Tail-Risk Hedges Sought in Another Dimension

How to take market risk and protect against liquidity crashes.

With the S&P 500 index close to record highs and U.S. Treasury yields near record lows, world markets increasingly resemble the ball-on-top-of-a-hill diagram used to illustrate an unstable state in popular science books. Roll to the left for a cataclysmic stock market collapse; roll right for resurgent global growth, soaring equity prices and a crash in bonds.

The view down the hill is shaped by two alarming facts:

One: Investment-grade companies mostly go under when interest rates are on the floor.

"If you go back 200 years," said Thomas Thygesen, head of cross asset strategy at Skandinaviska Enskilda Banken, in Stockholm, "you'll find all the big banking crises, all the waves of companies that go belly-up because they have too much debt, they don't happen when the interest rate is high, they happen when they cannot go any lower."

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Two: During the last three decades, despite emerging from a series of major debt crises, total debt in the G-7 plus China has continued to climb to record highs.

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So how do investors hedge the bursting of a debt bubble in China or the disorderly break-up of the European Union — or an unforeseen long-tail event? And how do they do so without sacrificing too much of the upside if disaster is averted and stock markets soar?

Traditionally, investors would buy far out-of-the-money options, but they've become more expensive as they've become more crowded, which means they'll make a bigger dent in returns while investors wait for a crash, according to Thygesen.

That's sparked a hunt for other, cheaper tail-risk hedges.

"I don't really see any solutions to the problem that would allow you to both pursue short-term opportunities and feel completely confident that you're not gambling with the survival of your portfolio or your company unless you start taking out tail-risk insurance somewhere in the system," said Thygesen.

Thygesen says SEB has been looking for non-linear liquidity risk insurance — hedges that pay out if the bond markets freeze over, the interbank market shuts or if there's a collapse in equity prices — by looking at factors and risk premiums. For instance, the valuation gap between small-cap companies and blue-chip companies would be expected to widen in a panicky selloff.

The aftermath of the Brexit vote was a good example of a knee-jerk reaction from investors to an unexpected event.

On Friday June 24, on the day after the vote, Unicredit's ETF trading desk "had 90 percent of flow only buying, just buying, and buying only blue chips," so no factors, no minimum volatility, no dividend, no value indices, said Paolo Giulianini, head of ETF trading at UniCredit Bank AG, at an ETF conference at Bloomberg's London offices on July 5. "In terms of flow, when there is a big market movement, clients are only trading blue-chip ETFs. They don't want to touch non-plain vanilla ETFs."

Non-linear hedges can be thought as operating in another plane to normal macro forces.

"When you have growth and inflation that plays with equity and bonds. You have this third dimension that is non-linear by nature and doesn’t exactly track the other two macro risks," said Thygesen. "So if you had small cap versus quality, it's in the non-linear liquidity space, unlike, say, government bonds versus commodity, which is in the inflation space."

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Other places to look for tail-risk insurance are FX carry, the low volatility factor and the curvature in the bond market, said Thygesen.

The beauty of this approach is that it's possible to hedge this non-linear risk using simple linear products such as listed futures. This means the products can easily be tilted toward active risk, so that the hedge also makes a positive contribution when markets are benign.

Investors using such hedges also avoid betting against the so-far persistent, long-term equity risk premium. This is the price paid by investors who short stocks as markets continue to climb.

As an example of how non-linear hedges might work, take an asset class with a large dose of embedded tail risk: high-yield bonds. In normal times the excess return of high yield over government bonds tracks equity premiums closely as investors' return for taking default risk. But when things get hairy, like in 2008, high yield bonds become more equity-like. This means that non-linear risks can be captured, say, by shorting high-yield bonds and buying U.S. Treasuries.

As a specific illustration, Thygesen says SEB has built a "pure credit" product which is long 100 percent U.S. investment-grade credit and short 85 percent Treasuries and 15 percent the S&P 500 index. This leaves a premium of around 75 basis points, he says, that isn't correlated with asset class returns, which is essentially payment for those rare episodes of tail risk and defaults.

There are some drawbacks to using non-linear hedges. Chief among them is that the return in the event of catastrophe isn't clearly defined as would be the case with out-of-the-money options. They might also be prone to the same overcrowding as put options.

As investors wise-up to this approach, some of these factors may become overvalued so that spreads are distorted and are themselves liable to crash risk.

Rob Arnott of Research Affiliates LLC, one of the founding pioneers of smart-beta ETFs, said in a paper in February that there could be a bubble brewing in factors like low volatility because they've outperformed due to their popularity.

"Most people regard things like quality as rather crowded trades, but we have been tracking this performance going back to the 1930s where you can see a lot of the same things happening as we've been seeing recently, where the tail risk in the premiums have become very correlated with other types of risk in the portfolio," said Thygesen. "My guess is that they could become even more expensive in times of severe crisis. That is obviously a concern and the reason why you need to consider an array of different ways to hedge that tail risk."

Perhaps smart beta ETFs will come to evolve and meet this demand for tail risk insurance.

"If you look at the proliferation of smart beta products they all seem to be taking steps in that direction, but not so very clearly with a tilt towards deselecting the premiums that are going to perform the same as other dangerous stuff in your portfolio." said Thygesen. "I'm pretty sure that it's something we're going to be hearing more of and everyone is trying to figure out how to do it."

This article was originally published in Bloomberg's Financial Regulation & Risk Brief.

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