- Recent events have reminded market participants of the risk of large market drawdowns, with some investors considering strategies for hedging tail risk to protect against further losses.
- The prices of put options imply a one-in-six chance of a further 20% decline in the U.S. equity market over the next three months — roughly five times higher than at the beginning of 2020.
- The cost of implementing a tail-hedging strategy is correspondingly high. Unless very well-timed before crises, our hypothetical tail-hedging strategies have lagged simulated portfolios that simply reduced exposure to risky assets.
As investors take stock of the fallout from the coronavirus and recent market volatility, some have begun exploring tail-risk-hedging strategies as a way to protect against further drawdowns. What are the potential costs and benefits of hedging against tail risk? We simulated a series of portfolios employing tail-hedging strategies and compared them against hypothetical all-equity and stock-and-bond portfolios.
“Tail risk” refers to the possibility of a large event that would be highly unlikely in a standard bell-curve distribution. But financial markets are “fat-tailed,” and such events are actually relatively frequent. The 100-year storm comes more like once per decade.
Tail-hedging strategies typically involve buying derivatives, such as deep-out-of-the-money put options, that are expected to pay off when these events occur. But this insurance costs money. Like other kinds of insurance, many tail-hedging strategies require regularly spending and losing money in order to avoid the worst losses. Other strategies, like a collar, pay for the downside insurance by selling away upside.1
The market prices of tail-risk-hedging instruments potentially provide information about two related questions: What likelihood of another large drawdown have markets priced in? And how expensive is it to insure against such a drawdown?
Paying for it all
The chart below shows how the option-implied “risk neutral” probability of a large drawdown has changed over time, starting before the 2008 global financial crisis and extending to the current coronavirus crisis. It shows the implied probability of a 20% or greater drawdown of the U.S. equity market over the subsequent three months, as inferred from the prices of out-of-the-money put options.2
Option prices imply an elevated risk of further drawdown over the next three months
Option-implied risk-neutral probability of a 20% or greater drawdown over the subsequent three months for the U.S. equity market. Source: OptionMetrics, MSCI
The rising implied probability of a drawdown coincides directly with the rising price of tail-risk insurance via the same options. While it may seem like the best possible time to have insurance, it is also an expensive time to buy insurance.
And while tail-risk insurance is especially expensive now, the chart below suggests that the cost of tail hedging has typically been high. The chart compares the simulated performance of U.S. equity alongside alternatives to reduce tail risk: a zero-cost collar tail-hedging strategy and simple reductions of risk exposure with a 70%/30% stock/cash or bond allocation.3 The tail-hedging strategy directly insured against tail risk, while the 70/30 strategies reduced tail risk through a reduction of risk exposure more generally, and the 30% bond strategy further benefited from a flight to quality in the Treasurys when equity declined. The alternative strategies all avoided the worst of equity’s losses, but the tail hedging came at a much steeper cost.
Tail-hedging strategies underperformed
Source: OptionMetrics, MSCI
The performance of other tail-hedging strategies showed a similar pattern, as shown in the table below. Unless they could have been timed to go into effect just before a crisis, the protection they provided was more than offset by their cost. Simple strategies to reduce risk overall had similar or smaller drawdowns, while the high costs of maintaining tail insurance eroded performance.
Various tail-hedging strategies underperformed simpler risk-reducing portfolios
|Strategy||Average Return||Maximum Drawdown||YTD Return||Sharpe Ratio|
|MSCI USA Index||8.3%||50.6%||-14.7%||0.48|
|Equity + Collar (10% downside)||5.1%||36.0%||-4.6%||0.40|
|Equity + Collar (15% downside)||5.9%||40.6%||-9.5%||0.37|
|Equity + Collar (20% downside)||6.9%||44.1%||-14.8%||0.39|
|Equity + Puts (10% downside)||5.4%||43.4%||-9.3%||0.34|
|Equity + Puts (15% downside)||5.8%||45.1%||-13.0%||0.33|
|Equity + Puts (20% downside)||6.3%||46.7%||-17.2%||0.34|
Source: OptionMetrics, MSCI
Historically, tail-hedging strategies are designed to add value during a crisis, but at what cost? Investors who avoided the full risk of a stock-market drawdown likely lost out on the full upside. There is no free lunch.
1A put option gives the holder the right to sell an underlying asset at a specified strike price over some future time period. It benefits the holder if the asset price falls below the strike price, but otherwise expires worthless. A “deep out-of-the-money” option is one for which the strike price is well below the current market price, so it acts like insurance against a tail event. A zero-cost collar pays for an out-of-the-money put option by selling an out-of-the-money call option for the same price on the same asset. However, the upside and downside are asymmetric: A call option of the same price as the put is typically much closer to being in the money, so a lot of upside is sacrificed to achieve more modest downside protection.
2The “risk neutral” probabilities neglect a risk-premium component of option prices, and tend to overstate the actual probability of a drawdown, but they are indicative of markets’ changing views of the likelihood of a crisis.
3The simulated zero-cost collar strategy buys 10%-out-of-the-money three-month S&P 500 put options, financed by selling a corresponding out-of-the-money call option at the same price. The hypothetical 70%/30% allocations combine 70% weight in the MSCI USA Index with a 30% weight in cash or a rolling 10-year U.S. Treasury portfolio. The 70%/30% ratio is chosen to have roughly the same realized drawdowns between 2007 and the end of 2019 as the collar strategy. Note that the 30% bond allocation could be taken further by using leverage to increase the allocation to U.S. Treasurys to more evenly balance exposures to a negative correlation between equity and bonds, as in risk-parity strategies.