Fend off tails

Guarding against tail risk is best achieved by a mix of approaches rather than adherence to one. Fortunately, we get a sense of what the mix should look like by putting choices on the same conceptual footing.

Firstly, we create a set of scenarios on which to evaluate potential outcomes for alternatives. Secondly, we evaluate the opportunity cost of using either the cash or option-based alternative. And thirdly, we evaluate the ability and the cost of switching into risk at each future point. None of this can be done without reference to the underlying portfolio and the objective function of the specific client – the client’s own utility function, tolerance for risk and return, investment horizon and, critically, the price that the client is willing to pay now for the opportunity to truncate the “left tails.”

Granted, this requires modelling and computation, but the concept of using all the tools at your disposal is obvious. What we also know from experience is that this strategy of actively mixing cash and multi-asset options can be successfully used to guard against market declines.

Ultimately, flexibility should be used for more robust portfolio construction, whether in picking assets or hedging against the downside risks that surely lie ahead.

John Wilson is head of PIMCO Australia