Robert Benson, CFA, Robert K. Chapiro, CFA, CAIA, Dane Smith, Ric Thomas, CFAVolume 1, Issue 4, pp. 32-47
The global financial crisis (GFC) of 2007-08 was remarkably severe not only in the magnitude of drawdowns suffered by individual asset classes, but also thedrawdowns of portfolios thought to be well diversified. The risk of such an outcome has come to be labeled tail risk in reference to the extreme left tail of an asset’s or portfolio's return distribution. Since the GFC, many investment organizations have launched tail risk protection strategies designed to address such periods of severe market distress. Likewise, flows intomanaged futures strategies (commonly thought to profit during periods of elevated volatility) increased dramatically.
Tail risk represents the loss at the most negative part of an asset or portfolio’s return distribution, or the left tail. Many studies show that equity market returns do not follow a normal distribution, with tails fatter than predicted (Fama (1965)). Extreme losses occur during times of crisis or financial market distress. In these times, we observe a contagion effect marked by a pronounced rise in many asset class correlations to equities. Since it stands out as the dominant explanatory risk factor in multi-asset class portfolios, equity return is used as a proxy for
financial market risk in our study. While protection against tail risk has generated considerable attention and asset flows, there is significant disagreement regarding the efficacy of such strategies and their cost/benefit
tradeoffs. Theoretically, a tail risk strategy should have a low required rate of return because it pays off at times
of market distress.
This paper measures the benefits and costs of several candidate tail risk protection strategies empirically using more than 20 years of monthly data from U.S. markets. We analyze four methods for controlling tail risk: (1) long volatility, (2) low volatility equity, (3) trend following, and (4) equity exposure management.
We consider an investment strategy to offer tail risk protection if it consistently outperforms equities when equity returns are most negative. We define portfolio tail risk as the conditional mean portfolio return in months where equity returns exceed a loss of five percent. For each tail risk strategy, we estimate the fixed allocation, that when combined with an equity portfolio, reduces tail risk by a constant proportion. In this way each tail risk strategy is compared on an equal footing based on its contribution to tail risk reduction. This paper also introduces two new measures of tail risk protection efficacy. First, we measure the cost of the protection in terms of annual performance drag when added to an equity portfolio. Then, we measure the certainty, or consistency, of the tail risk protection. The ideal tail risk strategy combines a low performance drag with a high certainty of protection. We identify a number of tail risk strategies that perform well along these two measures.
A Comparison of Tail Risk Protection Strategies in the US Market