Pin the tail (risk) on the donkey

Joel Hartley

Investment Partner

Time as a luxury

The wisest investors seemingly employ a beautifully simple ethos. Writing this piece on one of those elusive British warm and sunny days this Buffett (Warren, not Jimmy, although could be either…) quote appealed - “Someone is sitting in the shade today because someone planted a tree a long time ago”.

Of the hundreds of Buffett quotes to choose from unsurprisingly most of them distil into:

invest for the very long term;
don’t panic when the going gets tough;
don’t overpay.

Hard to disagree with any of that. But what happens if you don’t have a very long-term time horizon, you’re bound by certain regulatory shackles, and you’re responsible for directly paying steady retirement incomes for thousands? Like some closed defined benefit schemes for example. You might want to self-insure against the impact of a negative market event at an unhelpful time.

Someone is sitting in the shade today because someone planted a tree a long time ago

Bouncing back

To mitigate the impact of a large sell-off in risky assets a dedicated tail risk protection strategy could prove useful in certain circumstances.

Which could be:

Until your next regulatory reporting milestone point (investor results date, triennial valuation, etc); or
If you temporarily have a reduced tolerance to manage a downside shock (eg due to factors outside of your control, such as the macroeconomic or political environment, a weak sponsor, etc).

Whilst equity protection strategies (by which I mean options linked to equity indices) can help, sometimes the cost is excessive. So this is one of those infrequent occasions where it can make sense to delve into certain complex actively managed strategies, in search of a better value-for-money insurance policy. These include funds that actively trade options on major asset classes, or assets whose prices are linked to market volatility itself, or other insurance-type assets like credit default swaps.

Success is all about minimising the cost of the insurance and securing a “highly asymmetric” return profile – basically something that goes up by a lot in value quickly when mainstream assets are falling so you only need commit a small amount of your portfolio to see meaningful protection levels. These investments are liquid, regularly traded, and transparent, so you can act quickly and know what you’re getting into.

Jumping in

Arguably if you’ve been thinking about these types of investments for your portfolio, now doesn’t seem a bad time to go for it as benign market conditions mean that some protection assets are priced relatively attractively.

Several equity markets continue to hover around historical highs and investment grade credit spreads still appear reasonably “rich” – ie small – with pockets of value few and far between. Moreover, geopolitical risks remain heightened and, whilst we had a small market wobble in early August 2024, at the time of writing it hadn’t moved the market dial.

Looking ahead, in the short-term at least, major elections and diverging central bank policy could cause some bumps and readjustments, and major conflicts seem to be heading more towards escalation rather than easement. These could all quite feasibly lead to the next sharp market event and correction.

Rear view mirror

Historical drawdowns for S&P 500

Source: LCP analysis

Over the last 150 years, the S&P 500 has experienced a drawdown of:

10% or more about every one and a half years on average
30% or more about every 9 years on average.

So whilst the big drops are relatively infrequent, they’re not exactly once-in-a-lifetime events, and could quite easily cause some damage if you’re the sort of investor without a multi-decade investment horizon.

Of course if you can’t handle the heat you could just stay out of the kitchen, by which I mean just reduce your exposure to risky assets. But at some point you’ve got to go and eat again, and it can be behaviourally quite tricky to know when to change tack and buy risky assets again.

The other Buffett

Tail risk hedges are often expensive and underperforming very long-term investments – I’m fairly sure of that. So, if you have a very long-time horizon, few constraints, and a patient mindset, such investments might be unattractive. But if you don’t have all these luxuries as an investor, they could be worth looking at (especially now as the pricing is relatively attractive) to help get you out of a hole when you most need it.

Or as (the other) Buffett once said:

“If life gives you limes, make margaritas”.