StockTouch Blog

What is Tail risk and what does it mean to the average investor

July 6, 2012 by Peter

 

The mysterious world of hedge funds is always something fun to peer into as a normal investor, perhaps to get a glimpse of some genius trade ideas or just to follow the smart money. So this week when a new paper on tail risk and hedge fund returns came out we were clearly all over it. First thing though, what is tail risk and why do hedge funds care, and should you care as a retail investor? Well, Tail risk is a form of portfolio risk that arises when the possibility that an investment will move more than three standard deviations from the mean is greater than what is shown by a normal distribution. In simpler terms, When a portfolio of investments is put together, it is assumed that the distribution of returns will follow a normal pattern. Under this assumption, the probability that returns will move between the mean and three standard deviations, either positive or negative, is 99.97%. This means that the probability of returns moving more than three standard deviations beyond the mean is 0.03%, or virtually nil. However, the concept of tail risk suggests that the distribution is not normal, but skewed, and has fatter tails. The fatter tails increase the probability that an investment will move beyond three standard deviations. Distributions that are characterized by fat tails are often seen when looking at hedge fund returns.

Now few things in the investing community are more poorly understood than alpha creation and risk adjusted returns. Most investors in general have no idea whether their fund manager is actually generating returns that justify the risk levels or even if the manager is providing a service that justifies a fee that is higher than a correlated index. More often than not, we find that investment managers are mirroring an index or taking on more risk than their returns justify, but the investors don’t realize or understand how to properly benchmark their manager so they continue paying for something that is totally unjustified.  AiCIO recently interviewed the authors of the paper:

“We want to distinguish between genuine expertise of a hedge fund manager rather than outperforming by taking on extra risk — anyone can take on extra crash risk and get a higher return,” Kelly told aiCIO following the recent release of his academic paper on the topic, which he co-wrote with Erasmus University Professor Hao Jiang.

If investors want to measure risk correctly, they must be more careful about calculating the returns generated by hedge fund managers’ willingness to take tail-risk positions, exposing them to downside risk, according to Kelly’s paper titled “Tail Risk and Hedge Fund Returns.” The main thrust of the research: hedge fund managers tend to be more willing to take on positions that have a high likelihood of crashing in order to earn higher expected returns.

Paper abstract:

“We document large, persistent exposures of hedge funds to downside tail risk. For instance, the hardest hit hedge funds in the 1998 crisis also suffered predictably worse returns than their peers in 2007-2008. Using the conditional tail risk factor derived by Kelly (2012), we find that tail risk is a key driver of hedge fund returns in both the time-series and cross-section. A positive one standard deviation shock to tail risk is associated with a contemporaneous decline of 2.88% per year in the value of the aggregate hedge fund portfolio. In the cross-section, funds that lose value during high tail risk episodes earn average annual returns more than 6% higher than funds that are tail risk-hedged, controlling for commonly used hedge fund factors. These results are consistent with the notion that a significant component of hedge fund returns can be viewed as compensation for selling disaster insurance.”

While not all investors have the capital to be invested in hedge funds, its important to note that these analytical frameworks and ideals can be applied to any managed accounts. So regardless of if you are invested with Fidelity in their emerging markets mutual fund or some hot shot hedge fund in Greenwich, any smart investor should be making sure their manager isn’t taking on too much risk to get those returns.

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