Tail risk management strategies

An overview

Introduction – why focus on tail risks in the current environment?

Institutional investors recognise that there is a need to accept investment risk in order
to generate the target return outcomes set out in their investment objectives. A natural
outworking of this process (that is, investing in assets which are not ‘risk free’) is that
there are likely to be periods where risky investments perform undesirably and poor
outcomes occur.
Risk is often referred to in terms of the standard deviation/volatility of returns,
correlation with equity markets or an overall risk score or measure1. But in managing
their portfolios, investors are typically concerned with avoiding, or at least mitigating
the impact of, events that occur infrequently, but which have a large negative impact on
portfolio returns. These events are often referred to as ‘tail events’, by virtue of the fact
that they lie within the left ‘tail’ of the potential distribution of returns.
With the rise of the derivatives market, financial instruments are now available
to investors which provide insurance against an array of financial risks. However,
conventional wisdom and investment theory tells us that the fair price for financial
insurance usually exceeds the expected loss that is being protected against. This
means that, over the long term, a structural allocation in a portfolio to financial
insurance will typically result in a drag on returns and, as a result, investor interest in
this space tends to be highly cyclical (and often in response to, rather than in advance
of, periods of significant market turbulence).
Following several years of very low volatility in capital markets, the return of volatility and
drawdowns in risky assets in recent months have brought tail risk protection strategies
back to the forefront of investors’ attention. Whilst we view the recent episode of market
volatility as being relatively moderate from a medium-term perspective we do believe
that, as communicated in our Secular Outlook 2015 publication, there are fundamental
reasons why downside risks continue to be elevated at present, including:
•• The significant public and/or private sector debt burden which still hangs over the
major developed economies and represents a headwind to economic growth
•• The fact that we sit in an economic expansion that is now ‘long in the tooth’
(compared to post war averages) combined with our view that there are numerous
potential catalysts for a downturn
•• The extraordinary levels of monetary stimulus which have been deployed since the
Global Financial Crisis that has yet to be removed. This both constrains the ability of
policymakers to counteract a future economic downturn and has caused valuations
of risky assets to rise to ‘stretched’ levels as investors have pushed along the risk
curve in search of additional returns
•• We believe that financial markets behave like a complex adaptive system, that is,
a system that is constantly evolving, with no central control and complex collective
behaviour, where the actions of one participant impact the actions of other
participants and vice versa. The complexity and interconnectedness of markets
increases the degree of uncertainty around future outcomes and combined with
the fragile state of economies (themselves complex and adaptive) at present may
amplify any resulting downturn.

1. The risk measures commonly used by investors can understate or ignore the impact of tail events – for example the
probability of a negative return does not reflect the severity of negative return outcomes, and the standard deviation
of returns gives equal weight to upside and downside volatility.
 Towers Watson currently assigns a higher than
normal probability of downside risks materialising
and an adverse economic scenario playing out. A
materialisation of some of these scenarios might
see a 30%-50% drawdown in equities markets,
similar to the 2000 Tech Bubble or 2008 Global
Financial Crisis. As well as experiencing poor asset
returns during a crisis, a stressed environment
could also expose deficiencies in a fund’s abilities
to manage counterparty risk, meet cash flow
requirements, rebalance or monetise assets
and mitigate detrimental stakeholder behaviour.
Successfully navigating these risks may incur a
significant administrative burden.
With institutional funds facing a rising number of
risks to the downside, we believe that clients should
now consider adding a form of tail risk protection to
their portfolios. While this topic has been discussed
at length in the past, in general implementing
tail risk management strategies remains poorly
understood. In this paper we look to further inform
this discussion by:
•• Articulating the main objective of tail risk
management
•• Providing an overview of the broad range of tail
risk management strategies
•• Assessing the strengths and weaknesses of the
various strategies available, and
•• Setting out a framework for determining which
strategies are most appropriate for a particular
institutional investor.
What are tail risk management
strategies trying to achieve?
The common approach adopted by many Australian
funds to try to minimise the impacts of left tail
events is to look to hold a diverse portfolio of
assets. While a lot of traditional diversification
strategies can help to reduce portfolio volatility
and improve risk-adjusted returns during ‘normal’
market conditions, we believe there are a limited
Figure 01. Example distribution of outcomes
Very poor
Painful ‘left tail’ scenarios Normal course of events
Funds should be most concerned A diversified portfolio is expected
about tail events, as in these to be well positioned to deal with a
scenarios risky asset correlations range of economic scenarios
increase and even a well- under ‘normal’ market conditions.
diversified portfolio will suffer.
Tail risk hedging objective: manage the frequency and magnitude of downside outcomes
2 towerswatson.com
number of genuinely diverse strategies that are
effective during stressed market conditions (in
which asset class correlations converge). Many
asset classes considered ‘alternative’ or diversifying
prior to the Global Financial Crisis, demonstrated
a higher correlation to equity markets during the
crisis (for example, hedge funds, property). That
is, while we continue to believe in diversity as an
effective policy lever, there are tail scenarios where
diversity will provide less portfolio protection than
would be expected based on ‘average’ correlations
between asset classes. In this paper we explore how
investors could implement targeted strategies which
look to mitigate the effects of left tail events on a
portfolio.
Firstly, we should consider the key drivers of large
negative portfolio returns as this provides a lens
through which to view the objectives of tail risk
management strategies. Looking at a distribution
of returns (example in Figure 01 below) the worst
results occur when an outcome is drawn from the
left hand side of the distribution. The further to
the left of the distribution the outcome occurs, the
more painful and undesirable the result. Therefore,
what we are really trying to achieve is to manage,
or limit, the frequency and magnitude of downside
outcomes.
There are three characteristics of the return
distribution which will ultimately drive the degree of
tail risk inherent in a portfolio:
•• Location – the mean, or expected return, which
the distribution is centred around
•• Dispersion – the width of the distribution, often
expressed as the standard deviation
•• Shape – the most commonly understood
distribution shape is the ‘normal’ distribution.
However, in reality return distributions for most
asset classes are not ‘normal’. Asset return
distributions tend to have fat tails and/or are
skewed.
Very good
Upside events
Nice to have upside
returns.
Minimising a left tail event will necessitate managing outcomes and/or have negative correlations
the return distribution through trying to control or with risky assets in a market downturn, as
influence one or more of these attributes. However, shown in Figure 03. These strategies attempt to
investors are faced with two problems when trying remove the risk of return outcomes being drawn
to manage and mitigate left tail events – risk and from the far left of the distribution. However
uncertainty. these strategies will not necessarily influence
the shape or dispersion of the rest of the
Risk relates to the variability of future outcomes. An
distribution; therefore investors are still subject
investor generally does not know where, within the
to the uncertainty that return outcomes can be
distribution of possible returns, the outcome over
drawn from anywhere else in the distribution
the next period(s) will lie – put a different way, we
(which has an unknown shape).
do not know in advance whether we will receive a
return that is at the median of the distribution, at Figure 03. Explicit hedges
the lower 5th percentile, the upper 25th percentile 6

