EU and as ammunition is very helpful when these Dodd-Frank in the US are pushing “standardised” opportunities arise.” over-the-counter (OTC) derivatives onto exchange. However, not all will be deemed Regulation was the second-largest barrier in suitable for central clearing, and so it remains allocating to a tail-risk-protection strategy, cited to be seen how much regulation will improve the by over one-half (54%) of survey respondents, transparency and liquidity of direct hedges. and was noted as a major concern of a number of interviewees. Family offices are most worried Risk aversion was also a major barrier for survey about regulation (63%), while institutional respondents, selected by almost one-half (49%), investors are less bothered (44%). with private banks most concerned (54%) and family offices least worried (44%). As there has Pimco’s Mr Bhansali said: “Regulation means been a move to safety in overall asset allocation, that people are looking for more exotic ways to so has there been in hedging instruments. In protect themselves, as regulation can result in constructing a small portion of a portfolio to act more volatility and fat tails—we try to figure out as a tail-hedging component, Tim Hodgson, a what the unintended consequences of regulation senior investment consultant at Towers Watson, might be. In some cases, longer-dated equity also balances options and derivatives (for more options and CDS will be priced out, but currency sophisticated clients) with assets perceived as safe options still have a lot of value, as will some OTC havens, such as AAA sovereign bonds and gold. instruments that are moving on-exchange.” He is referring to ongoing moves in the US and Mr Hodgson adds: “We push the idea that cash is Europe to move the majority of vanilla derivatives a valuable tail hedge, although there is negative currently traded OTC onto exchanges in order to real yield in many Western markets. It gives the improve transparency and lower the industry’s option value that may rise with uncertainty, and risk profile. in a non-linear way. The worse the event, the more important cash is, because it allows the However, UoC’s Dr Kelly sounds a note of caution: investor to step in and buy distressed assets.” “There is some dimension of having trading on- exchange for derivatives that will be fantastic, Kleinwort Benson’s Mr Choukeir adds: “The because it improves counterparty considerations good thing with tail risk is that it provides and will make the market function better, but too16 © The Economist Intelligence Unit Limited 2012
  18. 18. Managing investments in volatile markets How institutional investors are guarding against tail risk events rigid regulation could take away people’s ability trades. The increased demand coupled with the to hedge.” decline in sellers has resulted in higher volatility and higher prices. And with other risk-mitigation Factors influencing strategy selection— strategies, such as use of other alternatives (like cost and short-termism infrastructure or commodities) or fund of hedge With many strategies scoring poorly for value— funds, the cost for holding these assets is usually just one, “other alternative” allocation, was higher than for other traditional asset classes like considered good value by more than one-half equities or bonds. of respondents—it is unsurprising that cost was a barrier in allocating to a tail-risk-protection Even holding traditional asset classes as part strategy for 42% of respondents. Consultants of a diversification strategy is getting more are particularly focused on cost (57%), while expensive, not because of the cost of holding institutional investors and private banks are less the assets but on account of their low returns. bothered (35% and 36% respectively). “If investors are willing to sacrifice 10bp a year, and they are getting 150bp at best on UK and Towers Watson’s Mr Hodgson comments: “Cost is German government bonds, this is very different the inherent problem with tail hedging. It is like to 50-100bp with an 8-9% return,” according to having fire insurance on your house. Logically, Mr Villamin at Coutts. “Because the return profile it is a stupid waste of money—the chance of has changed, the appetite to use a portion to your house burning down is negligible. It is the hedge has changed.” same with a tail hedge—you should expect it to cost you money, because if it happens, you can’t The short-term nature of many hedges is also financially recover without insurance.” responsible for the current issues with cost and availability for some products. Among A number of interviewees described tail-risk the interviewees, opinion is fairly firmly split hedging as the cost of staying in the game under between those who believe that short-termism current market conditions. Pimco’s Mr Bhansali is an inherent aspect of tail risk, although not notes that a long-term approach means that tail necessarily an attractive one, and those who are hedges will eventually pay for themselves in a convinced that only a long-term strategy will multi-year asset allocation strategy: “There is