In Praise of Risk Aversion
“And the seasons they go ’round and ’round
And the painted ponies go up and down
We’re captive on the carousel of time”
— Joni Mitchell The Circle Game
The hardest day to invest is always the current one. Despite this truth, investors have a tendency to look back and contend that making a buck was easier in the past. In our decades of investment experience, we can’t recall a single day that felt easy at the time.
History may repeat itself, it may rhyme, or it may prance to a different tune entirely. Although we can’t know which will occur, it sure feels a lot like we’re back on the same carousel we rode in the mid-2000s. Sitting high on their horses, credit markets are offering return-free risk, and massive leverage in the system has shifted from private to public hands. The discount rate on equities is artificially suppressed thanks to the constant running of monetary printing presses around the world, and equities have responded with fund inflows and returns for all.
Unfortunately, Herbert Stein’s law dictates that if something cannot go on forever, it will stop. Debt cannot grow unbounded, and the quantitative easing game that started by necessity to resuscitate a badly wounded financial system in 2008 will inevitably end.
The circle game of mean reversion plays out time and again in markets. Last quarter, emerging market equities touched an extreme point of underperformance relative to developed markets. Sure enough, a few months later, emerging markets soared in absolute and relative terms for reasons that few could have predicted a quarter ago. To put things in perspective, the global debt binge that will eventually revert is like a Clydesdale horse standing next to a tiny toy pony that represents the degree of underperformance by emerging markets.
What makes the environment so difficult for investors is not the macro-awareness that sovereign-buttressed conditions will end but, rather, the impossibility of knowing the timing. When the man at the control stops the carousel, or even suggests he might (see Bernanke, Ben), security pricing will search for a new, lower equilibrium and cause pain across many capital markets. Our challenge as investors is to figure out what to do about it.
The Tale of the Tail
“To protect or not to protect. That is the question.”
— Admittedly poor rephrasing of the famous opening of a soliloquy in Shakespeare’s Hamlet
Sources: Bloomberg, Protege Partners
Back in 2006 and 2007, the investment community worried so little about negative outcomes that the pricing of financial insurance was ludicrously cheap across the board. With implied equity volatility in the teens, high-yield credit spreads at historic tights, and sovereign credit default swaps trading at single-digit basis points, investors attuned to what might happen could have purchased a healthy amount of downside protection while still more or less fully participating in the upside should the markets have carried on unabated.
As the carousel ponies shifted from high to low in 2008, “tail risk protection” became the rage for institutions as a newly discovered area to allocate a risk budget. The great irony was that insurance was no longer cheap and was highly likely to contribute to underperformance. If given a choice, we would never purchase insurance on a $1 million home that costs $300,000 each year. Yet fear ruled the day, and those seeking protection after the crisis typically were solving for yesterday’s problem, not tomorrow’s.
After five years without a realized tail event, many investors who bought expensive insurance have grown weary of incurring losses year after year. Some have abandoned their “program,” rationalizing that tail events are less likely to occur than they were a few years ago. Whether or not that stance proves correct going forward, the notion of buying high and selling low(er) is anathema to investment success over time.
Even though we are all more macro-aware today than we were before 2008, the circle game of downside risk protection is exactly the same. We can protect portfolios from an event that we believe will cause pain in the future, but we need a good enough sense of timing to ensure that the sum of premiums paid before the day of reckoning will be less than the insurance we collect when that day comes. If we are too early, losing money will trump the intellectual satisfaction of being right.
When maintained through a cycle, tail protection is very expensive. Not only are tails low-probability events, but also, unlike amusement park ride insurance, we have no guarantee that we will spend our risk budget on the correct tail when lightning strikes. For example, in June 2009, one of the only forms of tail protection that would have made money — shorting sovereign debt — was the very safe haven many investors sought with their underlying assets in a moment of existential panic.
Today, we are stuck in the middle. Macro risks are high but seemingly not imminent. Some financial insurance seems appealing, but pricing is mixed. The Chicago Board Options Exchange Volatility Index (VIX) looks even cheaper than it did in 2007; however, the term structure of volatility is substantially steeper and makes the purchase of long-dated equity protection deceivingly expensive. High yield has entered territory that belies the moniker “high,” but most investors are allergic to the negative carry associated with shorting junk bonds. Long-dated volatility on U.S. Treasurys appears unusually cheap, yet G–7 credit spreads are quite wide.
Although I can’t profess to have a special insight as to when the big tail event may strike, markets are getting a little blasé in their acceptance of risk in the interim. Our challenge as investors is to position to compound capital at an adequate rate while protecting the portfolio sufficiently to survive a 100-year flood that could strike at any moment.
Buckle Up and Enjoy the Ride
When a steady budget for tail insurance incurs high opportunity cost and the timing of the big kahuna seems a ways off, the only other tool at our disposal is simply to take less risk. The investment strategies we pursue, and those followed across the board by risk-averse investors, share the common goal of winning a war after losing most of its battles. The majority of the time, markets rise and hedged strategies underperform. During the few times that markets fall, the outperformance of successful hedged strategies more than makes up for forgone gains during the good times. That results in a tricky political setup where investors must convince clients that their low batting average against the markets is little cause for concern. All too often, clients depart and funds suffer the unfortunate outcome of achieving higher time-weighted returns than dollar-weighted returns.
Despite its structural challenge, a risk-averse approach seems a wise route to pursue today. Were we handed a blank sheet of paper to allocate to assets around the world, it’s not clear that owning stocks could achieve long-term spending needs without a serious bump in the road, and it’s abundantly clear that buying and holding fixed-income instruments wouldn’t produce satisfying returns for a long, long time. Just as riding a carousel alongside our children somehow isn’t as much fun as we remember it being in our youth, the bull market since the crisis hasn’t been a joy ride for active managers with their reigns pulled back a touch in fear of what could happen.
Author’s Endnote: Laurence B. Siegel and Stephen C. Sexauer did a very nice job laying out a framework for thinking about tail risk investing in “Managing Tail Risk,” Retirement Income Journal, vol. 2, no. 3 (Fall 2012). It is also available here