or somewhere else. This is often managed by an 5

investor defining a maximum tolerance for downside

Probability density
4
losses and structuring the portfolio so that the
modelled downside risk for the portfolio falls within 3

the stated risk budget.

2

An issue with the conventional approach to risk

1
management is that it relies on knowing in advance
the width and shape of the return distribution 0
-50% -40% -30% -20% -10% 0% 10% 20% 30% 40% 50%
and in reality this is also an unknown and is Return
Unprotected Downside Hedge
potentially time-varying – this is what we refer to Source: Towers Watson

as uncertainty. That is, even if a level of tolerance

2. Attempt to re-shape the distribution (accept
can be articulated (for example, 1-in-20, 1-in-200)
risk, attempt to reduce uncertainty) –
the distribution of outcomes could be wider, more
Reshaping strategies generally aim to condense
negatively skewed or have a fatter left tail than
the return distribution (particularly the left
expected, which would result in downside outcomes
side), reducing the uncertainty of investment
being worse than predicted. As an example, it can
outcomes and, with it, the amount of tail risk
be observed that the realised volatility of equity
inherent in the portfolio. These strategies accept
returns has exhibited significant variation over time
that investment risk will always be present and
and that large drawdowns have tended to coincide
poor outcomes will occur. Instead, reshaping
with elevated levels of volatility, as shown in
strategies attempt to reduce or at least control
Figure 02 below.
the size of the tail of the distribution and reduce
Figure 02. Volatility vs realised returns the impact of a left tail event (or increase the
40%
degree of certainty around the size of such an
event). Following the implementation of these
20%
types of strategies the distribution of portfolio
Realised return (% pa)

0% returns might look as in Figure 04.

-20% Figure 04. Distribution reshaping
-40% 6

-60%
5
0% - 5%

5% - 10%

10% - 15%

15% - 20%

20% - 25%

25% - 30%

30% - 35%

35%+

Probability density

4
Realised volatility (% pa)

Source: Bloomberg LP, Towers Watson 3

Approaches to tail risk management

2

1
When looking to implement a tail risk management
program, there are two approaches investors can 0
-50% -40% -30% -20% -10% 0% 10% 20% 30% 40% 50%
take to try to (at least partially) mitigate investment Return
Unprotected Reshaped
risk or uncertainty:
Source: Towers Watson

1. Explicit downside hedges (accept

uncertainty, attempt to remove risk/tail of We identify strategies under both approaches which
distribution) – Attempt to remove/offset return can be implemented using either derivatives or
outcomes below a certain point through utilising physical assets; these are summarised in Figure 05.
strategies which either explicitly cut off downside

