Consultants advise asset owners to protect against tail risk

Aon senior portfolio manager of hedge funds Guy Saintfiet points to increasing demand for tail-risk protection strategies, as institutional clients consider whether their strategic allocations are right for current and future market conditions.

He tells Pensions Expert’s sister title MandateWire that while risk premia “look more attractive as risk has been repriced, in the short term continued uncertainty and volatility means that we’re still recommending to clients [that they] reduce their market sensitivity to equity and credit risk and add more diversification and protection to the portfolio”.

Aon’s preferred approach to tail-risk protection is to make investment portfolios “more resilient” in the first place by having a strategic allocation to “true” diversifying assets, rather than buying and holding equity options.

Continued uncertainty and volatility means that we’re still recommending to clients [that they] reduce their market sensitivity to equity and credit risk and add more diversification and protection to the portfolio

Guy Saintfiet, Aon

“If you hold this type of tail-risk protection through a cycle it will be very expensive and so there’s a risk that [asset owners] won’t have the staying power to keep these assets, and then when [they] need it [they] don’t have the protection,” Saintfiet says.

Safe haven assets

In the interests of building a diversified portfolio, clients are advised to look to safe haven assets – such as the US dollar, Japanese yen, US Treasuries and gold – that could protect against downside risks.

Saintfiet adds that hedge fund strategies such as global macro and commodity trading advisers may also offer tail-risk protection, as might uncorrelated hedge fund strategies such as relative value and market neutral. Investors in hedge funds rely mainly on manager skill to deliver the downside protection.

The type of tail-risk protection strategy adopted by Aon’s institutional clients will depend on factors such as their investment beliefs, governance and fee budgets, and the need for liquidity, he notes.

While some institutional clients may choose to adopt one tail-hedging strategy, others may use a combination of protection strategies, including equity options, Saintfiet adds.

WTW global delegated chief investment officer Chris Mansi tells MandateWire that the consultancy has become more concerned about negative market outcomes arising from either a stagflationary environment or a disinflationary recessionary environment.

Consequently, he says WTW is “trying to tread a fine line” by looking to invest in assets for its delegated consulting portfolio that can protect against inflationary outcomes, but also assets that may protect the portfolio if interest rate rises lead to a disinflationary environment.

As a starting point, institutional clients are advised to “get the overall risk level in their strategy right” and to view tail-risk protection as a “desirable supplement” to that strategic risk setting.

In terms of building a tail-risk protection strategy for its delegated consulting clients, WTW first looks to make a strategic allocation to global macro and trend-following strategies.

“Those strategies are not guaranteed to make money in a tail event, but they are expected to be lowly correlated to equities over time, and you’d expect them to be able to do pretty well when equity markets are falling,” Mansi says.

“That’s certainly been our experience [with these hedge fund strategies] over the first half of this year.” 

Dynamic asset allocation

He says the next step is to consider investing on a dynamically managed basis in assets such as US Treasuries.

“If you’re faced with an environment that becomes disinflationary recessionary, they can be great. On the other hand, in an environment that becomes inflationary, they can be bad. So, you need to think about the risks that you’re worried about, the potential assets and the price of [those assets],” he notes.

Asset owners could then decide whether or not to buy equity options. Mansi says WTW has not really considered equity options this year because it views them as pricey. But despite this, he notes that if equity markets fall, equity options will do well.

“We look to have structural holdings to macro and trend-following strategies, supplemented with those more dynamic holdings, which are more risk and price dependent,” he says.

“What that means in practice is that, over time, we have allocated to equity options, currencies, high-quality government bonds globally and commodities, but we don’t own all of them all of the time because of this need to be dynamic.”

Mercer partner and senior investment consultant James Brundrett explains that institutional clients are advised against looking at tail-risk hedging in terms of individual strategies.

Instead, the recommendation is to build “all-weather portfolios” on a structural level that include a diverse range of assets and strategies such as managed futures funds, global macro, trend-following, global tactical asset allocation funds, low-volatility equities, commodities and US Treasuries, that perform well in different environments.

“For example, our hedge fund portfolio has strategies like global macro, managed futures and global tactical asset allocation, some of which may or may not help in a tail-risk event,” Brundrett says.

“We also have specific tail-risk hedging strategies like short credit, [which is designed to] explicitly perform strongly in a stressed scenario.”

This article originally appeared on MandateWire.com