From the January 01, 2011 issue of Futures Magazine • Subscribe!

Watch your tail

We are hearing a lot these days about tail risk hedging. An internet hedge fund wire service earlier this year noted, “Tail-risk hedging is the summer buzzword among institutional investors.”

The story highlighted a new tail-risk fund that “could lose a minimum of between 1% and 1.5% per month (12-18% per year) just from the cost of the options strategy,” but would offer protection in case of a fat-tail event. While that is pretty expensive insurance, the story notes the fund already has more than $100 million under management from institutional investors.

In our cover Q&A with PIMCO’s Mohamed El-Erian, the co-chief investment officer said that we have entered a “new normal” environment, which will be highlighted by “flatter distributions with fatter tails.” He recommends that investors expand risk management to ensure that diversification is supplemented with cost-affective tail hedging.”

Most of the strategies concentrate on specific option hedges that will be a drag on returns in those periods without “fat-tail” events and seem to forget about what has been one of the most affective tail risk strategies; managed futures. Managed futures tend to be non-correlated to equities in benign market environments and negatively correlated in bear markets.

Investors may not be forgetting this as allocations to managed futures are at an all-time high and, according to BarclayHedge, have grown beyond any individual hedge fund strategy (see “We are #1”).

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Much of the justification for the use of tail risk hedging is 2008, a year when not only traditional long equity strategies struggled, but also most hedge fund strategies. It is the year when the BarclayHedge CTA Index returned 14.09%, its best performance since 1990 and perhaps best ever given the different interest rate environment. In 2008, 318 CTA programs returned more than 20%. That is a pretty good tail risk hedge.

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