a bear any fruit at all. short-term cost impact on the expected return, but it is the cost of being safe. It more than pays On the short-term side, UoC’s Dr Kelly says: “In for itself—it means clients can stay in the game, general, when people are hedging against tail and the hedges provide liquidity when they risk, they have the short term in mind. With the need it most. With a multi-year asset allocation Europe situation, we feel that if we get over the strategy, it more than pays for itself.” hump, things will be good in the long term, so we hedge against the hump. People are not looking There are several factors influencing cost. The at, say, global warming—they are looking at the availability of products clearly has an impact. holding period of their investments. There is a There has been some recent concern that the possibility that it is a fad.” crisis has led to an imbalance in the products available to hedge against tail risk, with certain Kleinwort Benson’s Mr Choukeir agrees that products being priced out of the market, notably short-termism is the current trend, but believes long-dated put options. Sellers such as the US- that this approach needs to change: “Everyone based Berkshire Hathaway have withdrawn from is worried about Europe and wants to protect the market owing to regulatory changes that against it and, as a result, the view of tail risk is require higher amounts of collateral for these very short term now. Tail risks always need to be © The Economist Intelligence Unit Limited 2012 17
  19. 19. Managing investments in volatile markets How institutional investors are guarding against tail risk events considered. It is in the positive times, when there is euphoria in the market, that you really need to worry.” At BT Pension Scheme Management, Mr Krishnan believes that another issue with cost is its lack of predictability, and it is this, rather than just escalated costs, which is causing potential problems for some investors. “The cost of some tail-risk strategies is higher than it used to be,” he explains. “We think about a longer-term, multi-decade profile, and it is harder to know at what cost you can transact, and what types of hedging will still exist in the future. You can’t know what terms you will get on, say, inflation protection in five years. We keep in regular contact with banks and regulators on this, so that we can respond quickly if we need to.”18 © The Economist Intelligence Unit Limited 2012
  20. 20. Managing investments in volatile markets How institutional investors are guarding against tail risk events 3 Are we protected? With investors worried about a range of barriers They show higher levels of use of managed to allocating their tail-risk protection, as well futures/CTA allocation, although—surprisingly— as the value and effectiveness of different they are slightly less likely to use the other seven strategies, it should be no surprise that many strategies covered by this survey. This may be are not entirely confident that they are protected because they are tougher critics, giving lower from the next tail risk event. Only 20% of ratings on the value of the strategies on all but respondents are very confident, with 21% less two out of eight. than “somewhat confident” that they have some form of downside protection in place for the next Perhaps most tellingly, confident respondents significant market event. However, the situation are more likely to say that they are prepared is better than before the 2008-09 global crisis: to sacrifice some upside potential in order to almost three-quarters (73%) of respondents provide tail-risk protection in their portfolios. believe that, owing to changes in their strategic They clearly ascribe to the motto currently that asset allocation, they are better prepared for the is doing the rounds in the markets: “people are next major tail risk event than they were before putting their capital where they think it will get the crisis. returned, not where they think they will make returns.” So what are those respondents who say that they are very confident doing differently from the The interviewees agree: the consensus appears rest? These respondents are more likely to believe to be that investors should be grateful enough to that the management of tail risk is an integral be protected, rather than worrying about missing part of a comprehensive investment plan and the out on a possible upside that, for the moment, events around the global financial crisis were seems unlikely to occur. As Mr Choukeir notes, more likely to have influenced them to reconsider “Investors need to try to avoid losses in the first their strategic asset allocation in order to provide place, not focus on making money.” more tail-risk protection. © The Economist Intelligence Unit Limited 2012 19
