The Rush to Hedge Against Black Swan Events

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Pimco Chief Executive Officer Mohamed A. El-Erian developed tail-risk strategies when he was manager of Harvard University's endowment in 2006 and 2007. Pimco, which manages about $1.1 trillion, opened its first mutual fund aimed at minimizing risks from systemic shocks in October 2008. The Pimco Global Multi-Asset Fund (PGAIX), co-managed by El-Erian and Vineer Bhansali, had about 7 percent of its $2.1 billion in assets invested in the SPDR Gold Trust (GLD) as of Mar. 31. It also held put options, including some on S&P 500 index futures that would pay off if the benchmark fell below 700 by December. Pimco is using tail-risk strategies in many of its funds, says Bhansali. "You don't want to try to be too smart in trying to forecast what is going to happen and which hedge is going to perform better," he says. "What you want to do is accumulate cheap protection."

Deutsche Bank is marketing a tail-risk hedging index that gains in value when a gauge of stock-market volatility increases, according to material the bank sent to clients. The so-called Equity Long Volatility Investment Strategy, or ELVIS, uses derivatives called variance swaps linked to the Standard & Poor's 500-stock index. These swaps increase in value when market turmoil hits and are designed to provide some insurance against a cataclysmic selloff.

Demand for such trading strategies prompted Citigroup to hire John Liu, a former employee of the Indiana pension fund, about two months ago to advise pension plans, endowments, and foundations on tail-risk hedging, according to a prospective investor who declined to be named because the hire hasn't been publicly announced.

Other asset management firms that hedge against Armageddon events in the market are creating funds to take advantage of demand. Pine River Capital Management, a Minnetonka (Minn.) firm with $2.1 billion under management, started the Nisswa Tail Hedge Fund last month, according to a June 15 filing with the Securities & Exchange Commission. The partnership was formed at the request of investors who wanted access to the hedging techniques used by Pine River's primary multistrategy fund, which gained 40 percent during 2008 and 2009, according to co-founder Aaron Yeary.

Still, investors should be wary of long-tail hedging products, says Eric Petroff, director of research at Wurts & Associates, a Seattle-based consulting firm that oversees about $30 billion on behalf of institutional investors. "Products that protect you from tail risk tend to crop up after the tail has occurred," he says. "Back in 2007 it made a lot of sense to hedge tail risk—but now it just seems brilliantly misguided."

Taleb set up tail-risk hedge fund Empirica in 1999 and ran it for six years. He thinks the hedging strategies are a Wall Street fad that won't last. Big payouts from long-tail insurance will be so infrequent that most money mangers will lose interest. "They will drop like flies," says Taleb, now a professor at New York University's Polytechnic Institute. "They and their customers will give up at some point. I've seen it before."

The bottom line: The financial upheavals of the past few years have persuaded many big investors to buy protection against market meltdowns.

Harrington is a reporter for Bloomberg News. Weiss is a reporter for Bloomberg News. Bhaktavatsalam is a reporter for Bloomberg News.

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