Tail Risk Management Strategies 3

 Figure 05. Summary of tail risk management strategies
Explicit Hedges
Physical •• Sovereign bonds
•• Gold
•• Commodities
Derivative •• Vanilla option strategies
•• Long volatility strategies
•• Constant Proportion Portfolio Insurance (CPPI)
•• Foreign currency (FX) exposure
Below we provide a brief overview of each strategy:
Physical assets – strategies that provide an
explicit downside hedge
Sovereign bonds – An exposure to long-duration
developed market government bonds, particularly
in a ‘safe haven’ currency (for example, US 30 year
Treasuries) has historically provided investors with
protection in most ‘flight to quality’ scenarios. Such
strategies may also involve leverage where suitable
long-dated bonds are not available (for example,
intermediate bonds could be leveraged) or to reduce
the capital intensity of the strategy. This strategy
may be particularly suited for investors with interest
rate-sensitive liabilities. However, there may also
be adverse economic scenarios (for example, a
sovereign debt crisis or a ‘right tail’ inflationary
growth slowdown) where bond exposures could be
additive to tail risk. In addition, current levels of
yields mean that government bonds may not offer
the same degree of downside protection as has
been the case in the past.
Gold – Historically investors have sought precious
metals as a ‘safe haven’ asset during times of
crisis. Gold can also act as a store of real wealth in
the event of an inflation ‘spike’. While gold may not
provide investors with the strongest equity market
hedge, it may protect against a variety of severe
market conditions, such as a (fiat) currency crisis or
a sovereign debt crisis. As well as direct investment
in the asset, investors could also gain exposure via
ETFs or derivatives – the latter options avoid having
to arrange for, and fund the cost of, storage which
is a common problem with physical investment in
commodities. Another problem with investment in
gold is the fact that it does not satisfy the usual
criteria for an asset – it does not have an associated
cash flow stream, nor is it a common input into
production of goods and services. As a result it is
extremely difficult to assess the attractiveness or
otherwise of gold prices.
Commodities – Exposure to a broad index of
commodities may provide protection from a tail
event that is characterised by an inflationary spike.
However the drivers of the spike will determine
4 towerswatson.com
Distribution Reshaping
•• Diversity strategies
•• Dynamic asset allocation
•• Managed volatility
•• Dynamic asset allocation
•• Put spreads
•• Fixed budget option strategies
the effectiveness of the hedge and also which
commodities will provide the highest level of
protection for the portfolio. Exposure to a basket
of commodities is likely to underperform in a
general economic downturn, where demand for
major commodities (for example, oil and iron ore) is
curtailed.
Physical assets that are expected to act as explicit
hedges against downside outcomes have common
advantages in that they are relatively liquid,
straightforward to implement and can be accessed
at a reasonable cost. The key disadvantages of
these strategies are that their effectiveness is highly
dependent on the nature of the tail event that occurs
and the payoffs from these strategies are relatively
linear. This means that high and/or leveraged
allocations are required to have a meaningful impact
in the event that equity markets suffer a significant
drawdown. Furthermore, the need to purchase
and hold physical assets may lead them to cause
noticeable impact/disruption on the structure of a
portfolio.
Physical assets – strategies that seek to
reshape the return distribution
Diversity strategies – True diversity involves
reallocating away from equities towards other, more
niche, assets that have exposures to return drivers
other than the equity risk premium. This, in theory,
results in a reduced concentration of macro risks
within a portfolio. There are essentially four key ways
investors could materially look to increase diversity
in decreasing order of impact and governance:
1. Increase the allocation to ‘diversifying strategies’
a. Liquid alternatives (for example, alternative
risk premia, skill based strategies)
b. Real assets (for example, real estate,
infrastructure and natural resources)
2. Better diversify the credit portfolio (for example,
high yield, loans, ABS and illiquid credit)
3. Better diversify within the equity portfolio (for
example, private equity and long-short equity)
4. Increased targeting of the skill premium within
the existing asset mix (for example, higher active
share equity managers).
While we expect diversity to continue to be a
valuable policy lever in the current environment, we
would note that these strategies have historically
underperformed equities in upwards trending
markets. In addition, these strategies generally
result in increased complexity/governance
requirements, and also generally higher direct
costs and illiquidity risk. Further, the nature of
these ‘uncorrelated’ strategies is that they are
unlikely to be well understood by the market and
therefore generate part of their excess return from a
‘complexity premium’ which, if re-priced, could result
in these strategies underperforming unexpectedly.
Finally, a number of these strategies essentially
exploit different forms of an insurance risk premium
and therefore have ‘left-tailed’ characteristics (that
is, incremental positive returns punctuated by sharp
losses).
Dynamic asset allocation – By dynamically adjusting
allocations to the underlying asset classes/
strategies in the portfolio, an investor can take
into account elevated valuations and/or downside
risks and allocate away from strategies that offer
unattractive risk adjusted returns at a given point
in time. Dynamic positions can be implemented
using either judgement or a rules based systematic
approach (or a combination of the two).
While Towers Watson does not currently (as at
October 2015) identify any areas where we observe
extreme mispricing, we would expect mispricing
opportunities to appear in any market characterised
by either excess or fear. A dynamic strategy should
encourage investors to purchase assets which
have been eschewed in an environment of excess
(generally, where the market has less exposure to
these assets they will likely outperform in a crisis).
Conversely, in a market ‘shock’ or downturn, panic
is likely to lead to risky assets being oversold
and market dislocations/mispricing opportunities
to occur. Furthermore, we expect divergence
of economic (and therefore capital market)
performance and heightened volatility to be key
themes over the medium term which should also be
favourable for a dynamic asset allocation process.
Whilst not an explicit downside hedge, simply
holding a higher allocation to cash could be
considered as complementary to a downside
protection program. During a market downturn, a
higher cash allocation would reduce the impact of
any losses, provide precious liquidity and could
be used to take advantage of any mispricing
opportunities which emerge. This takes advantage
of the so-called ‘option value’ of holding cash but is
contingent on the skill of an investor to be able to
identify an appropriate time to redeploy capital in
the market (otherwise this approach reduces long-
term expected returns).
A well implemented dynamic asset allocation
process will require significant internal and/or
externally sourced governance and resource in order
to ensure that decisions are well informed and can
be implemented efficiently.
Derivatives – strategies that provide an
explicit downside hedge
Vanilla option strategies – Options can be used to
provide a specified level of downside protection. This
could involve put options, collars and cash plus call
option strategies, and can be implemented across
various asset classes including equity, interest
rates, volatility and credit default swap markets. We
explain these terms below.
The simplest way to implement downside protection
via options is to buy (‘go long’) an out of the
money put option (that is, strike price lower than
current price) on a specific index (or security). It is
analogous to purchasing insurance in that the buyer
pays a premium which will profit if a market falls
below a specified level. The strike price of the option
can be chosen to set a specific ‘floor’ on returns for
the asset class being protected (at varying costs).
A long equity collar strategy involves the purchase of
an out of the money put option in conjunction with
the sale of an out of the money call option. This is
similar to the strategy above except that any upside
in excess of the call option strike level is foregone,
thereby somewhat (or in some cases completely)
offsetting the cost of the put option. For investors
adopting this strategy, implementing low cost
protection may take precedence over maintaining
upside potential, or alternatively an investor’s
preference for additional returns may not be linear
beyond a certain level (for example, a liability-driven
investor may receive diminishing benefit from returns
beyond a certain threshold/required level).
A cash plus call strategy involves obtaining exposure
to an asset class through holding cash plus a long
(typically at the money) call option as an alternative
to physical exposure to the asset. This strategy
provides exposure to appreciation in asset prices
while limiting downside to the cost of the call option
(less the return on the cash holding).
Implementing an option strategy can be complex
and involves a number of decisions other than
just the type of strategy to be implemented. Key
decisions include the level of protection sought
(for example, the strike levels of the options) and
whether any ‘upside’ will be given up in order to
reduce the cost of protection. In addition, the
Tail Risk Management Strategies 5
 choice in which markets to buy protection is not
trivial either as there is a natural trade-off between
complexity and cost (smaller markets may exhibit
lower liquidity/higher derivative trading costs), and
basis risk (whilst equity markets would be expected
to be globally correlated, idiosyncratic events can
impact individual markets in isolation). All of these
decisions will impact the cost of an option strategy.
The relative attractiveness of option prices may vary
across markets, strikes and tenors which means
that dynamic management of these factors can add
material value. In addition, as options have a fixed
maturity, these strategies are not ‘set and forget’