  21. 21. Managing investments in volatile markets How institutional investors are guarding against tail risk events Conclusion The market is still very much focused on the covered by the survey, just three (managed- possibility of downside events and how to volatility equity strategies, managed futures/ protect against them effectively without too CTA allocation and “other alternative” allocation) much financial pain, in terms of costs and impact have seen an increase in use since the global on returns. This is only natural: with constant financial crisis. Two strategies (diversification speculation over where the next tail risk event across traditional asset classes and fund of will come from and unrelenting daily bulletins on hedge fund allocation) have actually declined the latest woes, be that below-expected earnings in popularity, perhaps as confidence over their from banks or critical unemployment problems value or effectiveness as tail-risk-mitigation from Spain, it would be difficult to find investors techniques has wavered. who are worried about anything else. Investors are still trying to decide which method This survey supports the idea that investors are is best. But there is also a question of whether taking the threat of tail risk seriously, with 71% the tools that are currently available to investors of respondents believing that a tail risk event are adequate. Survey respondents rated is likely or highly likely to occur in the next 12 diversification as the most effective strategy months, 73% agreeing that tail risk events are (selected by 60%), but they are clearly still likely to be more severe than in the past and 80% sceptical. Just 14% disagreed with the the idea concurring that managing tail risk should be an that the long-held belief that diversification of integral part of any comprehensive investment a portfolio across traditional asset classes of plan. Even 79% of those surveyed say that they equities and bonds would provide some form are willing to sacrifice some upside potential of insulation against tail risk events has been in order to provide tail-risk protection in their disproved. This indicates that there may be an portfolios. appetite for new strategies, too. But despite this, the pace of adoption of tail-risk strategies has been slow. Of the eight strategies20 © The Economist Intelligence Unit Limited 2012
  22. 22. Managing investments in volatile markets How institutional investors are guarding against tail risk events Appendix: Survey results Do you agree or disagree? Rate on a scale of 1 to 5 where 1 is strongly agree and 5 is strongly disagree. (% respondents) 1 Strongly agree 2 3 4 5 Strongly disagree Tail risk events are likely to happen more frequently now because of the increased correlations of financial markets. 20 54 19 5 2 The long-held belief that diversification of a portfolio across traditional asset classes of equities and bonds would provide some form of insulation against tail risk events has been disproved. 11 36 40 10 4 Tail risk events are likely to be more severe now than they were in the past because of the increased interconnectedness of financial markets. 29 42 23 4 3 Managing tail-risk should be an integral part of any comprehensive investment plan. 41 38 18 31 Even those investors who are familiar with the notion of tail risk almost always underestimate its frequency and severity. 25 31 33 10 2 © The Economist Intelligence Unit Limited 2012 21
  23. 23. Managing investments in volatile markets How institutional investors are guarding against tail risk events What do you feel will be the most likely cause of a tail risk event occurring in the markets in the next 12 months? Select up to three. (% respondents) The global economy falls into recession 36 Europe slips back into recession 35 The eurozone breaks up 33 Greece exits the euro 29 The US slips back into recession 21 Major bank insolvency 20 US politicians remain deadlocked over tackling the huge fiscal deficit 17 Chinas economy slows significantly 15 Country bankruptcy 10 Large company bankruptcy 9 An oil price shock 9 Monetary stimulus leads to new asset bubbles, creating renewed financial turbulence 9 Economic upheaval leads to widespread social and political unrest 9 Tensions over currency manipulation lead to a rise in protectionism 8 Political extremism or violence 6 What do you consider to be the most damaging factors in recent market crises? Select up to two. (% respondents) Rise in volatility 50 Severe drawdown in equity markets 38 Positive serial correlation of asset prices 30 Disconnection of markets to fundamental valuations 26 Lack of access to truly diversifying asset classes 19 Failure of long-only absolute return strategies 10 Increased correlation of some alternative asset classes to more traditional assets 922 © The Economist Intelligence Unit Limited 2012
