Among the notable developments sparked by the 2008 Global Financial Crisis was an explosion of interest in "tail risk hedging." As elaborated by Black Swan author Nassim Taleb and as periodically suggested by real-world market behavior, the probabilistic distribution of market outcomes may not follow a "normal" statistical distribution pattern. In layman's terms, the "normal" statistical distribution model resembles a bell curve under which extreme events on either end of the curve have only a tiny probability of occurring. Yet, empirically, many have suggested that extreme dislocations, or "tail events" (such as the 2008 global markets meltdown, the 2011 and 2002 waterfall declines of the US equities market, the 1997 collapse of Asian stock markets, the 1987 Black Monday crash, etc.) seem to occur far more frequently than the normal distribution model would predict.
As any investor who has lived through these events can attest, extreme volatility results in a white-knuckled ride that inevitably shakes the nerves of even long-term, unleveraged buy-and-hold investors as most prefer smoother, "sleep-at-night" returns. Accordingly, developing the skill and mindset to identify low-cost tail risk hedges may be of value for the average retail investor.
This article briefly examines the concept of alpha-oriented tail risk portfolio insurance and identifies and analyzes an example, long-dated out-of-the-money put options on the EWH (a Hong Kong equities ETF), that may be timely in the current market. The purpose of this exercise, in addition to providing a potential actionable recommendation, is to illustrate a back-of-the-envelope analytical process that the average retail investor can use to identify attractive tail risk hedges.
Understanding Tail Risk Insurance
The surprisingly frequent occurrence of fat-tail market events over the past couple of decades has given rise to interest among institutional investors in purchasing various forms of cost-effective "insurance" to protect long-biased portfolios against mark-to-market losses arising from such dislocations. PIMCO, Universa Investments and other sponsors have over the past few years originated various products, some based upon volatility indices, designed to generate outsized gains upon the occurrence of a severe "volatility event" with the idea that such gains would offset losses elsewhere in a long-biased portfolio. However, aside from the fact that most such hedges are not widely available to the average retail investor, passive tail risk hedges are correctly seen as an expensive drain on an investor's long-term returns, i.e. a nearly guaranteed loser much like one's homeowner's insurance.
While abandoning one's homeowner's insurance may be imprudent, one alternative in the investment arena is to pursue an alpha-oriented version of tail-risk hedging. In other words, one should look for really fat tails, i.e. unstable, deteriorating situations where the magnitude and probability of extreme downside moves is not yet appreciated by the markets (or at least, not yet priced in).
Hedge fund manager Kyle Bass of Hayman Capital is perhaps the most notable practitioner of this strategy. Famous for making massively profitable one-way bets against US sub-prime mortgages prior to the Global Financial Crisis, Bass in recent years is on record as having allocated a small portion of his portfolio to derivative contracts that will pay off in spades if his predictions on the imminent demise of Japan's government bond market play out.
For a retail investor, identifying an attractive, alpha-driving tail risk hedge involves two steps. First, while "black swans" are by definition unpredictable, it's worth making efforts to identify the likely source of potential instability in the global financial markets. Second, one must identify investment instruments with outsized exposure to the potential volatility event and analyze the risk-reward based on pricing and historical performance (which may include an analysis of historical comparables).
The Chinese Credit Bubble - The Next Black Swan?
In recent months, the financial markets have become increasingly cognizant of the risks posed by the inevitable unwinding of China's massive credit and real estate bubble with George Soros noting "eerie resemblances with the financial conditions that prevailed in the US in the years preceding the crash of 2008" and citing China as currently presenting the biggest structural risks facing the global economy. Swiss macro hedge fund manager Felix Zulauf has described "the most dramatic credit boom in modern history" as now being "in the terminal stage" and recommends selling short EWH, the exchange-traded fund comprised of major Hong Kong-listed stocks.
Given a nominally closed capital account and extensive direct state controls over both credit allocation and various key industrial sectors, speculation has abounded over both (i) the potential for Chinese authorities to orchestrate an orderly, managed slow-down and (ii) the extent to which the effects of any financial collapse in China may be contained to the Chinese markets and those markets most levered to the Chinese property and infrastructure build-out such as Australia and Brazil. However, past experience with credit bubbles suggests both that "containment" is a difficult feat to achieve and that the knock-on effects from financial crises are very difficult to gauge-given feedback loops and the central role of market psychology, contagion has a habit of spreading very quickly.
Accordingly, a fair argument can be made that a Chinese financial crisis represents one of the highest probability tail risk events (one of the "fattest tails") in the current market.
