Tales of Hedging Tail Risk
Primum non necere.
At first glance, the phrase “primum non nocere”—first, to do no harm—relates to the fundamental tenet medical professionals abide by. However, it is worth asking whether such a concept can be applied to the world of asset management as well.
It’s a fundamental question. How do you construct a portfolio that accounts for the infrequent market calamities that wreak havoc on a portfolio and wipe away good returns? The risks that cause these scenarios are often called tail risks since, on a typical bell-shaped curve depicting the distribution of returns, these scenarios lie on a part of the curve that is thin (i.e., uncommon), and at the far-left end (i.e. very negative). Over time, tail risk events have varied – the Crash of ’87, the Russia/Long Term Capital implosion of 1998, the burst of the Dot-Com bubble in 2002, and of course the 2008 Global Financial Crisis (“GFC”) — but managing investments through each has required an acknowledgement and understanding of market dynamics that are beyond business as usual.
Our answer to the tail risk question marshals a combination of our investment philosophy, the rigorous tools and processes that guide our overall investment processes, the stated mandate from investors, the appropriateness given the strategy, and a clear view of what we need in our portfolios in order to tail risk hedge where we believe appropriate.
Focus on beta. As a general matter, we concentrate our tail risk hedging on major market risks—the systematic, benchmark-driven, “beta” risks that all investment products carry to some degree. These are the risks that our clients must assess in their own asset allocation strategies, so it is important that Magnetar’s betas be accurately summarized for their benefit. Major market betas can also be highly correlated, thereby amplifying portfolio moves. Consider, for example, the tendency of credit markets and equity markets to perform in sync during big market moves—especially downward.
It is important to note here that while we aim to maximize hedge performance in the identified tails, Magnetar generally refrains from micro-managing betas to smaller market moves.
In addition, we do not gear our tail risk hedging to the rarer, idiosyncratic risks found in sub-sectors of our portfolio or in individual investments. Returns on those risks constitute alpha—that is, returns explained by specific investor choices, not major market moves. Those risks tend to be less correlated than beta risks making diversification a simple and effective risk management tactic; accordingly, we believe that diversification can often be a simple and effective risk management approach. Our investors also encourage us to find, design and retain attractive portfolio alpha. So, while we optimize the risk-return with respect to alphas, using asset selection and structuring to minimize losses, we tend not to hedge idiosyncratic risks at the portfolio level.
Capping losses in real time. Using this framework and Magnetar’s proprietary risk models, we generate a universe of potentially adverse outcomes specific to the applicable portfolio, and define the modeled worst negative outcomes in that universe as the “tails.”
When appropriate, we hedge at the portfolio level with a goal of capping losses within a high degree of confidence as determined by the mandated risk profile. We measure a portfolio’s risk profile using a factor-based model and a bottom-up approach that looks at market factor loading and idiosyncratic asset specific risk by individual security. As assets move, our proprietary risk model measures correlations and volatility through a common set of factors. Just as portfolio risk can change with movements in financial markets, hedging costs can too. Under Magnetar’s risk management discipline, current, executable market prices are constantly incorporated to determine the hedged risk profile of a portfolio. If a hedge no longer delivers the targeted loss limits—or if the portfolio is over-hedged to the point of placing a drag on returns—Magnetar’s dynamic, real-time hedge-optimization process will kick in to adjust the portfolio’s hedge.
Magnetar has invested significant resources in building in-house IT infrastructure that leverages real time data and analytics to monitor and adjust hedge ratios daily. We believe that this allows us to be more precise and to dynamically hedge.
Efficient hedging tactics. We believe the insights derived from Magnetar’s correlation models help us to identify efficient tail risk hedges. If price is no object, tail risk hedging is a simple matter: just spend a lot of money on out-of-the-month options that will pay off in a catastrophe. Options can, however, be an expensive drag on returns in normal environments, so a discriminating, insight-driven approach is key to keeping costs down.
The fact that markets often move together in a downturn means that a hedge from one asset class may be a good substitute for a hedge in another asset class—again, think stock prices and credit spreads. This insight helps us to identify what we believe to be the “cheapest to deliver” hedges (to borrow a term from the futures market), permitting us to maximize our payout per unit of cost. We can overlay hedges that seek to protect against a range of identified adverse outcomes, as opposed to a single tail scenario. We also evaluate what changes to market volatility (skew, in particular) might occur, further refining our selection and sizing of our hedges.
To ensure that we can realize our hedge gains, we generally stick with liquid hedge instruments across asset classes. The alternative—highly customized products—can end up being illiquid in a distressed market environment, making it difficult to realize those gains.
Another derivative of efficient tail risk hedging tactics has been the rise of Crisis Risk Offset (“CRO”) strategies. CRO can be thought of as a portfolio designed to deliver both positive real returns in normal market environments and enhanced performance in a correlated risk sell-off. To date, exposures in CRO strategies have typically included some combination of Treasury rate duration (long-maturity government bonds), systematic trend following, liquid alternatives (risk premia, systematic trading), discretionary global macro, reinsurance and/or put buying strategies. While the primary intent has been to produce modest positive real returns across a full market cycle, with outperformance during equity market drawdown periods, scalability and cost effectiveness have been cited as potential additional benefits2 in employing a CRO strategy.
Tail risk hedging at Magnetar is not just an answer to a single problem, but rather a matter of attempting to solve several problems. The effort is supported by a top-notch team and extensive data and analytical resources, continuously informed by the pulse of the market. By pinpointing the risks that we believe should be hedged, targeting the maximum acceptable losses in a market dislocation, and then applying and rebalancing hedges based on evolving market conditions, Magnetar aims to weather market washouts and maintain sustainable growth and performance.
Footnote 2: Pension Consulting Alliance (PCA), Crisis Risk Offset Class Memorandum, September 2015.
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