  24. 24. Managing investments in volatile markets How institutional investors are guarding against tail risk events What strategy(ies) did you have in place before the global financial crisis to protect against tail risk events? Select all that apply. (% respondents) Diversification across traditional asset classes 81 Risk budgeting techniques 69 Managed volatility equity strategies 51 Managed futures/CTA allocation 43 Direct hedging - buying puts/straight guarantee 40 Fund of hedge fund allocation 39 Single strategy hedge fund allocation 32 Other alternative allocation (e.g. property, commodities) 57 What strategy(ies) do you currently have in place to provide some protection against a future financial shock? Select all that apply. (% respondents) Diversification across traditional asset classes 76 Risk budgeting techniques 68 Managed volatility equity strategies 58 Managed futures/CTA allocation 48 Direct hedging - buying puts/straight guarantee 39 Single strategy hedge fund allocation 33 Fund of hedge fund allocation 30 Other alternative allocation (e.g. property, commodities) 65 What do you think is the likelihood of a tail risk event occuring in the next 12 months (leading to a 25%+ peak to trough drawdown in equities)? (% respondents) Highly likely 15 Likely 56 Neither likely or unlikely 16 Unlikely 8 Highly unlikely 3 Not sure 3 © The Economist Intelligence Unit Limited 2012 23
  25. 25. Managing investments in volatile markets How institutional investors are guarding against tail risk events Which strategies do you feel provide the most effective hedge against tail risk? (% respondents) Diversification across traditional asset classes 60 Risk budgeting techniques 55 Managed volatility equity strategies 52 Direct hedging - buying puts/straight guarantee 50 Managed futures/CTA allocation 39 Single strategy hedge fund allocation 38 Fund of hedge fund allocation 37 Other alternative allocation (e.g. property, commodities) 43 Which strategies do you feel provide the best value hedge against tail risk? (% respondents) Diversification across traditional asset classes 50 Risk budgeting techniques 47 Managed futures/CTA allocation 40 Managed volatility equity strategies 39 Direct hedging - buying puts/straight guarantee 37 Fund of hedge fund allocation 29 Single strategy hedge fund allocation 28 Other alternative allocation (e.g. property, commodities) 53 How confident are you that you have some form of downside protection in place for the next significant market event? (% respondents) Very confident 20 Somewhat confident 60 Neither confident nor unconfident 14 Somewhat unconfident 4 Not confident at all 1 Not sure 224 © The Economist Intelligence Unit Limited 2012
  26. 26. Managing investments in volatile markets How institutional investors are guarding against tail risk events What barriers do you see or did you have to overcome in allocating to your tail-risk protection strategy? (% respondents) Liquidity of underlying instruments. 64 Regulatory adherence/understanding 54 Risk aversion 49 Transparency of underlying instruments 46 Fees/cost 42 Understanding the investment returns/persistency of returns 33 Lack of general understanding of new asset classes 28 Do you believe that most institutional investors have an accurate understanding of the frequency and severity of tail risk events? (% respondents) Very good understanding 14 Some understanding 72 No understanding 9 Not sure 6 Do you agree or disagree? Rate on a scale of 1 to 5 where 1 is strongly agree and 5 is strongly disagree. (% respondents) 1 Strongly agree 2 3 4 5 Strongly disagree We are prepared to sacrifice some upside potential in order to provide tail-risk protection in our portfolio. 25 55 16 3 2 The events of 2008 and the global financial crisis have made us re-consider our strategic asset allocation in order to provide more tail-risk protection. 24 39 28 7 3 Due to changes in our strategic asset allocation we are better prepared for the next major tail event 27 46 21 51 We consider tail-risk-protection strategies are now a mainstay of our asset allocation process. 22 37 30 8 3 © The Economist Intelligence Unit Limited 2012 25
  27. 27. Managing investments in volatile markets How institutional investors are guarding against tail risk events In which of the following countries are you personally located? (% respondents) United States 40 United Kingdom 12 Switzerland 10 Sweden 8 Italy 6 Spain 6 Netherlands 5 France 5 Germany 5 Belgium 2 Luxembourg 2 In which region are you personally located? (% respondents) Western Europe 60 North America 40 In which one of the following countries is your company headquartered? (% respondents) United States 40 United Kingdom 14 Switzerland 11 Sweden 8 Italy 6 Netherlands 6 Spain 5 France 4 Germany 3 Belgium 2 Luxembourg 1 Norway 126 © The Economist Intelligence Unit Limited 2012
  28. 28. Managing investments in volatile markets How institutional investors are guarding against tail risk events What is your organisation’s assets under management (AUM)? (% respondents) Less than $100m 12 Between $100m and $300m 15 Between $300m and $500m 6 Between $500m and $1bn 9 Between $1bn and $5bn 20 Greater than $5bn 38 What is your job title? (% respondents) Board member 0 CEO/President/Managing director 5 CFO/Treasurer/Comptroller 6 CIO/Technology director 9 Other C-level executive 17 SVP/VP/Director 15 Head of business unit 5 Head of department 43 Manager 0 Other 0 How do you describe your company’s function? (% respondents) Institutional investors 34 Private bank 27 Family office 20 Consultant 19 © The Economist Intelligence Unit Limited 2012 27
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