Tail-risk management is a new frontier of asset allocation, but industry experts are divided about the most cost-effective delivery mechanism. PHILIPPA YELLAND reports.

More frequent nonnormal returns and dramatic swings in valuations are turning the spotlight on tail risk, says Michele Hardeman, manager of foreign exchange sales at State Street Global Markets in Australia. Some asset managers began 2010 armed with options strategies designed to fend off tail risk for multi-manager funds. But rather than outsourcing this function to a third party, funds should be looking to develop in-house options expertise, says Wade Matterson, financial risk management practice leader at Milliman Actuaries and Consultants. “Yes, use a third party in the short-term, but funds need to take ownership,” he says.

“If they’re legitimate about keeping costs down, then they must think inhouse.” State Street’s Hardeman said the single greatest failure of risk management recently was the use of average risk numbers rather than regime-specific analysis to gauge risk. “The study of financial turbulence seeks to help asset allocators to develop more reliable inputs into portfolio construction and risk management during volatile markets,” she said. However, Matterson says the missing link is to align tail-risk hedging to members’ specific circumstances. “It’s putting the cart before the horse to take a blanket approach to risk management,” he says. Considering a member’s position in the age pension “taper zone” was crucial in the application of tail-risk management, he says.

For a member receiving the full pension, “tail-risk management is of very limited usefulness. For someone on a part-pension, it’s slightly more useful, and for a member who’s not on an age pension, it’s very useful.” Matterson’s criticism is that the new products don’t offer this customisation. “Investors are not drawing the line for the members. It’s not a matter of market timing, it’s a matter of the members’ positions in the investments zone.” The managers suggest that investors need to be more wary of outlier events these days. Hardeman says non-normal investment returns and dramatic swings in valuations may occur more frequently in the future than the usual standard deviation and bell-curve models suggest. But while the financial crisis called into question Harry Markowitz’ modern portfolio theory (MPT), its findings remain “deeply relevant”, she says.

“The central concept of MPT – the balancing of risk and return assumptions – is arguably more relevant than ever.” However, while various optimisation methods were available, including classic meanvariance, investors may want to look at full-scale optimisation, Hardeman adds. She cautions, though, that managing tail-risk with sophisticated overlays and hedges might be expensive, “so investors may have to optimise their use of optimisation”. Matterson agrees with Hardeman in that it’s “fine to talk about risk. This has been neglected because of strong equity returns, but what if equities go down?” he asks. “How do you implement this if that happens? Which risks need to be managed? It’s mainly market risk – and then which markets do you insulate against?

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