fter living through the market debacles of the past few years including the market crash of 2008, the “flash crash”, and European sovereign debt crisis, risk and its mitigation have become an important consideration for asset owners, including pension funds, endowments and foundations. The most important components of risk management are the identification and understanding of portfolio risks and the development of a concise step by step approach to hedge that risk across asset classes. So how do investors get there?
To mitigate tail risk, investors need real world examples, common sense solutions, and an awareness of the advantages and disadvantages of each hedging alternative. Given the potential dire effects of a tail risk drawdown event, investors should seek out, analyse and implement various hedging strategies to help mitigate the potential investment losses of such events.
Tail risk is broadly described as the risk of extreme market moves that typical financial and risk models employed on Wall Street or in the City tend to underestimate. A tail risk event for our investors is an event, as defined in our stress testing analysis, that has a 10% probability or less of an occurrence such as the 1987, 2000, and 2008 stock market crashes. Though such events are rare, the magnitude and implications of a potential loss can be dramatic for investors. A pension fund’s underfunded status will worsen and affect its ability to meet the future financial obligations to its pensioners. An endowment or foundation may not be able to meet its annual spending targets, thus delaying or even terminating capital spending projects or student tuition assistance programmes.