Beefing up Tail Risk Protection in Volatile Markets

Beefing up Tail Risk Protection in Volatile Markets

In times of uncertainty and high volatility, investors need to employ ample and robust tail-risk hedging strategies and actively manage their investment allocations.

Tail risk is a form of portfolio risk where there is a chance that the standard deviation of an investment portfolio may shift beyond three standard deviations from its prevailing price. Tail risk gauges the variance of investment returns from its average returns.

While tail risk technically refers to both right/upside and left/downside tails, investors are most worried about losses (right/downside tail). The fact that tails risks are rare and most often come unexpectedly makes it difficult to prepare for. What makes things even more complex is the interconnected and interdependent nature of today’s global financial markets.

In 2022, a global asset management company PGIM conducted research on global tail risks and questioned 400 senior investment decision-makers at institutional investors in Australia, China, Germany, Japan, the UK, and the US with a combined AUM of more than $12 trillion. Based on the company’s findings, global investors see inflation as the primary market risk (69% high risk), followed by a recession (57%), interest rate risk, and stock market risk (both 42%). Inflation and recession risk are considered the biggest market risks across all regions and particularly among investors in the US and Europe.

Although a global market crash is a too far-fetched probability scenario, the recurrence of crises in major stock markets over years when equities perform especially poorly, makes it imperative for investors to have a dynamic multi-asset strategy that factors in macro tail risk and capital preservation to provide reliable diversification against volatile market environments. And one of the most rational ways of building portfolios is to diversify across investment options with low correlations to one another and the market.

“You have to have a mixture of bets because what happens will be different than anything you plan for, and where you think you have the protection you might not,” said Sushil Wadhwani, CIO of PGIM Wadhwani in the company’s Global Tail Risks Report 2022

One of the effective hedging solutions to tail risks are investment strategies that employ liquid alternative investments (or liquid alts), - typically exchange-traded funds (ETFs)with downside protection or so-called Separately Managed Accounts (SMA ) that can be bought and sold daily and come with lower minimum investment requirements than the typical hedge funds have.

Thus, Sigma Global Management, our partnering company in asset management utilizes liquid alternatives to provide investors with diversification and downside protection through exposure to market-neutral, long-short volatility-based strategy. The strategy is based on mathematical models of mean reversion - a phenomenon in financial markets where asset price volatility and growth rate will tend towards their long-term average values. The strategy is intended to generate performance that does not depend on the direction of the market movements.

It should be pointed out that Sigma’s strategy allowed to successfully neutralize the impact of the 2022 global and American financial markets’ crisis on accounts managed by the company, preventing double-digit drawdowns observed in the market throughout the year.

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