Great Expectations… (of the unexpected)

When you live a single life in this constantly busy metropolis of London, you’re reliant on
certain things that are imperative to maintain the on-the-go lifestyle. Good friends who
possess great energy, an ‘in’ with the party hosts at the best clubs, flat shoes to run around
in (heels are to be kept in a hold-all so one can slip into them moments before making an
entrance)...and last but by no means least, a functioning freezer. Yes, you did read that
right. Being able to go from pack to plate in under five minutes is essential when you’re
regularly racing the clock.

So when your trusty freezer that has been working splendidly for the last four years
suddenly malfunctions, it’s a shock. Its occurrence is out of the blue and if not entirely
devastating, it’s certainly pretty darn inconvenient. In the investment world, we call this
type of incident a ‘tail event’. It falls under the realm of possibility but difficult to predict
and not a frequent occurrence.

When the equivalent of a freezer breakdown happens in the markets, shares take on the
consistency of melted Ben & Jerry’s ice cream, corporate bonds are like defrosted poultry,
laden with multiplying bacteria and a source of food poisoning. The portfolio that you have
carefully put together loses its structure altering into a soggy, congealed mess. Fortunately
there is the equivalent of home contents insurance in the investment world.

The fear of a breakdown, it appears is very much instilled in investors’ psyches after the
collapse of Lehman Brothers back in September 2008. Economists and Wall Street, despite
their complex multifactor models failed to predict both the event and the extent of the
fallout. This was the black swan that Nassim Nicholas Taleb had warned of; the widely held
belief that only white swans existed until black ones were discovered in Australia. Many
failed to realise that just because they hadn’t seen a black swan, it did not necessarily mean
they didn’t exist. Now in the face of the Greek sovereign debt crisis and the possibility of the
collapse of the Euro, demand for insurance products to protect investors against any
cataclysms is surging.

Besides the sovereign debt crisis in Europe, many believe ‘tail risks’ may come from a misstep
in monetary and fiscal policy leading to hyperinflation from bailing out the global
financial system. There are many clever clogs out there who have constructed insurance
hedges that allow trading on these very fears. Many of the hedges are designed to increase
in value as other portfolio assets (everything from stocks to the Canadian dollar) plummet.
One of these instruments has been getting a lot of attention lately and goes by the name of
VIX futures. This is a future on the VIX or Volatility index created by the Chicago Board
Options Exchange (CBOE). The VIX has become the default ‘fear index’ since volatility often
signifies financial turmoil and can be helpful in evaluating potential market turning points.
During the financial crisis of 2008, there was a spike in volatility sending the VIX index level
up to 80. During the latter part of 2009, stock markets moved higher and a low volatility
level in the region of the teens was reached.

The attractive thing about the VIX is that it has a strong negative correlation to many
equities. That is you’re likely to make up part of the losses in one asset class with gains in
another. The correlation between US large cap stocks and volatility is -0.65. A simple way to
think about this would be imagine stocks went down 100 points, volatility partially offsets
this loss by increasing 65 points. Deutshce Bank has created proprietary products with
catchy names like ELVIS [replace mental image of the white-suited fat guy singing in Vegas
with Equity Long Volatility Investment Strategy] that gain in value with investor expectation
of stock market volatility increases. Having the benefit of foresight would be beneficial here
as one cannot be entirely sure these products will work in a crisis when correlations all tend
towards 1. In this instance, when stocks lose 100 points, so will volatility.

VIX options and futures, as well as credit default derivatives (iTraxx and CDX) and out-ofthe-
money index puts (on the FTSE, S&P500 etc) are just a few of the ways to hedge at the
broader portfolio level in a similar vein as buying home contents insurance covers
everything from jewellery to your Jimmy Choos to your Fridge-freezer. But all this comes at
a cost. And this cost is rising. According to data compiled by Bloomberg, investors buying
options that paid off should the S&P500 plunge were paying 75% more than those
speculating on the S&P500 rising.

While these strategies undoubtedly have a place in the investment world, investors should
be wary of overpaying for these insurance products. Buying expensive insurance is just like
buying any other overpriced asset and a desire to be always hedged using these strategies
can prove to be too expensive and not worth the trouble.

There are ways to hedge tail risk using dynamic asset allocation methods. The most obvious
and common sense approach is to hold a larger cash balance. There are other traditional
asset classes like short term Treasuries and Gilts that can serve as a hedge. A flight to safety
during an equity or credit market crisis makes these attractive securities to hold if they are
attractively priced. Right now yields are almost inconceivably low and prices too high to
consider.

7IM’s investment management team mitigate unforeseen portfolio risk by tailoring cash to
their perceived risk levels rather than that dictated to them by market consensus.
Continuously monitoring economic developments, working through several different
economic scenarios ranging in intensity, and not managing to a fixed model also allows the
team to implement sudden and necessary changes in portfolios. Furthermore a layer of risk
management is done via currency hedges as movements in currencies increasingly reflect
risks in the macroeconomic environment. This of course, is all in addition to benefits of
diversification our clients already receive by investing in a range of asset classes from
equities and bonds to commodities and timber.

Yes, it is very hard to predict when that freezer will let you down or where the next Lehman
is going to come from. But the important thing to remember is that while tail risks may vary
in their origin, they can have considerable impact on your portfolios and some level of
portfolio contents insurance will prove useful.

***

And finally….... A black bear has gone to extreme lengths to secure its meal. Attracted by the
smell of a peanut butter sandwich, it managed to open the door of a car, climb in and
promptly got stuck. The car rolled down a slope into the trees after the creature managed to
knock the gear stick into neutral. Expect profit warnings from peanut butter manufacturers
who now are prepared for bearish conditions to persist well into the second half of the year!
Have a good weekend.

Aparna Ram
Investment Research Analyst
Seven Investment Management Limited