Asset owners seek diversification in distressed markets, but when considering tail hedging and offsetting portfolio positions, clients must consider cost, reliability, reactivity and upside potential, an expert panel has said.
Speaking at the Investment Magazine Absolute Returns Conference in Sydney, Paul Fraynt, head of risk premia at K2 Advisors, started off with a simple definition of the tail hedge: “Something that will go up whenever your portfolio will go down. Unfortunately, when it comes to simplicity, this is where it ends.”
“We drilled it down to six key characteristics clients are looking for,” Fraynt said. “To start with, even though everyone wants a tail hedge over a long period of time, clients would like to not lose money, and preferably make money, in a tail hedge. That’s one. Secondly, they would like to have strong negative correlation, which is another term for strong reliability. Whenever the equity market goes down, they would like positive returns in the tail edge.”
Other features include convexity, ample liquidity for low cost of implementation, having a tail hedge that is always on and the possibility of upside capture.
These six characteristics are “very difficult” to deliver at once, and Fraynt said he was not aware of a single strategy that could produce that outcome. Asset owners should consider the trade-offs among tail hedges such as out-of-the-money puts, put ratios and vehicles that could be systematically rolled. Another choice is a dynamic option, with momentum and mean reversion strategies but Fraynt said K2 Advisors did not favour this.
“Our preferred approach is to stay away from dynamic – or let’s say less reliable – strategies and to suggest clients construct their tail hedge from more reliable, better-known strategies, which tend to work over entire economic cycles and deliver tail protection at the most attractive cost,” Fraynt said.
Vimal Gor, head of income and fixed interest at Pendal Group, said there were a variety of ways to achieve these offsets, including asset diversification. Gor also pointed to using multiasset volatility approaches.
“That’s going long volatility in other assets that correlate with equity market volatility,” Gor explained. “It’s not doing [realised volatility] RV, it’s actually buying” FX volatility or commodity volatility, which give you differentiation and a cost advantage, but has a strong correlation to equity vol.”
Moderator Con Michalakis, chief investment officer at Statewide Super, told the conference audience the fund did not have any tail hedging in place, given its goal of being a growth fund.
“We think asset allocation is the first thing,” Michalakis said. “We choose active management, we have some long/shorts, we have some alternative, we have [absolute] return, bonds.
“The second thing, when the market is down 30 per cent or 40 per cent and a balanced growth fund is down 15 per cent or 16 per cent, if you’re a couple of per cent better than that, that’s probably as good as you’re going to get. You’re not going to wipe it out. If you’re going to wipe it out, it’s going to cost you a lot of money, and you’re going to miss out on the run-up.
“Should you introduce these types of strategies? I think most of the super funds here are looking at it and how much you should be putting into it. This is the harder question and something we’re all trying to figure out.”