The Rush to Hedge Against Black Swan Events

Wall Street's hottest new product is fear. Pimco, Deutsche Bank (DB), and Citigroup (C) are among firms offering clients protection against "long-tail" risks—extreme market moves that Wall Street's financial models fail to anticipate. In what Morgan Stanley strategists say is an indication that more investors are seeking insurance against financial turbulence, they estimate there was as much as a fivefold increase last quarter in trading of credit derivatives that speculate on market volatility.

The growing interest in catastrophe insurance shows that investors still haven't recovered from the Lehman Brothers bankruptcy on Sept. 15, 2008, which erased $20.3 trillion in stock market value worldwide and caused credit markets to freeze. Recent events such as the May 6 stock market rout that briefly sent the Dow Jones industrial average down almost 1,000 points have added to the anxiety.

High unemployment, housing woes, and slow growth in the U.S. continue to keep the markets unsettled. "Everyone is starting to realize that this is going to be a much longer, much more difficult path to recovery," says William Cunningham, head of credit strategies and fixed-income research at State Street's (STT) investment unit in Boston, which oversees almost $2 trillion. "It's really quite fragile and vulnerable in a way that we haven't seen in our lifetime."

The term long-tail risk is derived from the outlying points on bell-shaped curves that forecasters use to plot the probability of losses or gains in a given market. The most probable outcomes lie at the center. The least probable, such as a decline of 5 percent in an index that most days rises or falls by less than 0.25 percent, are plotted at the "tail," or the end of the curve. The greater the deviation, the longer the tail.

Before the 2008 financial crisis, author Nassim Nicholas Taleb warned bankers that they relied too much on probability models and had become blind to potential cataclysms, which he labeled black swans. That's a reference to the widely held belief that only white swans existed—that is, until black ones were discovered in Australia in 1697. His 2007 book, The Black Swan, contends tail risks are becoming more severe.

The increasing frequency of events that fall on the fringes of probability is prompting pension fund managers and other institutional investors, who once shunned costly hedging strategies, to reconsider. The Indiana Public Employees' Retirement Fund, which manages $14.1 billion, asked financial institutions in January to send information on a tail-risk management program that would protect it against "an extreme market downturn."

"People are trying to move beyond historic notions that tail-risk events are so infrequent on the one hand, and so extreme on the other hand, that there is nothing you can do about them," says Eugene A. Ludwig, who started Washington-based risk management firm Promontory Financial Group after serving as U.S. Comptroller of the Currency under former President Bill Clinton.

Pimco Chief Executive Officer Mohamed A. El-Erian developed tail-risk strategies when he was manager of Harvard University's endowment in 2006 and 2007. Pimco, which manages about $1.1 trillion, opened its first mutual fund aimed at minimizing risks from systemic shocks in October 2008. The Pimco Global Multi-Asset Fund (PGAIX), co-managed by El-Erian and Vineer Bhansali, had about 7 percent of its $2.1 billion in assets invested in the SPDR Gold Trust (GLD) as of Mar. 31. It also held put options, including some on S&P 500 index futures that would pay off if the benchmark fell below 700 by December. Pimco is using tail-risk strategies in many of its funds, says Bhansali. "You don't want to try to be too smart in trying to forecast what is going to happen and which hedge is going to perform better," he says. "What you want to do is accumulate cheap protection."

Deutsche Bank is marketing a tail-risk hedging index that gains in value when a gauge of stock-market volatility increases, according to material the bank sent to clients. The so-called Equity Long Volatility Investment Strategy, or ELVIS, uses derivatives called variance swaps linked to the Standard & Poor's 500-stock index. These swaps increase in value when market turmoil hits and are designed to provide some insurance against a cataclysmic selloff.

Demand for such trading strategies prompted Citigroup to hire John Liu, a former employee of the Indiana pension fund, about two months ago to advise pension plans, endowments, and foundations on tail-risk hedging, according to a prospective investor who declined to be named because the hire hasn't been publicly announced.

Other asset management firms that hedge against Armageddon events in the market are creating funds to take advantage of demand. Pine River Capital Management, a Minnetonka (Minn.) firm with $2.1 billion under management, started the Nisswa Tail Hedge Fund last month, according to a June 15 filing with the Securities & Exchange Commission. The partnership was formed at the request of investors who wanted access to the hedging techniques used by Pine River's primary multistrategy fund, which gained 40 percent during 2008 and 2009, according to co-founder Aaron Yeary.

Still, investors should be wary of long-tail hedging products, says Eric Petroff, director of research at Wurts & Associates, a Seattle-based consulting firm that oversees about $30 billion on behalf of institutional investors. "Products that protect you from tail risk tend to crop up after the tail has occurred," he says. "Back in 2007 it made a lot of sense to hedge tail risk—but now it just seems brilliantly misguided."

Taleb set up tail-risk hedge fund Empirica in 1999 and ran it for six years. He thinks the hedging strategies are a Wall Street fad that won't last. Big payouts from long-tail insurance will be so infrequent that most money mangers will lose interest. "They will drop like flies," says Taleb, now a professor at New York University's Polytechnic Institute. "They and their customers will give up at some point. I've seen it before."

The bottom line: The financial upheavals of the past few years have persuaded many big investors to buy protection against market meltdowns.

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