Think the global financial crisis was a one-off? Think again. Such crashes are more common than you might imagine. “The history of markets is pockmarked by crashes,” said Seth Weingram, senior vice-president and strategist with Acadian Asset Management. He was speaking at the 2015 Risk Management Conference held in Muskoka, Ontario, in August.
While the recent financial crisis, Black Monday and the Great Depression may be top of mind for most, there’s evidence of debt crises dating back to ancient Mesopotamia, he explained. “While we may not want to admit it, crashes are actually pretty frequent.” And no matter how hard we try—and despite the significant impact of crashes on cumulative equity returns— we’re just not very good at preventing them.
How to manage crash risk
“As an equity owner, you already own crash risk,” said Weingram. So it’s critical to figure out how much you really want in your portfolio and how to manage it.
Typical approaches fall into three categories, he explained.
Standard operating procedure – Essentially, this means using conventional methods of portfolio diversification but not explicitly managing crash risk. “The majority of asset owners fall into this category,” said Weingram.
Asset selection – Some investors explicitly choose holdings, such as low volatility strategies or safe havens like treasuries, to limit the severity of loss in an acute market decline.
Hedging – This strategy involves overlaying an instrument— an out-of-money put, for example—over the portfolio that
is specifically designed to offset losses in certain holdings.
The cost of crash protection
If crash risk is so important, why aren’t more asset owners actively managing it? Cost is one reason. “Crash hedges tend to look expensive,” Weingram explained. Complexity and capacity are also challenges.
But innovative tools are now available to investors such as options on non-equity ETFs, volatility trading instruments and dedicated tail hedging strategies. These offer “greater ability to customize exposure and greater flexibility in how hedges are financed and funded,” he added.
The baseline assumption for investors should be that reducing crash risk means giving up some returns. But Weingram added that there are active approaches, such as managed volatility strategies, that may help improve the risk-return trade-off.
He advised investors to carefully explore the opportunities for risk mitigation, and to be skeptical of simplistic solutions.
“Despite the analytical challenges that crash risk assessment presents, consciously consider and moderate your exposure,” Weingram advised. In short, understanding and managing crash risk may be a difficult task for investors, but it’s not something they should ignore.