and decisions will need to be made including:
•• How to manage counterparty risks if over-the-
counter/non-collateralised instruments are used
•• Whether to ‘monetise’ options in the event that
a tail event does occur and gains accumulate
and, if so, what to do with the proceeds (for
example, reinvest in the asset class on the basis
that valuations are more favourable or purchase
cheaper protection instruments)
•• How to structure the expiry dates (for example,
laddered expiry vs single expiry), and
•• What to do when the options expire (for example,
reinvest the same protection strategy, adopt
a different strategy or invest in physicals).
The price of options can vary significantly over
time as market conditions change and can be
significant in periods of high market volatility.
Long volatility strategies – These are more complex
option-based strategies which involve purchasing a
portfolio of derivatives designed to deliver a ‘convex’
payoff in the event of a market drawdown associated
with a sharp rise in volatility. As noted in the first
section of this paper, periods of market stress
are often associated with a spike in volatility. As a
result, derivatives with a high ‘vega’ (that is, high
sensitivity to the volatility of the underlying asset –
typically long-dated and/or deep out of the money
options) will deliver strong returns in these types
of environments. Due to the convex nature of the
payoff profile, a long volatility strategy may generate
a return which is several multiples greater than the
underlying drawdown in equities (for example, a 25%
drawdown in equities could result in a payoff for a
long volatility strategy in excess of 100%).
There are a number of these types of strategies
offered by fund managers aiming to deliver a
strong payoff if a tail event occurs. In addition,
these managers generally look to generate ‘alpha’
relative to holding a naïve portfolio of options and
dynamically manage the portfolio (for example, by
looking across geographies, markets and tenors
to identify where volatility can be purchased more
cheaply) to mitigate the cost of premium ‘bleed’ in
periods where no event occurs.
6 towerswatson.com
Constant Proportion Portfolio Insurance (CPPI)
– CPPI utilises quantitative models to allocate
dynamically between risk free and risky assets
in order to replicate an option-type payoff. A CPPI
strategy seeks to cap an investor’s downside
risk while maintaining exposure to risky assets
in sideways and upwards trending markets. The
rebalancing of risky asset exposures is typically
done using listed futures to limit trading costs and
to improve liquidity.
The advantage of CPPI strategies is that they are
not subject to the premium drag associated with
traditional options. The downside is that because
these approaches are reliant on rebalancing
between risk free and risky assets in response
to market movements (which incurs transaction
costs and cannot be done in continuous time), CPPI
strategies do not protect against scenarios where
markets fall sharply or ‘gap’. CPPI strategies can
also be exposed to losses in sideways markets as
they are effectively trying to anticipate the beginning
of a trend which may not materialise. In addition,
as these strategies increase the allocation to cash
(as the price of risky assets fall), they effectively
become ‘cash locked’ when the protection floor
is reached, preventing participation in any future
recovery.
Foreign currency (FX) exposure – In financial
market crises, ‘risk-on’ currencies (such as the
Canadian Dollar and Australian Dollar) have tended
to depreciate against ‘risk-off’ developed market
currencies (such as the US Dollar, Japanese Yen
and Swiss Franc). Investors could hold an exposure
to a basket of risk-off vs risk-on currency pairs, if
they have conviction that the correlation between
equities and risk-on currencies will hold in future
market downturns. This strategy may incur a
cost of carry (depending on relative interest rate
differentials of the underlying countries for the
currency exposures held), but a specific currency
basket could be constructed and accessed relatively
easily and inexpensively using derivatives.
Derivatives – strategies that reshape the
return distribution
Managed volatility – These approaches recognise
that the volatility of asset classes varies over
time and utilise quantitative models to estimate
the prevailing level of asset class volatility using
market data (which may include historical return
data, implied volatility or a combination of both
and other factors) and use this to make predictions
about the level of volatility in the near future.
These strategies then use listed futures to adjust
the exposures to the underlying asset classes to
target a level of either asset class or total portfolio
volatility that is specified by the asset owner.
Simplistically, if measured volatility is higher than
the target level then total portfolio risk is reduced
and vice versa – minimum/maximum limits around
asset class exposures (for example, to ensure the
portfolio remains long-only) can also be applied. In
principle, these approaches can be applied across
a wide range of asset classes, including equities,
fixed income, credit, commodities and currencies.
They can also be implemented as an overlay to the
portfolio or as a managed fund solution.
If the model being used to estimate volatility is
effective then the realised volatility of portfolio
returns should be controlled within a relatively
narrow range rather than being allowed to vary
with market conditions. This in turn addresses the
problem of uncertainty addressed earlier, providing
an investor with greater confidence in the estimate
of the magnitude of potential downside outcomes
for their portfolio. As an example, a managed
volatility overlay could be implemented that targets
a level of portfolio volatility that is equal to the
volatility assumption used by an investor in its
asset allocation model. In addition, if the historical
observation that expected returns are higher in a
low volatility environment and vice versa (as shown
in Figure 02) holds in future, then strategies should
both reduce the magnitude of downside outcomes
and also be accretive to expected returns. However,
it should be noted that these strategies do not
explicitly limit downside risk.
As these strategies use listed futures they are
highly liquid and can be implemented at low cost. A
systematic approach is also transparent and avoids
risks associated with using human judgement. On
the other hand, managed volatility strategies rely
on the modelling of prevailing volatility at a point
in time. The strategies are therefore susceptible
to model risk and will underperform in situations
where markets and/or the models used misprice
or misestimate volatility. The performance of
these strategies is also somewhat reliant on the
assumption that the historical negative correlation
between volatility and returns on risky assets holds
in the future.
Dynamic asset allocation – A dynamic asset
allocation process could also be implemented using
derivative instruments (for example, using futures,
options and/or other instruments) to implement
over/underweight exposures to asset classes. This
would be particularly appropriate for a process that
uses a relatively short time horizon (12 months or
less) or where only a moderate level of conviction
is required to implement a dynamic position, which
would in turn imply a higher frequency of position
changes. For some asset classes, using derivatives
is likely to be more efficient and cost effective than
purchasing the physical assets.
Put spreads – A put spread consists of purchasing
and selling put options covering the same notional
asset class value at differing strike prices. In
the context of managing tail risks this will involve
purchasing an out of the money put option and
selling a put option that is further out of the money
– essentially a put spread involves purchasing
protection at a certain level and selling away
protection at a lower level. This in turn results in
the portfolio being fully protected for losses that
fall between the two strike levels of equivalently the
portion of the return distribution falling between the
two strikes being ‘shifted’ to the initial protection
level. These strategies can also involve selling out of
the money call options to further reduce the overall
cost if an investor is willing to forego upside beyond
a certain level.
Option prices exhibit a volatility ‘skew’ which means
that, per unit of protection provided, put options
become relatively more expensive as they become
further out of the money (that is, as the strike
price decreases) – this reflects both risk aversion
to significant losses and also market demand/
supply dynamics. This means that the range of
returns protected by a put spread can be set to
cover the most likely range of losses (for example,
those expected to occur with say 90% to 95%
likelihood) whilst avoiding paying for protection from
more extreme losses that are a) very unlikely and
b) expensive to protect against. These types of
strategies may also be appropriate for investors who
are highly peer sensitive as they are lower cost than
simply buying put option protection and generate
outperformance relative to long-only investors
without an option overlay in the event of moderate
market losses.
Fixed budget option strategies – As a variation
of vanilla put option strategies, an investor could
allocate a fixed dollar budget towards purchasing put
options. The amount of protection offered by this
strategy will vary over time as option prices change.
This strategy would be appropriate for a cost
sensitive investor who has a fixed amount they are
willing to spend on purchasing portfolio protection.
In addition, it has often been observed that implied
volatility (and therefore option prices) tend to lag
market events. In particular, implied volatility tends
to rise sharply after a large equity market fall or
increase in realised volatility and also that such falls
tend to be preceded by a period of unusually low
realised and implied volatility. This means that, in
many cases, option protection was ‘cheap’ at exactly
the time it would have been beneficial to be holding
such protection and very expensive after the event
– a fixed option budget strategy would therefore be
consistent with a belief that this phenomenon is
likely to continue to repeat in the future.
Tail Risk Management Strategies 7
 Assessing tail risk management can be made separately from the decision regarding
strategies which tail risk management strategies to employ.

