Almost two years after Lehman Brothers Holdings Inc.'s failure caused world markets to seize up, Pacific Investment Management Co. is planning a fund that will offer protection to investors against market declines of more than 15 percent.
Wall Street's hottest new product is fear.
Almost two years after Lehman Brothers Holdings Inc.'s failure caused world markets to seize up, Pacific Investment Management Co. is planning a fund that will offer protection to investors against market declines of more than 15 percent. Morgan Stanley strategists estimate demand for hedges against such cataclysms helped drive as much as a fivefold increase last quarter in trading of credit derivatives that speculate on market volatility.
The efforts to protect against another disaster, which helped drive up the relative costs of the most bearish credit derivatives to the highest in two years, show that investors' psyches still haven't recovered from the Lehman bankruptcy on Sept. 15, 2008, which erased $20.3 trillion in stock market value worldwide and caused credit markets to freeze.
“Everyone is starting to realize that this is going to be a much longer, much more difficult path to recovery,” said William Cunningham, head of credit strategies and fixed-income research at Boston-based State Street Corp.'s investment unit, which oversees almost $2 trillion. “It's really quite fragile and vulnerable in a way that we haven't seen in our lifetime.”
Demand for protection against so-called tail risks, extreme market moves that Wall Street's financial models fail to detect, is increasing as investors react to events such as the May 6 stock market rout that briefly sent the Dow Jones Industrial Average down almost 1,000 points, or Greece's sovereign debt crisis, which on June 7 sent the euro to a four-year low against the U.S. dollar.
Black Swans
For much of the year before Lehman's collapse, Nassim Nicholas Taleb warned bankers that they relied too much on probability models and had become blind to potential catastrophes, which he labeled black swans, a reference to the widely held belief that only white swans existed -- until black ones were discovered in Australia in 1697. His 2007 book, “The Black Swan,” contends tail risks are becoming more severe.
To hedge against tail risks, investors usually look for the cheapest insurance against a cataclysmic market sell-off, mainly through derivatives that are expected to multiply in value as prices plummet for everything from stocks to the Australian dollar.
The Indiana Public Employees Retirement Fund, with $14.1 billion of assets, asked financial institutions in January to send information on a tail-risk management program that would protect it against “an extreme market downturn,” according to a request for information on the manager's website.
Tail-Risk Pioneer
The term long-tail risk is derived from the outlying points on bell-shaped curves that forecasters use to plot the probability of losses or gains in a given market. The most probable outcomes lie at the center. The least probable, such as a decline of 5 percent in an index that most days rises or falls by less than 0.25 percent, are plotted at the “tails” of the curve. The greater the deviation, the longer the tail.
Taleb helped pioneer tail-risk hedging in the 1980s, trading options for banks including First Boston Inc., now part of Credit Suisse Group AG. Taleb built what he later termed a “massive” position in options on Eurodollar futures when the stock market crashed on Oct. 19, 1987. The Dow's biggest one-day drop in history prompted the Federal Reserve to pump liquidity into the banking system, lowering interbank borrowing rates and causing the futures to surge.
‘Drop Like Flies'
Pimco, manager of the world's biggest bond fund, Deutsche Bank AG and Citigroup Inc. are among firms offering clients tail-risk protection, either through funds or traded instruments that act as hedges. Taleb said few will have the stomach to stick with the strategy.
“They will drop like flies,” said Taleb, now a professor at New York University's Polytechnic Institute, who in 1999 set up tail-risk hedge fund Empirica LLC, which he ran for six years. “They and their customers will give up at some point. I've seen it before.”
Besides the sovereign debt strains in Europe that led to Greece, Spain and Portugal having their credit ratings reduced, investors such as Kyle Bass, who made $500 million three years ago on the U.S. subprime collapse, are concerned that even top- ranked governments may face hyperinflation from bailing out the global financial system. The U.S. has $8 trillion of Treasuries outstanding, up from less than $4.5 trillion in mid-2007.
China is grappling with a property bubble as its world- leading 11.9 percent economic expansion slows. Prices in 70 cities rose 11.4 percent in June from a year earlier following a record 12.8 percent in April and 12.4 percent in May, according to China Information News.
