Tail-Risk Events
February 15, 2011
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Protecting against sudden, severe market drops is as crucial as it is difficult. A plethora of approaches to this problem have been brought to market in last few years, and to evaluate them my firm, Brinton Eaton Wealth Advisors, developed a set of rigorous criteria. These criteria led us to a solution that works for us and for our clients, and I’d like to share our approach with you.
In the wake of the market devastation that took place in the fourth quarter of 2008 and the first quarter of 2009, we, like many firms, increased our attention to tail-risk hedging. While carefully designed asset allocation and opportunistic rebalancing repeatedly got our clients through other bear markets, big and small, the contagion that roiled the markets during those infamous six months – when virtually every asset class suffered simultaneously – was quite another matter. The crisis rendered those time-tested approaches temporarily impotent.
Clearly, we needed something else to supplement traditional portfolio risk management.
One approach is tactical maneuvering (sometimes referred to as “dynamic asset allocation”). This article is not about that; it’s about another class of solutions – tail-risk hedging – that come to the rescue automatically and do not require active intervention.
After the financial crisis, many among the multitude of solutions and quasi-solutions that came to market played on investor fears. Against this barrage, we made sure we had very stringent criteria to clearly articulate what we wanted – and did not want – in a solution. Most failed one or more of our requirements, but we did find some very promising approaches. In this article, I’ll explain how we applied our criteria to critically evaluate a number of proposed solutions.
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