In this section we look to measure each Liquidity – In a stressed market environment

strategy against the following criteria for tail risk
management strategies.
Strategic and cyclical attractiveness – The
economic cycle can be considered to have four
broad phases – recession, trough, recovery and
peak. As discussed earlier in this paper, we believe
that we are currently in the ‘peak’ phase of the
global economic cycle and that there is an elevated
risk of a recession occurring over the medium term.
As the key drivers of the economy and therefore
capital markets differ through each phase of the
cycle, so too does the relative attractiveness of
various risk management strategies. We set out
in Figure 06 below the typical attractiveness of
different risk levers through the economic cycle
(absent of valuation considerations).
Figure 06. Cyclical attractiveness of various risk
levers
Lever Recession Trough Recovery Peak
Diversity    
Bonds  
Option
 
Strategies (sell) (buy)
Extreme  
Hedges
liquidity is often scarce, therefore it would be
desirable if the strategy(ies) implemented can be
monetised quickly and efficiently so that payoffs can
be realised if a tail event occurs.
Complexity – Strategies that can be both easily
understood and implemented are preferable to more
complex ones.
Operational risk – The risk of loss resulting
from inadequate or failed internal procedures,
people and systems. The nature of a number of
the tail risk management strategies discussed in
this paper is that they involve a greater degree
of potential operational risk compared to more
conventional investment strategies, whether due
to human error or systems failure. Strategies with
greater operational risk will require advanced (fund)
governance structures in place.
Model assumption risk – The risk of the strategy
not capturing/mitigating the risks it was designed to
due to errors in the models or assumptions utilised.
This is predominantly applicable for quantitatively
driven strategies and processes. This risk is also
relevant for strategies that rely on specific historical
relationships applying in the future in order to be
fully effective.

Cost – Strategies which look to mitigate downside

risks tend to involve costs that exceed the
expected loss being protected against – ideally the
strategy(ies) implemented by an investor will be
selected and managed in such a way as to minimise
these costs. We consider both explicit costs
(incurred when adopting/moving to the strategy or
maintaining the position) and implicit costs (such
as the impact of negative carry on some derivative
positions or the opportunity cost of having to hold/
purchase ‘risk off’ assets which may create a drag
on performance in normal market conditions).
We note that a number of protection strategies
can be implemented on a relatively cost effective
basis at the moment. One benefit of the monetary
tightening which has occurred across the developed
world across the past several years is that
numerous protection strategies can be accessed
relatively cheaply (particularly strategies which incur
a cost of borrowing) due to the low interest rate
environment.
Portfolio disruption – We generally prefer
strategies that limit, as far as is practicable, the
disruptive impact on the rest of the portfolio – in this
way the broader strategic asset allocation decision

8 towerswatson.com
 We set out in Figure 07 below an assessment of the various tail risk management strategies identified in this
paper against the criteria set out on the previous page, as well as assign an overall rating (between one and
three).