Market Liquidity
At the same time, traders say that market liquidity, or the ability of investors to easily trade in and out of positions as markets change, hasn't fully recovered from the Lehman collapse. Even though the amount of Treasuries outstanding has increased about 75 percent the past three years, the average daily trading volume of the securities among the primary dealers has declined about 12 percent, according to Fed data.
“In some of these asset classes, it's just not practical to reduce risk by selling given the lack of risk appetite and illiquidity,” said J.J. McKoan, co-director of global credit investments in New York at AllianceBernstein LP, where he helps manage $199 billion in fixed-income assets.
Improbable Occurs
Investors were reminded that the improbable can happen by the events of September 2008 -- from the government seizure of mortgage-finance companies Fannie Mae and Freddie Mac to Lehman's bankruptcy and the near-failure of American International Group Inc., once the world's largest insurer. Defaults on mortgages given to the least creditworthy borrowers drove financial institutions worldwide to take $1.8 trillion in writedowns and losses.
The seemingly growing occurrences of events that fall on the fringes of probability are prompting pension fund managers and other institutional investors -- who once shunned costly hedging strategies -- to reconsider. And they're doing it even as economists predict the U.S. economy will grow an average of almost 3 percent through 2012 and as analysts forecast the Standard & Poor's 500 Index will gain 17 percent through year- end.
“People are trying to move beyond historic notions that tail risk events are so infrequent on the one hand, and so extreme on the other hand, that there is nothing you can do about them,” said Eugene Ludwig, who started a Washington-based risk management firm called Promontory Financial Group after serving as U.S. Comptroller of the Currency under former President Bill Clinton.
‘New Normal'
Pimco Chief Executive Officer Mohamed El-Erian developed tail-risk strategies when he was manager of Harvard University's endowment in 2006 and 2007, and wrote about the importance of such hedging in his book, “When Markets Collide.”
El-Erian, who describes America's economic future with the term “new normal,” advocated the strategy he applied at Harvard on returning to Pimco in January 2008. Pimco, which manages about $1.1 trillion, opened its first mutual fund aimed at minimizing risks from systemic shocks that October. The Pimco Global Multi-Asset Fund is co-managed by El-Erian and Vineer Bhansali.
Pimco, the Newport Beach, California-based investment firm that runs the $234 billion Total Return Fund, is using strategies in many of its funds to protect against tail events, said Bhansali, chief architect of the company's tail-risk management program.
‘Cheap Protection'
“You don't want to try to be too smart in trying to forecast what is going to happen and which hedge is going to perform better,” said Bhansali, who holds a doctorate in theoretical particle physics from Harvard in Cambridge, Massachusetts, and ran the exotic and hybrid options trading desk at New York-based Citigroup. “What you want to do is accumulate cheap protection.”
The Pimco Tail Risk Hedging Fund 1 will be the first in a potential series of partnerships, according to a private placement filed with the U.S. Securities and Exchange Commission on June 23. The initial fund will be designed to protect investors from a drop of more than 15 percent in a benchmark index that Bhansali declined to identify.
ELVIS
Deutsche Bank is marketing a tail-risk hedging index that gains in value when investor expectation of stock-market volatility increases, according to material the bank sent to clients. The so-called Equity Long Volatility Investment Strategy, or ELVIS, uses derivatives called variance swaps linked to the S&P 500 that bet on the index's volatility. Derivatives are contracts whose value is tied to assets including stocks, bonds, commodities and currencies, or events such as changes in interest rates or the weather.
Citigroup hired John Liu, a former employee of the Indiana pension fund, about two months ago for a newly formed unit that will advise pension plans, endowments and foundations on tail risk hedging, according to a prospective investor who declined to be named because the hire hasn't been publicly announced.
Liu was formerly the managing director of equity strategies at Vanderbilt University, the Nashville, Tennessee-based college that in late 2005 tried to hedge portions of its endowment by using tail-risk insurance.
“This has become something of a ‘me-too' trade lately,” said Mark Spitznagel, a former Taleb trading partner at Empirica, who now runs Santa Monica, California-based Universa Investments LP, which Taleb advises. “These guys are all very new to a difficult game that we've been playing for a very long time now.”
