James Montier always provides a wonderful blend of value and behavioral principles, as well as humor in his written work. His books (I'm the proud owner of a signed copy of Value Investing) and articles are always worthwhile reads (and available for free on the GMO website once you create an account). Here is a tail risk hedging article Montier wrote in June 2011 (around the same time AQR published another piece on tail risk hedging – see our previous post on the AQR piece).
A year later, tail risk hedging remains popular. As Montier astutely points out, “The very popularity of the tail risk protection alone should spell caution for investors.” Nevertheless, he gives some practical advice on how to approach with caution, including:
- “Define your term.” – what exactly are you trying to hedge?
- Once defined, consider locating alternatives to “hedging” that could help achieve the same result. Montier gives a few examples of how to “hedge” the illiquidity/drawdown risk we experienced in 2008 without actually buying hedges.
- If buying insurance is the best course of action, be sure to calculate the expected return vs. the cost of insurance. This may require forward looking predictions on how certain existing securities/assets in portfolio will do in a tail event.
- Last but not least, the most difficult part: getting the timing right.
I will add the following remark skimmed from a previous PIMCO discussion. Be sure to consider your benchmark before indulging in tail risk hedging products. In certain instances, the annual premium of these insurance contracts may be greater than what you can afford. For example, in today’s environment, foundations aiming to achieve CPI + 500 via relatively senior fixed income securities may find it difficult to sacrifice a couple hundred basis points of performance to hedging premium.