Figure 07. High level evaluation of tail risk management strategies

Strategic Cost Portfolio Liquidity Complexity Operational Model/ Overall

and cyclical disruption risk assumption rating
attractiveness risk
Physical assets – strategies that provide an explicit downside hedge

      
Sovereign
bonds 
Gold
       
Commodities
       
Physical assets – strategies that seek to reshape the return distribution

      
Diversity
strategies 
      
Dynamic asset
allocation 
Derivatives – strategies that provide an explicit downside hedge

      
Vanilla option
strategies 
      
Long volatility
strategies 
CPPI
       
FX exposure
       
Derivatives – strategies that reshape the return distribution

      
Managed
volatility 
      
Dynamic asset
allocation 
Put spreads
       
      
Fixed budget
options 

Positive  Neutral  Negative 

We summarise the key advantages and disadvantages of each strategy in the Appendix to this paper.
Notes
•• We assume that all derivative contracts are exchange traded or collateralised and therefore have not
factored credit/counterparty risk into the ratings.
•• Vanilla option ratings assume a long put strategy is employed.

Tail Risk Management Strategies 9

 Aligning a tail risk management strategy
with Fund beliefs, objectives and
circumstances
In addition to the metrics outlined on the previous
page, the suitability of the various strategies is critically
dependent on an investor’s beliefs, circumstances and
objectives. Before adopting a tail risk management
strategy we would encourage investors to consider the
following steps:
1. Consider the strategies in the context of risk
objectives or risk statement – The starting point
for all investment strategy decisions is an investor’s
risk objectives and/or risk appetite statement as
particular approaches are likely to be more aligned
with certain objectives.
For investors who aim to limit the ‘probability of
negative return’, reshaping strategies may perform
better as narrowing the return distribution can serve
to reduce/control the shortfall probability.
Explicit downside hedging strategies that look to
remove negative outcomes beyond a certain point
will tend to result in similar (or potentially slightly
increased) shortfall probability outcomes and are
therefore likely to be more suitable for investors who
aim to limit the ‘5th percentile return’, or ‘expected tail
loss’.
For investors who aim to perform well relative to
peers in poor markets, strategies which attempt to
moderate negative returns (for example, put spreads
or [a low] fixed budget option strategy) will perform
well. These strategies will materially outperform the
‘average fund’ in a downturn, while only incurring a
moderate cost to maintain the position(s) across calm
markets (where arguably sensitivity to peer risk is
lower in any case).
2. Identify any specific risk(s) to the portfolio –
Once key tail risks or ‘pain’ thresholds have been
identified, specific strategies can be identified to
mitigate these risks.
One approach is to determine which particular
scenarios and/or subset of the portfolio poses the
biggest threat to the portfolio achieving its investment
objectives. Having completed this process, investors
could decide to target either specific or idiosyncratic
risks (for example, long sovereign bonds if liabilities
are interest-rate sensitive) or a broader approach
encompassing a variety of risk scenarios. However
most investors will conclude that equity market risk
poses the biggest threat to their mission impairment
and it is the risk of a sharp fall in equity markets
which needs to be cushioned.
In addition, the nature of the downturn will materially
impact which lever is most attractive:
•• In a sharp downturn, options and other strategies
with a convex payoff profile are likely to perform
best as this will likely coincide with a sharp rise in
10 towerswatson.com
volatility and the payoff will be monetised before
too much premium drag is incurred
•• In the event of a continued period of calm in
markets or a gradual downturn strategies that look
to reshape the return distribution (in particular
diversity and other strategies that do not incur cost
of carry) will likely perform better.
It is important to note that whilst we have evaluated
each strategy in isolation in this paper, utilising
multiple downside protection tools could be the most
effective approach towards protecting a portfolio
across a spectrum of potential adverse scenarios.
3. Gauge how much tail risk exposure exists in
the portfolio – Quantitative modelling, such as
calculating portfolio Value at Risk (VaR), can be useful
for indicating the potential magnitude/amount (of the
tail loss) a fund could be expected to incur.
Even at the portfolio level, left tail events will tend to
occur more frequently than standard models predict
because in times of stress:
•• Correlations among risk factors typically rise
•• Different economies and factors may behave like
one another, and
•• Volatilities across most markets will generally rise.
We would encourage investors to look at ways in
which their existing modelling frameworks can be
enhanced/augmented to compensate for these
limitations, including:
•• Recognition of the impact of uncertainty by
incorporating multiple volatility regimes and/or the
possibility of market ‘gaps’/jumps
•• Application of ‘left tail multipliers’ to modelled
tail risk outcomes and/or carrying out modelling
with increased correlations, in particular when
considering more complex strategies with limited
track records, and
•• Stress testing portfolios using deterministic
scenarios that represent events that are expected
to materially impair the portfolio.
Quantitative measures of downside risk should be
treated only as indicative. These are likely to only
capture a select number of possible ‘paths’ or
adverse scenarios which could play out. However,
quantifying downside risk can provide a fund with
valuable perspective for how a downturn may affect
the portfolio.
4. Have a (broad) cost budget for implementing the
tail hedge – Estimating costs for implementing tail
risk management strategies can be difficult. However
investors should recognise/accept that it is likely that
there will be some ongoing cost for sustaining a tail
risk management program and then ascertain the
level of cost they are willing to outlay for protection.
It is generally acknowledged that implementing
tail risk hedges is expensive, as investors end up
paying away a risk premium in order to remove
these risks from their portfolio. This is because the
tail risk that an investor wants to remove has to be
passed on to someone else –almost all investors
want to remove this risk, and virtually no investors
structurally benefit from a market downturn.
However, there are two possible approaches
to minimising the cost of a tail risk protection
program.
Opportunistic tail risk protection: The simplest
way to implement a position is to purchase the
instrument/asset and maintain the protection
