The Rush to Hedge Against Black Swan Events

Wall Street is seeing a boom in funds that offer protection from market calamities known as "long-tail risks"

By Shannon Harrington, Miles Weiss and Sree Vidya Bhaktavatsalam

Wall Street's hottest new product is fear. Pimco, Deutsche Bank (DB), and Citigroup (C) are among firms offering clients protection against "long-tail" risks—extreme market moves that Wall Street's financial models fail to anticipate. In what Morgan Stanley strategists say is an indication that more investors are seeking insurance against financial turbulence, they estimate there was as much as a fivefold increase last quarter in trading of credit derivatives that speculate on market volatility.

The growing interest in catastrophe insurance shows that investors still haven't recovered from the Lehman Brothers bankruptcy on Sept. 15, 2008, which erased $20.3 trillion in stock market value worldwide and caused credit markets to freeze. Recent events such as the May 6 stock market rout that briefly sent the Dow Jones industrial average down almost 1,000 points have added to the anxiety.

High unemployment, housing woes, and slow growth in the U.S. continue to keep the markets unsettled. "Everyone is starting to realize that this is going to be a much longer, much more difficult path to recovery," says William Cunningham, head of credit strategies and fixed-income research at State Street's (STT) investment unit in Boston, which oversees almost $2 trillion. "It's really quite fragile and vulnerable in a way that we haven't seen in our lifetime."

The term long-tail risk is derived from the outlying points on bell-shaped curves that forecasters use to plot the probability of losses or gains in a given market. The most probable outcomes lie at the center. The least probable, such as a decline of 5 percent in an index that most days rises or falls by less than 0.25 percent, are plotted at the "tail," or the end of the curve. The greater the deviation, the longer the tail.

Before the 2008 financial crisis, author Nassim Nicholas Taleb warned bankers that they relied too much on probability models and had become blind to potential cataclysms, which he labeled black swans. That's a reference to the widely held belief that only white swans existed—that is, until black ones were discovered in Australia in 1697. His 2007 book, The Black Swan, contends tail risks are becoming more severe.

The increasing frequency of events that fall on the fringes of probability is prompting pension fund managers and other institutional investors, who once shunned costly hedging strategies, to reconsider. The Indiana Public Employees' Retirement Fund, which manages $14.1 billion, asked financial institutions in January to send information on a tail-risk management program that would protect it against "an extreme market downturn."

"People are trying to move beyond historic notions that tail-risk events are so infrequent on the one hand, and so extreme on the other hand, that there is nothing you can do about them," says Eugene A. Ludwig, who started Washington-based risk management firm Promontory Financial Group after serving as U.S. Comptroller of the Currency under former President Bill Clinton.

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