The anatomy and usage of a tail-hedging index.
[This article originally appeared in the May/June 2014 issue of the Journal of Indexes.]
The three-year period defined by the start of the credit crisis in 2008, the intervening “flash crash,” and the subsidence of the sovereign debt crisis in 2011 marked one of the most volatile regimes in market history. Of particular note were the successive waves of “tail events,” market dislocations deemed a priori to be statistically improbable. Although differing in both intensity and duration, these events, collectively known as “fat-tail events” or “black swans,” precipitated abrupt and immense drawdowns as stock prices unraveled from company and macroeconomic fundamentals.
Why Hedge Tails?
As an example of the potential impact of tail events upon a market portfolio, consider the magnitude of the drawdowns experienced during the heart of the credit crisis in 2008. As seen in Figure 1, under the assumptions of normality embedded into modern portfolio theory, it is anticipated that over the course of a trading career, one would observe at most one one-day drawdown in excess of 4 standard deviations (i.e., 5+ percent). Yet as shown in Figure 2, during the four-month period from August to December 2008, the market experienced 10 such declines—negating six years of equity growth in the span of four months. On the surface, therefore, the most obvious and oft-cited reason to hedge against tail events is to mitigate the severity of market drawdowns.
A more subtle and arguably more important benefit of a tail hedge, however, is that it addresses the most disruptive feature of a tail shock—specifically, the impact-associated market distortions that often accompany tail events. These market distortions undermine 1) the underlying principles of financial valuation—causing a departure of asset prices from their “fair” values; and 2) the stabilizing assumptions of portfolio construction, including:
- Breakdown in portfolio diversification (via correlation)
- Negative feedback loops (via volatility clustering)
- Beta instability (via cross-asset contagion)
- Discontinuous trading
Often during these events in which in-house volatility-based risk limits are suddenly breached, portfolio managers (“PMs”) and traders are forced to sell out of tactically unattractive but strategically desirable positions. Tail hedges can provide a volatility buffer to mitigate the need to exit these positions or to lessen the impact of increased volatility.
It is somewhat ironic that downside tail events also provide the best opportunity to outperform. In fact, some of the greatest equity-market outperformances (i.e., upside tail shocks) followed immediately on the heels of the market’s sharpest sell-offs. Take, for example, the crash of 1987, in which the market collapsed 23 percent over the course of one day but recouped the bulk of the losses over the course of the next two days. A good way to recover returns lost due to a tail shock is therefore to invest during times of market duress. However, in many cases, trader positions are often drastically pared down as the aforementioned risk limits are breached. An important function of tail hedges is therefore to provide a source of funding that accrues as the market is in decline and that can then be used to lever into a long position to allow the portfolio to more quickly recover.