Betting on tail risk seriously endangers your wealth

August 23, 2010

Investment strategies designed to benefit from tail risks are fast becoming the next bubble. Investors are paying over the odds to reap benefits from remote catastrophic risks and are ignoring more moderate but much more likely outcomes that will cost them a great deal in the interim.

Following the banking crisis and the flash crash, Wall Street is rushing to meet demand from investors wanting to make money from betting on extreme market dislocations and other “black swans” by taking long positions in rare, high-impact events at the tail ends of probability curves.

Bets on tail risks have become increasingly popular and come in a variety of guises. Buying out-of-the-money puts on the major stock averages to benefit in the event of another crash; commodity futures and options to benefit from resurgent inflation or a sudden supply disruption in supply; or physical gold and long-dated Treasury bonds to protect against deflation.

What all these strategies have in common is they function like insurance contracts. Investors incur a small cost each month (in the case of gold and Treasuries, the opportunity cost from not owning higher-yielding assets) but receive a big payout in the event disaster strikes.

A report to the trustees, staff and advisers of the California State Teachers Retirement System (CalSTRS) confirmed: “Investors should view commodity performance as analogous to insurance. Commodity investments may not always produce high returns and may impose some form of opportunity costs similar to an insurance premium. During unexpected investment-related events, such as high inflation, commodities are expected to outperform”.

A similar case is being made for why investors should include 100-year bonds, gold, commodity futures and a host of other insurance-like contracts in their portfolio to protect against a range of investment risks — from inflation and deflation to flash crashes, a global energy crisis or bad harvests.

The comparison with insurance should give investors pause. The only people who make money from insurance are generally the sellers. For buyers, they amount to a cost — and sometimes not very good value. Some companies such as BP and some other oil majors decide it is cheaper to self-insure against at least some risks.

Insurers make money because the amount collected in premiums and earned by reinvesting them exceeds the amount paid out in the event of insurable events. Providing insurance is profitable because (a) insurable events are not common; (b) insurers have reserves to absorb periodic large losses; and (c) insurers pool risks across uncorrelated markets.

The key is that buyers of insurance generally pay more up front in premiums (ex ante) than they ever claim in payouts (ex post). Precisely the same thing is happening in many of these newly popular markets for tail risks. Investors will pay far more for the exposure to tail risks than they will ever get back if and when those risks eventually occur.

Consider the example of wheat. In just over five weeks, front-month wheat prices on the Chicago Board of Trade (CBOT) rose 90 percent, from 441.5 cents per bushel on June 30 to a high of 841 cents on Aug. 6, as drought and fires damaged grain crops in the Black Sea region and across large parts of the Russian Federation <Wc1>. This is precisely the sort of tail risk that buyers of commodity futures contracts are trying to insure against (or benefit from).

But did they make money on the position? It rather depends how many months they had been long of wheat futures contracts, and thus how many premiums they had paid over — in the form of negative roll returns in a contango market or outright option premiums.


Chart 1 contrasts wheat prices since 1988 with the return to investors from a long position in front-month wheat futures rolled forward each month since then. Following the drought, wheat prices are now about 112 percent higher than at the start of 1988. But investors have paid so much in contango (storage and finance) to roll their position forward that the value of their investment has shrunk by almost 84 percent.

Promoters of this type of insurance might object that no one would hold a long position more than 20 years. So consider a position established at the start of 2005, when commodity futures were coming back into vogue. Wheat futures prices have risen about 138 percent since then. But the value of a position in front-month wheat futures carried over this period has fallen 8 percent (Chart 2).

So far, the analysis has focused on excess returns — that part of the returns on commodity futures attributable to the futures contracts themselves, rather than the total returns from a fully collateralised position invested in Treasury bonds or other low-risk instruments.

Let’s be generous and allow investors to count these returns as part of their “commodity investment”. In that case, a wheat futures position has lost almost 60 percent of its value since 1988. It is up almost 6 percent since 2005, but that is hardly a good performance when spot prices have soared 138 percent in the same period.

For purchasers, the usefulness depends on a careful balancing of the costs of the insurance contract against the real likelihood of loss. Apart from their greater ability to spread risk and capacity to absorb short-term losses than the individuals they insure, insurers make money because those they insure often over-estimate risk and therefore over-pay for protection.

The same is now happening on Wall Street. Institutions and individuals risk focusing too much on tail risks and overestimating the likelihood of their occurrence. As a result they may pay far more in premiums for protection than they can ever hope to claim back even if these remote risks come to pass.

In 1940, Fred Schwed published an investment classic entitled “Where are the Customers’ Yachts? Or a Good Hard Look at Wall Street”. It critiqued products that failed to meet investors’ needs. The same problem may now be manifesting itself with the fashion for tail risk products and strategies.

There is a strong case for using commodity derivatives as a tool for risk management. The case for adding them to an investment portfolio as a source of returns or diversification is weaker; the costs of carrying positions for months and years until medium or long-term risks manifest themselves eat deeply into any expected returns.

Legendary investor Warren Buffett has repeatedly noted that diversification is not an end in itself. Investors need to consider the costs imposed by diversification strategies as well as the benefits. Via his Berkshire Hathaway insurance businesses, such as General Re and GEICO, Buffett makes money by selling, not buying, tail risks.

Another big operator benefiting from the craze for tail risks is the U.S. Treasury, which is finding strong demand for “insurance” in the form of very low-yielding government securities sold to investors terrified by the risk of deflation.

In the wake of the financial crisis and flash crash, and amid uncertainty about the outlook, investors risk overpaying for very costly insurance against possible but improbable outcomes, like a homeowner suddenly prepared to pay whatever it takes to insure his house after it has already burned down.

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