How to Hedge a Swan's Tail

Nassim Nicolas Taleb, author of a book about the inevitability of unpredictable events, told Bloomberg Television last spring he gets irritated every time he hears the coronavirus pandemic referred to as a "Black Swan" – an event of enormous impact and consequence that couldn't have been predicted. 

For Taleb, the pandemic is more like a "White Swan", long hiding in plain sight and wholly predictable – something he, Bill Gates and others had been pointing at for years. 

Whatever color swan it is, the pandemic (and the ensuing global economic lockdown that macro research firm Strategas argues is the true Black Swan) is only one of several potential society-threatening extreme events identified in the book 7 Deadly Scenarios, written by Andrew Krepinevich. (Don't read it at bedtime.) Like a nuclear attack or a naval altercation with China in the South Pacific, the COVID-19 public health crisis is one of innumerable scenarios, seen and unseen, that could easily trigger a precipitous 35% drop in global market values like the one we experienced in March. And, as Taleb argues, in a complex, globally interconnected and increasingly fragile world the likelihood of such extreme events is increasing. 

All this has renewed interest from institutional and individual investors alike in hedging against so called "tail risk."

Tail risk is usually defined as the chance of loss due to rare events. It is often quantified as a price movement three standard deviations outside the norm. 

The case for protecting against tail risk in portfolio holdings is fairly straightforward and compelling. It's similar to the rationale for buying insurance on your house. 

Where it gets interesting is around execution: how best to hedge against downside risk.

The traditional "keep it simple" time-tested advice from financial advisors has been to diversify across asset classes. For example, to allocate your portfolio 60% to stocks, 30% to bonds and 10% to cash. Which historically has worked pretty well. In his book, Wealth, War and Wisdom, the late investment strategist Barton Biggs looked at the performance of different asset classes during World War II, one of the most globally disruptive events in history, and concluded a 60%-40% stock bond allocation maintained value as well as any other allocation. (Though he also recommended buying farmland as extra protection.)

Many institutional investors adopt a similar approach but diversify less to bonds and cash and more to hedge funds or real assets, strategies that are harder to access for smaller investors. 

Few would argue traditional diversification smooths out portfolio returns, moderating peaks and troughs in performance. The problem today is that (a) with bonds and cash yielding close to nothing, cash has a bigger impact on what a portfolio can earn than in a higher interest rate environment. (Assuming a 7% nominal long-term return on equities, allocating 40% to bonds and cash would reduce those returns to slightly more than 4%.) Also, (b) with bonds fully valued, their ability to provide non-correlated positive returns in a stock market sell off is diminished. 

Enter the "tail risk" specialists. Among them Taleb, who advises the firm Universa's tail risk hedging program, which was famously terminated by the California Public Employees Retirement System (CalPERS) pension last fall and winter, only months before it would have earned the fund an estimated $1 billion in gains during the March drawdown. 

Tail risk insurance comes in many flavors. But the idea is to allocate a small portion of a portfolio say to strategies that pay off when the world seems like it's coming to an end, allocating the rest of the portfolio to stocks. Depending on where the insurance kicks in (down 15%, down 20%, etc.), the price of volatility and an investor's willingness to sell off upside, the overall cost of the insurance can be managed to less than .50% annually. At least by institutional investors and/or family offices with the expertise to construct custom hedges. 

For individual investors there are a few hedging strategies offered by specialists like Parametric, including various forms of put buying or collaring. A zero cost collar, for example, has no upfront costs but may limit your upside in strong equity markets. Without a budget, buying puts can be costly. Depending on current levels of volatility, investors may have to spend 3%-5% or more annually to receive the downside protection they desire. These strategies aren’t for everyone, as they typically have higher minimums of $1mm or more.

So, what's an individual investor to do?

One of my favorite ideas is to arrange for as much in lines of credit as your bank, wealth management firm or other reputable financial institution will lend you.

Financial markets are nothing if not resilient. They have recovered following every major crisis in our lifetimes. But as Warren Buffet, the most famous advocate of a fortress approach to liquidity management, puts it, "to finish first, you must first finish". You must have enough in reserves to stay invested during a crisis, enough to survive without having to sell your assets on the way down, at the bottom, or on the way up, before they have fully recovered their value. 

Liquidity is the key to making it to the other side of a market crisis. Credit facilities are an underappreciated way to create liquidity. And unlike cash, many lines of credit don't cost anything... until you draw them down. 

Which is (sort of) like not having to pay for insurance before you file a claim. 

^{Past performance is not indicative of future results and diversification does not ensure a profit or protect against loss. All investments carry some level of risk, including loss of principal.}