Deep Out-of-the-Money Put Options on the EWH
The EWH instrument mentioned by Zulauf is an exchange-traded fund designed to mimic a broad index of Hong Kong-listed equities. Significantly, in line with the Hong Kong economy, it consists primarily of financial and property stocks.
|EWH Top 10 Components||% Weighting|
|AIA Group Ltd.||15.76|
|Hutchison Whampoa Ltd.||7.98|
|Cheung Kong Holdings, Ltd.||6.18|
|Sands China Ltd.||5.50|
|Sun Hung Kai Properties, Ltd.||5.49|
|Galaxy Entertainment Group, Ltd.||5.28|
|Hong Kong Exchanges and Clearing Ltd.||4.57|
|CLP Holdings Ltd.||3.59|
|Hang Seng Bank Ltd.||3.41|
|Hong Kong and China Gas Co., Ltd.||3.26|
Accordingly, the EWH is heavily weighted toward industries and a geography that lie squarely in the path of the next potential financial hurricane. What makes the EWH particularly attractive for bearish positioning is that in addition to being massively exposed to any Chinese financial meltdown, it has historically suffered steep waterfall collapses during each and every global risk-off event over the past 20 years regardless of whether such events originated in Asia.
|Market Event||EWH Peak Price(s)||EWH Trough Price(s)||Percentage Decline|
|Asian Financial Crisis||18.19 (Aug 1997)||9.88 (Oct. 1997)||-46.7%|
|LTCM / Russian Debt Default||5.31 (Aug. 1998)||-70.8%|
|2002 US Bear Market (Worldcom Fraud)||10.23 (May 2002)||6.77 (Oct. 2002)||-33.8%|
|Global Financial Crisis (US Sub-prime)||24.29 (Oct 2007)||8.36 (Nov 2008)||-65.6%|
|22.54 (Jan 2008)||-62.9%|
|European Sovereign Debt Crisis||19.57 (May 2011)||13.30 (Oct 2011)||-32.0%|
Thinly-traded over-the-counter options are available on the EWH although longer-dated LEAPs are unavailable, with calls and puts expiring January 17, 2015 representing the longest duration currently listed. Of particular interest for tail-risk hedging might be the January put options with strikes of 15 and 16 (the EWH, at 19.5 at the time this article was written, has been trading in recent months between 19 and 21). The mid-points of the bid/ask spreads for these options are $0.15 and $0.25, respectively.
In assessing the protective value of these put options, it's critical to consider the question of how much the EWH might decline in the event of a severe financial crisis originating in China and/or Hong Kong. This obviously involves some guesswork. The previous table suggests that historically, severe declines can be expected even for volatility events that do not originate in Asia.
Another approach involves looking at how comparable investments fared under similar conditions. While most of the EWH's holdings are blue-chip financial and property stocks, it's notable that in 2011 during the European sovereign debt crisis, blue-chip bank Deutsche Bank (NYSE:DB) declined by over 60% on a one-year peak-to-trough basis with most of the decline happening in a brief two-month span once panic hit. Taking all of this together, it's not unreasonable to expect the EWH to quickly lose at least 50% of its value in the event of a severe Chinese financial crisis in which case such put options could return 30x-40x if purchased at current prices.
The next question to consider is the extent to which a Chinese financial panic might impact US equity markets. This plays into the question of how much protection a US equity investor would wish to buy (in the form of EWH put options) to offset a decline in a US-based portfolio. Again, analysis of historical comparables can play a role.
During 2011, a psychological shock involving the US debt-ceiling debate precipitated the most severe phase of the European sovereign debt crisis. Buoyant US markets promptly crashed by about 20% while European stocks fared far worse. Of course, while US markets were buoyant and complacent prior to the 2011 meltdown much like they are today, US markets currently trade at higher valuations than they did in early 2011. This suggests there is no guarantee that after a similar shock, they will find a floor after only a 20% decline.
Nonetheless, assuming a Chinese debt crisis triggers a 15-20% decline in the S&P 500 prior to the commencement of reflationary rescue efforts by the US Federal Reserve and other central banks, allocating a mere 50 basis points to EWH puts could easily protect a portfolio against all losses arising from such an event. In addition, such put options may potentially protect to some degree against any major financial collapse (such as a 2008-magnitude event or a Japanese bond market meltdown) that does not specifically originate in China but nonetheless craters the highly cyclical, high-beta Hong Kong stock market with its vulnerability to external shocks.
Finally, with exposure limited to the relatively modest price of the options premium, deep out-of-the-money put options on the EWH may represent a far less risky way of expressing a speculative view on a Chinese financial crisis than the capital-intensive straight short-sale position recommended by Zulauf (with its unlimited potential losses) particularly given that the Chinese authorities may still have further levers to postpone any day of reckoning. While EWH puts, unlike short-selling, are time-constrained and will also not provide any gains in the event of a slow, grinding decline, they should insure a US-focused portfolio against contagion in the event of any Chinese financial panic.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.