Costs Rise
Along with the demand, the costs of tail-risk hedging have also climbed. In June, investors buying options that paid off should the S&P 500 plunge more than 23 percent from its April high were paying 75 percent more than those speculating on gains. The premium was the highest ever, according to data compiled by Bloomberg and OptionMetrics LLC. Options give investors the right to buy or sell shares at a predetermined price.
The risk premiums that investors were willing to pay for the most bearish options on a European credit index rose to the most since before Lehman's collapse. The so-called three-month volatility skew, a measure of the risk premium for options trading far from their strike price -- known as out-of-the-money -- versus those trading close to the strike, reached 30 percentage points on June 4, the highest in at least two years, and up from 5 percentage points at the end of 2009, Goldman Sachs Group Inc. data show. The skew has since fallen back to 9 percentage points.
In absolute terms, the cost of an out-of-the-money four- month option giving the right to buy protection against default by 125 European companies was $930,000 for a $100 million trade in May, compared with $630,000 yesterday.
‘Sudden Storm'
Goldman Sachs strategists said last month that investors were overpaying for the derivatives as fears of a sovereign default in Europe became too extreme, and not paying enough to hedge against higher-probability scenarios such as a prolonged period of low growth that spares the financial system while causing a jump in defaults among the lowest-rated borrowers.
“To put it into sailing terms, investors are paying a high premium to hedge against a sudden storm,” Goldman Sachs strategist Alberto Gallo in New York said. “But they're not willing to hedge against a prolonged period of no wind. This creates a buy opportunity for credit.”
Trading in options used to speculate on price swings in benchmark credit-default swap indexes rose as much as fivefold last quarter from the beginning of 2010, according to estimates of activity at Morgan Stanley, said Sivan Mahadevan, global head of equity and credit derivatives strategy at the firm in New York.
Bondholder Protection
“It's one of the most significant credit developments since 2008,” Mahadevan said. “Investors can't just think of credit as being a low volatility asset class anymore.”
Credit-default swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt.
Investors should be cautious in following the herd, said Eric Petroff, director of research at Wurts & Associates, a Seattle-based consulting firm that oversees about $30 billion on behalf of institutional investors.
“Products that protect you from tail risk tend to crop up after the tail has occurred,” he said. “Back in 2007, it made a lot of sense to hedge tail risk but now it just seems brilliantly misguided.”
Pine River
Other asset managers that have been hedging against improbable events are creating funds to take advantage of demand. Pine River Capital Management LP, a Minnetonka, Minnesota, firm that has $2.1 billion in assets under management, started the Nisswa Tail Hedge Fund LP last month, according to a June 15 filing with the SEC. The partnership was formed at the request of investors who wanted access to the hedging techniques used by Pine River's primary multi-strategy fund, which gained 40 percent during 2008 and 2009, according to Aaron Yeary, a co-founder.
“By buying prudent hedges and staying liquid, it allowed us to be on the offense during the crisis,” said Yeary, who is running Nisswa Tail Hedge with Nikhil Mankodi. “Some sold their liquid investments and were left with garbage,” Yeary said, adding that Nisswa Tail Hedge has about $200 million in assets.
Capula, Ionic
Capula Investment Management started a tail-risk fund in March with about $100 million, which has grown to about $650 million, according to a person familiar with the fund, who declined to be identified because the fund details are private. It may top $1 billion in the next two months, the person said.
Ionic Capital Advisors LLC, a New York-based investment firm founded by former employees of Highbridge Capital Management LLC, is offering tail risk protection through Ionic Select Opportunities Fund LLC, according to a private placement notice filed with the SEC on June 11. Mary Beth Grover, a spokeswoman for Ionic, declined to comment.
Taleb said sticking with a tail-risk strategy can be psychologically challenging because payoffs, while big, are less frequent.
“If you looked at numbers over a period of time -- six, seven, eight years -- there's much higher return,” Taleb said. “But if you watch a trader in any given year, he looks like an idiot. No trader wants to feel like he's an idiot.”