indefinitely (rolling it over if using derivatives). This
is called a static hedge and it can be expensive to
roll-over and maintain. A cheaper alternative to a
static hedge is to ‘turn on’ the tail risk hedge when
there is a signal that there is an elevated likelihood
of a left tail event occurring in the near future. The
key issue with an opportunistic approach to hedging
is timing – both being able to foresee when market
corrections may occur and having the appropriate
governance structure in place to implement the
tail-risk hedge expediently and also to determine
when the hedge should be removed. An additional
risk associated with an opportunistic approach is
that after identifying an appropriate time to add
protection the price of the instruments being used
to manage tail risks may rise sharply before the
relevant strategies can be implemented.
Derivatives based strategies are likely to be more
compatible with an opportunistic approach where
positions need to be adjusted quickly and in a cost
efficient manner. In contrast, where protection is to
be held on a strategic basis strategies which use
physical assets may be more appropriate.
Indirect tail-risk hedging: Depending on timing and
market dynamics, often the most ‘direct’ hedging
solution will be the same protection that other
investors are looking to buy and therefore the
most expensive. However, there may be ‘indirect’
hedging alternatives that provide sufficient left-
tail protection at a significantly cheaper cost.
For example, the cost to hedge equity risk using
options can vary greatly across global markets for
a similar type of protection. Different asset classes
or derivatives may also provide suitable hedging
proxies (for example, it is often observed that Asian
implied volatility tends to sell off in the event of a
crisis that impacts developed market risk assets
but derivative pricing tends to be cheaper in Asian
markets than in the major developed markets due
to the demand/supply dynamics of the regional
structured products markets). The protection
coverage offered by indirect hedging alternatives
can be very strong, especially during times of
market stress when asset correlations tend to ‘go
to one’. Of course, these patterns will not hold in all
circumstances.
5. Other considerations – These may include
investor-specific requirements and restrictions.
Two common restrictions in the tail risk protection
space include the use of derivatives and leverage.
Many investors currently do not directly trade
derivatives in their portfolio, either due to explicit
guidelines and/or laws. While investment into
funds which use derivatives, such as ‘real return’
funds or hedge funds is generally acceptable, pure
derivatives based strategies are still generally
avoided. Similarly there may be a limit on a fund’s
ability to use leverage within the portfolio.
Investors should confirm and clarify applicable
restrictions with their investment guidelines and
legal counsel before looking to implement specific
tail risk management strategies.
6. Articulate the key parameters for the tail risk
management program – Once an investor has
decided to implement a tail risk protection program,
it is beneficial to articulate the key parameters for
any proposed tail risk management strategy(ies),
including the objectives of the program and the
timeframe over which these are to be achieved.
When implementing a risk mitigation strategy,
success measures can be difficult to define. For
example, the best outcome would be that no
negative tail event occurs, in which case most
tail risk strategies would be expected to detract
value. However, stipulating the goals and objectives
should assist in giving a clear purpose for any
downside protection program and is also useful
for reconciling any strategy implemented against
the underlying objectives of the program. This is
crucial if the program is to be implemented over an
extended timeframe.
The types of parameters which could be
established include:
•• The range of returns that are to be protected
against at the portfolio and/or asset class level
•• The expected performance of the program (in
the event that returns in the ranges set out
above materialised)
•• Actions to be taken if an event occurs (for
example, take profit vs reinvestment rules)
•• Time horizon for the program (including criteria
for winding-up the program)
•• The cost budget for the program
•• Liquidity requirements
•• Monitoring requirements and responsibilities.
Tail Risk Management Strategies 11
 Conclusion
As set out in this paper and also in our Secular Outlook 2015, in the current environment there are a range of
potential catalysts for a further market downturn. As always, how or when a downturn will occur is unclear. We
therefore continue to believe that diversification across a diverse range of risk premia and investment strategies is
the primary lever investors should use to manage risk in the current environment. This will result in a portfolio that
has less concentration to any one specific macro risk.
This said, we believe that investors should consider adding tail risk management strategies to their portfolios to
reflect growing downside risks in the current environment. We believe that with a wide array of downside protection
tools available (the majority of which can be implemented cost effectively) investors should be able to identify a
strategy aligned with their investment objectives. To this end, the aim of this paper is to go beyond the diversity lever
and to familiarise investors with various strategies which could add an additional layer of protection to portfolios, as
we move to a market environment where risks to the downside are steadily increasing.
There is no single perfect solution, and the suitability of each strategy is largely going to be fund specific. Towers
Watson’s role is to assist our clients in determining which investment ideas may be suitable for their portfolios.
Figure 08 below provides a very high level summary of the types of investors for whom different strategies might be
appropriate.

Figure 08. Aligning a tail risk management strategy with your fund

Explicit Tail Hedges Reshaping Distribution

Physical •• Investors defining risk as VaR/expected tail loss •• Investors defining risk as shortfall probability
Assets •• Low governance investors •• Investors looking to manage (limit) the dispersion
of returns
•• Low/medium governance investors
Derivatives •• Investors defining risk as VaR/expected tail loss •• Investors defining risk as shortfall probability
•• Investors looking to protect against a sharp •• Investors aiming to outperform peers
drawdown •• Investors with a low cost budget
•• Investors with a moderate to high cost budget •• Investors intending to implement a highly dynamic
•• Investors intending to implement a highly dynamic tail risk management program
tail risk management program •• High governance investors
•• High governance investors

