Worst-case scenarios: Fat-tail attraction | The Economist Page 1

costs money in most good

years or average years , but it makes you a fairly large return when all your other assets

are performing very poorly . ”

Sellers naturally claim it is worth the cost. Mr Bhansali of PIMCO, which offers several tail
funds, estimates that it costs investors between 0.5% and 1% of assets to hedge against
tail risk, but that investors will break even in three to five years. That is partly because
the market does
Worst-case not have to crash in the way that it did in 2008 for hedges to pay their
scenarios
way. PIMCO now oversees around $30 billion in tail-risk products, mostly in separate
Fat-tail attraction
accounts. Other funds have also seen inflows. Take, for example, Universa Investments ,
Investors’ interest in hedging tail risk is growing
a tail fund advised by Nassim Taleb, author of “The Black Swan”, which has grown from $
0 Like 228
Mar 24th 2011 | NEW YORK | from the print edition
300m in 2007 to around $6 billion today.

Even so, Mark hedging

“TAIL-RISK” Spitznagel,
wasthe
the boss Universa,
talk of Wall Streetcomplains
in 2008 about complacency among
investors. Demand is very uneven. The price of
after global markets nosedived and traumatised investorshedging varies, rising when markets are
volatile
tried toand investors
figure most
out how need
they couldit, and declining
protect duringfrom
themselves bull markets. It is difficult, after
all,
extreme
to keeporstomaching
“black swan”losses
events
from—those
hedged
wellpositions
outside as
an markets rise: “The kids outside
playing
ordinaryin the snow without
distribution sweaters andcause
of outcomes—that scarves seemed to have much more fun than
massive
those of us
losses. who were
Interest bundled
is revving up up,”
againsays Steven Englander
as revolutions in the of Citigroup.
Middle East and Japan’s earthquake have destabilised
markets and increased volatility, leaving battered investors
searching anew for protection .
Peddlers of tail-risk products like to compare them to
insurance: investors pay premiums every year to avoid
financial catastrophe later. Some even get philosophical.
Vineer Bhansali of PIMCO, a big fund manager, has likened
tail risk to Pascal’s wager—the argument that you’re better Is it a bird, an extreme event or
a cliché ?
off believing in God than suffering the consequences of
being wrong. The same is true with drastic dives in markets.
Tail risk is technically defined as a higher-than-expected risk of an investment moving
more than three standard deviations away from the mean. For mere mortals, it has come
to signify any big downward move in a portfolio’s value. There are different ways to hedge
tail risk, but a popular one is to create a basket of derivatives that will perform poorly
during normal market conditions but soar when markets plunge. These include options on
a variety of asset classes, such as equity indices and credit-default-swap indices.

Some banks have started to sell tail-risk products. Deutsche Bank has created the ELVIS
index, which generates returns when stockmarket volatility increases. Big asset managers
like BlackRock and PIMCO have made a business of advising customers on managing for
the worst case. Hedge funds have also got in on the act. Several “tail funds”, which invest
in assets that should rise in bad economic times, have started up in the past few years.
These funds tend to lose around 15% each year when the market is normal but can
return 50-100% when the market dives. Or more: 36 South, a hedge fund, saw its tail
fund gain 234% in 2008. According to Gaurav Tejwani of Pine River, which launched a
tail-risk fund last year that now manages over $200m, “It

http://www.economist.com/node/18443412/print 4/23/2011 11:34:56 PM

Worst-case scenarios: Fat-tail attraction | The Economist Page 2

years or average years, but it makes you a fairly large return when all your other assets
are performing very poorly.”

Sellers naturally claim it is worth the cost. Mr Bhansali of PIMCO, which offers several tail
funds, estimates that it costs investors between 0.5% and 1% of assets to hedge against
tail risk, but that investors will break even in three to five years. That is partly because
the market does not have to crash in the way that it did in 2008 for hedges to pay their
way. PIMCO now oversees around $30 billion in tail-risk products, mostly in separate
accounts. Other funds have also seen inflows. Take, for example, Universa Investments ,
a tail fund advised by Nassim Taleb, author of “The Black Swan”, which has grown from $
300m in 2007 to around $6 billion today.

Even so, Mark Spitznagel, the boss of Universa, complains about complacency among
investors. Demand is very uneven. The price of hedging varies, rising when markets are
volatile and investors most need it, and declining during bull markets. It is difficult, after
all, to keep stomaching losses from hedged positions as markets rise: “The kids outside
playing in the snow without sweaters and scarves seemed to have much more fun than
those of us who were bundled up,” says Steven Englander of Citigroup.
from the print edition | Finance and Economics

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