Tail risk management

February 1, 2012

Since the height of the Global Financial Crisis in 2008, institutional investors have spent considerable time investigating ways to limit the downside risk in their portfolios. The term “Black Swan” has been used extensively to classify hard-to-identify, but impactful, events that cause “tail risks” in investors’ portfolios. Investor timeframes and constraints differ and, thus, the decision of whether and how to hedge these risks will vary for investors.

In this paper, we discuss the nature of tail risks and evaluate at a high level the options available to institutional investors. We determine that managing tail risk can be done strategically or tactically, primarily through asset allocation, derivative overlay strategies, or through tail risk hedge funds. Importantly, each approach will have an associated cost, either explicit or implicit, and we discuss the trade-offs for each approach.