The main actions that we suggest investors take at the current time are as follows:
1. Make a high-level decision as to whether 5. Determine an acceptable total budget/cost for
consideration should be given to implementing purchasing tail risk protection
tail risk management strategies in the portfolio,
6. Determine the range of strategies that are in
taking account of investment beliefs, mission
scope, taking into account any investor-specific
and governance
requirements or restrictions
2. Consider existing risk objectives to determine
7. Articulate key parameters for the tail risk
what categories of tail risk management
management program, and
strategies are likely to be appropriate
8. Using internal resource or external advice
3. Identify the key drivers of tail risks in the
(or a combination), design and implement an
portfolio and a ‘pain threshold’
appropriate basket of tail risk management
4. Assess the level of downside risk in the portfolio strategies.
using quantitative models, enhanced where
possible to reflect the shortcomings of traditional
models

12 towerswatson.com
Appendix – Advantages and disadvantages of key tail risk management strategies
Advantages Disadvantages
Physical Assets – strategies that provide an explicit downside hedge
Sovereign •• Highly liquid, low cost •• May not offer sufficient upside at current yields
bonds •• Low governance, simple to implement and understand •• Capital intensive, requires significant allocation and/or leverage
•• Should protect against most likely (disinflationary) to achieve meaningful protection due to linear payoff
downside scenarios
Gold •• Store of wealth, should protect against a range of •• Likely negative expected long-term carry
downside scenarios •• Assessing valuation extremely difficult
•• Low governance, simple to implement and understand •• Capital intensive, requires significant allocation and/or leverage
•• Can be implemented via ETFs to achieve meaningful protection due to linear payoff
Commodities •• Liquid, relatively low cost •• Will only hedge against an inflationary/right-tail scenario
•• Low governance, simple to implement and understand •• Assessing valuation extremely difficult
•• Capital intensive, requires significant allocation and/or leverage
to achieve meaningful protection due to linear payoff
Physical Assets – strategies that seek to reshape the return distribution
Diversity •• Reduces concentration of macro risks •• Typically involves greater illiquidity and higher costs
strategies •• Strategically attractive in all parts of the cycle •• A number of ‘uncorrelated’ strategies are untested across
•• Positive carry different environments
•• Tends to underperform in strong equity markets
•• May still exhibit correlation to equities in a crisis
Dynamic •• Addresses elevated valuations •• Significant governance/resources required
asset •• Should perform well in an environment characterised by •• Wide asset allocation ranges required to achieve meaningful
allocation divergence protection
Derivatives – strategies that provide an explicit downside hedge
Vanilla option •• Offers absolute downside protection •• Relatively expensive if held on a rolling basis
strategies •• Low capital intensity/impact on portfolio •• Ongoing management not straightforward
•• Relatively straightforward to understand
Long volatility •• Provides returns that are a multiple of equity market •• Complex, not transparent
strategies drawdowns in the event of a significant market event •• Potentially less liquid than other strategies
•• Relatively small allocation required to achieve material •• Significant judgement required/reliance on manager skill
level of protection
•• Negative carry (but this can be managed to some extent)
CPPI •• Liquid, relatively low cost •• Exposed to market ‘gaps’/jumps
•• Transparent, systematic approach •• Complex to implement, material operational risk
•• Can become ‘cash locked’ when protection floor is reached
preventing participation in any subsequent recovery
FX exposure •• Highly liquid, low cost •• Exchange rates (and foreign currency exposure) can be highly
•• Low governance, simple to implement and understand volatile
•• Less capital intensive than other physical solutions as •• May incur a carry cost (particularly for unhedged AUD exposures)
implemented as an overlay •• Relies on historical relationship between ‘risk-off’ currencies and
risky assets holding in the future
Derivatives – strategies that reshape the return distribution
Managed •• Directly addresses uncertainty associated with •• Reliant on effectiveness of model used to estimate prevailing
volatility measuring downside risk market volatility
•• Liquid, relatively low cost •• Some exposure to operational risk via execution capability of
•• Transparent, systematic approach manager
•• In theory should be accretive to risk-adjusted returns
•• Can be run as an overlay, minimal portfolio impact
Dynamic •• Addresses elevated valuations •• Reasonable level of governance/resources required
asset •• Should perform well in an environment characterised by •• Wide asset allocation ranges required to achieve meaningful
allocation divergence protection
Put Spreads •• Lower cost than a strategy of holding out-of-the-money •• Somewhat more complex than a vanilla option strategy
put options •• Material governance/resources required to manage on an
•• Protects against most frequently experienced losses ongoing basis
and avoids paying for insurance against very rare losses •• Exposure to operational risk via internal or external execution
•• Will improve peer relative outcomes in weak markets capability
Fixed budget •• Cost is known in advance •• More complex to understand and manage than a program with
options •• Consistent with empirical observation that significant fixed notional exposure
market downturns often follow periods of low volatility •• Level of protection is variable – may not have protection when it
is required
Tail Risk Management Strategies 13
Contact
If you would like to discuss any of the areas covered in more
detail, please contact your usual Towers Watson consultant,
or:
Jeffrey Chee
Senior Investment Consultant,
Head of Investment Strategy, Australia and Asia-Pacific
+61 3 9655 5126
jeffrey.chee@towerswatson.com

About Towers Watson
Towers Watson is a leading global professional services company
that helps organisations improve performance through effective
people, risk and financial management. With 16,000 associates
around the world, we offer consulting, technology and solutions in
the areas of benefits, talent management, rewards, and risk and
capital management. Learn more at towerswatson.com

The information in this publication is general information only and does

not take into account your particular objectives, financial circumstances
or needs. It is not personal advice. You should consider obtaining
professional advice about your particular circumstances before
making any financial or investment decisions based on the information
contained in this document.

Towers Watson Australia Pty Ltd

ABN 45 002 415 349, AFSL 229921
TW-AP-15-45582. October 2015

Copyright © 2015 Towers Watson. All rights reserved.

towerswatson.com

/company/towerswatson @towerswatson /towerswatson