Investors move to protect against tail risk (even if they don’t know what it is)

Institutional investors fear a ‘tail risk event’ in the next12 months, but are unsure what strategy would be effective protection against it, according to research from State Street Global Advisors.

A report following the polling in March and April of 310 investors worldwide indicates there is more awareness now of the possibility of a tail risk event than at any time since the 2008 financial crisis. Some investors have made asset allocation changes to reflect their concern, while others have been slower to react.

However, there are clear differences by geographic location and by type of investor – from pension and insurance funds, to family offices, funds of funds and high net worth individuals – on what they perceive as a source of threat, and how they deal with it.

Over 70% of respondents believe there will be a “significant tail risk” in the next 12 months, while 12% considered that highly unlikely.

Tail risk is theoretically defined as an investment that moves more than three standard deviations from the mean of a normal distribution of investment returns. The likelihood of a tail risk event rises in less volatile markets and falls in more volatile times, suggesting that mathematically, the likelihood is now lower than it has been for some time.

A broader definition of tail risk encompasses any unforeseeable event, such as the tsunami in Japan, the euro crisis and the Arab Spring, which critics argue are in fact simply ongoing market risk which is part of normal analysis and strategy.

Respondents to the poll were overwhelming based in the US, followed by the UK. Respondents in all Continental European markets combined made up the balance of participants. Over one third of respondents managed more than $5bn in assets under management.

Asked what they thought might provoke tail risk in the next 12 months, there was almost equal support for global economic recession, Europe slipping back into recession and the breakup of the eurozone.

Global recession was the main concern for US investors (No 4 for those in Europe; followed by eurozone break up (No 3), European recession (top for European investors), Greece exiting the euro (no 2) and recession in the US (which did not feature among European concerns). In Europe, “major bank insolvency” was identified as a top tail risk.

A majority of those polled considered protecting against tail risk should be an integral part of any investment strategy, a view most strongly held in the US and Italy (by 83%). Germany (60%) was less convinced, possibly because local investors typically hold less risk assets.

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