This sets the scene for the need for investors, despite geographical and asset class diversification, to contemplate downside risk management in these larger tails to manage these large drawdowns.

The cost of hedging 

One approach to manage tail risk is to hedge the risk by paying for protection. However, equity hedging is costly. Estimates of even highly-liquid US equity three-month option premium costs can average 1.5%, but the cost range has large positive skew and can go as high as 3.5% to 4.5%. We believe that a passive approach or mechanical mindset of rolling can be expensive, and is not the optimal solution. An active approach is needed to minimize hedging costs.

Hedged strategies do, however, help to cushion large falls, so there is a case for tactical hedging, although continuous hedging is not practical.

Investors need to step back and choose when to add protection. STANLIB Absolute Returns uses a lens approach, in which we look at markets through different lenses. One of these lenses is volatility. We found that different volatility regimes (high, medium and low), as assessed from the VIX, can provide vital information on the forward risk (as measured by future drawdowns) depending on the regime. This regime can signal when it might be more economical to hedge.

Volatility signals

The most liquid market for trading volatility is the S&P 500. There is an inverse relationship between the VIX Index and the S&P 500. When we see large positive changes in the VIX Index, we can expect the S&P 500 has negative monthly returns. The potential drawdowns for investors can greatly depend on the state of market volatility at the outset. This holds important information for the timing of hedging.

Active managers will choose when to put on hedging protection, agree on a budget for the inevitable drag of protection on the return, make informed calls on which contracts to buy (given the volatility term structure), and what derivative strategies to put on (e.g. put spreads). This will also be done in the context of the other portfolio assets and market conditions.

Apart from derivatives, other approaches to manage downside risk are non-traditional assets such as risk premia, private equity, hedge funds, FX or volatility strategies. These all have pros and cons but can be proactive ways of addressing the bond equity correlation in extremes.

Implications for retail investors and fiduciaries

• The traditional balanced fund approach of simply holding bonds is not a guarantee of safety. In extreme market conditions, conditional correlations between equities and fixed income can rise, as we saw in March 2020. Bond funds are not the only answer to manage risk.
• Hedging tail risk is one way of managing tail risk, but a passive systematic ‘always putting your foot on the brake pedal’ approach is very expensive, both in return upside foregone, as well as the actual risk in implementation.
• There is a growing need for active investment management approaches to choose non-traditional ways to tactically deal with non-linearity – choosing the appropriate conditions and execution for hedging.
• More than one lens is needed to view the market. Volatility conditions can provide insight into when hedging can be more cost-effective.
• In very benign markets, equity hedging eats up returns and downside risks are low. In highly volatile markets, when fear is already high, it is not the time to hedge. Protection costs are excessive. It is really in the “Goldilocks” times that dynamically hedging can take the sting out of the drawdown tail.

Multi-asset approaches need to evolve, both in how managers address diversification in extremes and how they purposefully hedge tail risk. Multi-strategy is such an evolution.