24 March 2020
Within financial markets, ‘tail risk’ events refer to rare and unpredictable events that can cause sudden sharemarket crashes. While there is a statistical definition (a greater than three standard deviation movement from the mean), in layman’s terms the price movements of the past month are a very good example of a tail risk event.
Tail risks are notoriously difficult to predict, and often fall outside of the ‘expected’ market return profile of a normal distribution. This creates a problem for many asset allocation and risk management models, which rely upon ‘normally distributed’ returns to assess and analyse expected returns. In reality – and particularly in times of crisis – these models systematically under-estimate the risk of loss, in large part to the nature of crashes which can be extremely vicious on the way down.
For example, our analysis of the MSCI World Index for the period 1970-2017 shows that observed tail risk events occurred 6-8 times more frequently than these models suggested, when based on a normal distribution.
Furthermore, during periods of higher than average market volatility, research by Peters (2009 & 2014) suggests the risk is not 6-8 times more likely, but more than 20 times more likely!
After a 12-year period of relatively muted volatility and strong equity price gains, it does appear we are on the cusp of a period, potentially extended, of high market volatility and uncertainty.
There are two major impacts of tail risk events on investor outcomes.
Large losses, particularly in the 5-10 years immediately preceding and after retirement, can be devastating in terms of outcomes. This well-documented issue is known as sequencing risk, and is particularly relevant for retirees and pre-retirees due to the large sums of money involved; the relative lack of time that retirees have to recover from these losses; and the necessity for retirees to draw down income during these periods.
In our report The retiree and the 100-year storm we provide an example of sequencing risk in some detail.
Compounding the sequencing risk dilemma is the behavioural finance theory of loss aversion, referring to the human preference of avoiding losses more than acquiring equivalent gains. Put simply, the pain of losing $100 is more pronounced than the joy of making $100.
Studies have shown that retirees are far more sensitive to this ‘emotional magnet’ than any other age cohort.
Well-crafted long-term investment plans can be disregarded overnight, as investors that are weighing the emotional response of a sharp loss look to move to the relative safety of cash at precisely the wrong time. However, by selling at the bottom when much of the damage has already been wrought, losses can be effectively locked in and longer-term investment outcomes more difficult to achieve.
For most people, the move to retirement should also include an increased allocation to more defensive asset classes, such as cash or fixed income. While these more defensive allocations will usually help defend capital during a tail event, in the more recent low-interest rate environment these allocations have also come with significantly diminished returns. Low interest rates, combined with increasing investor life expectancies, may actually serve to increase the likelihood of a critical failure such as a retiree outliving their savings.
Within equities, increased allocations to more defensive sectors such as utilities and consumer staples can also assist. However, there comes a point where correlations for all stocks and sectors increase, something we have witnessed in the past week or so.
An alternate solution, and one we employ systematically at Wheelhouse, is actively managed tail protection that relies on derivative overlays, and the principles of insurance. Our tail protection strategy, once engaged, physically increases in value for every move down in the market. In fact, the way our strategy is designed is that the hedge increases in value at a faster rate than the market is falling. This means that the worse the market falls, the more our hedge goes up.
As an example, one protective trade we entered in mid-February 2020 (when market conditions were benign) for $4.62 had increased in value by over 50x and was monetised for an average $248.32 in mid-March. In the current environment, hedging a portfolio is as expensive as it was at the peak of the GFC and really validates the Wheelhouse approach of having protection ‘always on’. These little ‘sleeping securities’ are expected to cost performance around 1.0-1.5% over the year, but during market stresses they increase in value exponentially. The chart below illustrates the performance of the tail hedge in the Wheelhouse Global Equity Income Fund year to date, where it has added 700 basis points year to date, and nearer 720 basis points since the market commenced its decline.
Similar to insurance, tail protection needs to be managed. Trying to buy flood protection after the rain has started, or hurricane protection after the storm, is typically an expensive exercise. However, when ‘always on’ and actively managed, insurance policies put in place before the market turmoil can increase significantly in value.
In retirement, we believe many portfolios would benefit from an insurance mindset. For example, when we are young and working our primary asset is our salary, or our human capital, that we rely upon to provide for ourselves and our families. Thus it comes as no surprise that we often take out ‘income protection’ type policies to protect that human capital.
As we move into retirement, that human capital becomes financial capital, or our investments and savings. With decreased opportunity to return to work as we age, we believe our financial capital should be protected in a similar fashion – namely with tail risk protection strategies. By protecting capital, this allows income to be generated on a more stable financial base. For retirees, we believe this combination of income and protection is key.
This information is issued by Bennelong Funds Management Ltd (ABN 39 111 214 085, AFSL 296806) (BFML) in relation to the Wheelhouse Global Equity Income Fund. The Fund is managed by Wheelhouse Partners, a Bennelong boutique. This is general information only, and does not constitute financial, tax or legal advice or an offer or solicitation to subscribe for units in any fund of which BFML is the Trustee or Responsible Entity (Bennelong Fund). This information has been prepared without taking account of your objectives, financial situation or needs. Before acting on the information or deciding whether to acquire or hold a product, you should consider the appropriateness of the information based on your own objectives, financial situation or needs or consult a professional adviser. You should also consider the relevant Information Memorandum (IM) and or Product Disclosure Statement (PDS) which is available on the BFML website, bennelongfunds.com, or by phoning 1800 895 388 (AU) or 0800 442 304 (NZ). BFML may receive management and or performance fees from the Bennelong Funds, details of which are also set out in the current IM and or PDS. BFML and the Bennelong Funds, their affiliates and associates accept no liability for any inaccurate, incomplete or omitted information of any kind or any losses caused by using this information. All investments carry risks. There can be no assurance that any Bennelong Fund will achieve its targeted rate of return and no guarantee against loss resulting from an investment in any Bennelong Fund. Past fund performance is not indicative of future performance. Information is current as at 16 March 2020. Wheelhouse Investment Partners Pty Ltd (ABN 26 618 156 200) is a Corporate Authorised Representative of BFML.
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