Pimco reviews the arguments for tail risk hedging in EM equities
Flexibility and diversification are key in developing a tail hedging approach to emerging market equities, suggests Pimco’s managing director and portfolio manager Vineer Bhansali (pictured), and executive vice president
and portfolio manager Masha Gordon.
PIMCO’s secular view speaks to an evolving, multi-speed world where emerging market (EM) countries are poised to lead global economic growth. This strong multi-year story is likely to be punctuated, however, by periods of volatility as policymakers respond to inevitable cyclical challenges. These potential headwinds argue for an approach that is designed to help investors manage their downside risks while still maintaining their overall exposure to EM equities.
Emerging market equities have been, simply stated, a volatile asset class. While historical returns have been compelling, and we believe that on a risk-adjusted basis they have appropriately compensated investors for enduring this volatility, EM equities nevertheless have experienced periodic, broad-based and dramatic selloffs, or “drawdowns,” as some market professionals refer to them.
Generally speaking, active management and a discipline to own what we believe are quality companies can help defend portfolio returns in these difficult periods, but we believe that explicit management of this downside risk through tail risk hedging (TRH) can be a key advantage in navigating these markets.
Tail risk refers to potential investment outcomes on the edges of statistical return distributions. In a typical bell curve, the tallest areas near the center represent the higher probability outcomes. The “tails” are where the bell curve tapers down toward the edges. Of course, there are both left tails and right tails; in other words, there are relatively low probabilities of very bad and very good outcomes. Because in reality, markets don’t neatly follow the bell curve, underestimating the likelihood and severity of events on the tails can negatively affect portfolio returns.
For example, we looked at nearly 6,000 trading days for emerging market equities from January 1998 through December 2010. First, we estimated the number of occurrences of daily returns beyond a certain return threshold based on expectations inherent in a normal distribution. We then compared these expectations to actual results.
This study shows that the actual number of big down days meaningfully exceeds what would be expected in a neat bell curve. Therefore in emerging market equities, the tails tend to be “fatter” and the probability of big losses tends to be higher.
PIMCO Takes a Holistic View Toward Managing Tail Risk
For many years, PIMCO has implemented tail risk hedging and in total we manage nearly $30 billion in tail risk hedging mandates for a wide variety of investment portfolios. Over the years, we have arrived at some important conclusions on tail hedging:
* Key inputs: To create a tail risk strategy, we need to know (1) exposures to key risk factors (for example, equity beta, country, currency, industry and style factors), (2) attachment levels, or a portfolio value level where the hedges are designed to kick in to help mitigate losses, and (3) target cost per annum. In an attempt to create a cost efficient hedge we look across markets, but this tends to create correlation or basis risk. Thus, as an input we also need to know the portfolio’s tolerance for basis risk, i.e., the risk that the value of the tail risk hedge portfolio differs from that of a direct hedge. Given these four elements, we can search for an optimal balance of hedging instruments, using a mix of direct and indirect hedges.
* Using correlations to our advantage: Since correlations between many assets tend to rise when there are severe drawdowns in the risk markets, an efficient tail hedge should use attractively priced instruments from a wide variety of asset classes to help reduce cost without sacrificing the potential potency of the hedge conditional on the fat tail events happening.
* Multiple approaches: We think that the best approach for tail hedging is a flexible one, using dynamic rebalancing, diversification, and composed of affordable option-like securities to build a tail hedging program. We think intelligent investors should use all tools at their disposal, including potentially moving into cash when cash looks to be an effective way to weather market volatility.