NEW YORK (TheStreet) -- In only two years, we've seen global stock markets double in value and a number of "risk assets" (commodities; high yield bonds) likewise rally significantly. You'd think that investors have short-term memories and are willing to throw caution to the wind.But lurking beneath that seeming confidence is a nagging concern that at any moment, for any reason, global equity markets are about to implode. Greece, U.S. debt, Middle East unrest, another nuclear disaster, take your pick -- it will become all too obvious after the fact. Leave it to the investment industry to recognize this fear and to take advantage accordingly. Some money center banks are approaching clients to offer ways in which to protect against financial Armageddon. Hedge funds like Capula Investment Management and 36 South Capital are managing investor capital with this goal in mind. The financial engineers at firms like Pimco have incorporated "tail risk" management into some of their product offerings. And now comes the news that Universal Investments, which already manages $6 billion with global financial calamity in mind, will be rolling out a "black swan" ETF that any ordinary investor can access. To be sure, none of these products have appeal without some catchy buzz words to describe the phenomena that they are protecting. "Tail risk" identifies the remote possibility that something highly improbable will occur. "Black swan" takes the tail risk concept a step further: Not only is the event highly unlikely, but it has a significant impact (such as a devastating hit to your wallet). After its impact, pundits will inevitably rationalize the event as if it could have been expected and managed properly in advance. Therein lies the rub. Since this event could have been expected and managed properly in advance, shouldn't an investor have this tail risk insurance in his/her investment portfolio? After all, that's what this is, the equivalent of earthquake or tsunami insurance.
Then there's "basis risk" in having this type of insurance. Basis risk is a fancy way to say that an imperfect or uncorrelated hedge might be implemented by the fund manager. What if the fund manager buys insurance on the wrong set of risks? For instance, let's say a manager makes investments to protect you against a Chinese equity market meltdown by buying protection against an economic recession in China, which would devastate global economic growth and cause a global stock market collapse. That's a terrific strategy if indeed China cannot sustain its rapid rate of economic growth, leading to a drop in the value of global equities. But what if the U.S debt ceiling isn't raised, the U.S. Treasury defaults on an interest payment, and capital flees the U.S. equity markets for other global markets (like China), fomenting solely or primarily a U.S. equity market debacle? You would be experiencing a tail risk, but your manager would likely not have put the proper insurance in place to protect your portfolio. There's also "counterparty risk," which means the firm from which you are buying your insurance can't pay you. From 2005 to 2008, AIG and investment banks were major counterparties to many hedge funds and investors who had executed credit default swaps (another fancy term for insurance) against the ability of subprime homeowners to pay their mortgages. Many hedge funds and investors found themselves unsure if they would ever be paid, in part or in whole, for their bet against the ability of homeowners to pay their mortgages because it was unclear that the counterparties had the capital to meet those obligations. Any tail risk manager today that enters into an investment requiring a counterparty had better be confident that the counterparty is good for the money, especially when times get tough.
Let's not forget the high costs of putting this type of insurance in place. Let's say you hold a portfolio equally weighted between bonds and stocks, and let's say that your portfolio might generate a 6% annualized rate of return, albeit subject to periodic, unexpected declines in value (some investors define this kind of "volatility" as being "risk.") With levels of volatility (as measured by vehicles such as the VIX Index ) trading today at historically low levels, you might think that buying tail risk insurance would be cheap.
Hey, wait a minute. Isn't that why I hire tail risk manager? Can't the manager find creative ways to mitigate or lower that annualized cost of insurance? Well, let's hope so. But bear in mind that the manager is actually introducing basis risk and counterparty risk into the equation. Who knows what kind of risks that manager may be taking to generate some returns? Moreover, what about the manager's annual fees, which are anything but low. Those fees will also be deducted from any value that is generated by this tail risk insurance. So what's an investor to do? If these tail risk products are expensive, typically generate losses, and are only likely to work when times are really bad, why not just wait and "time your entry" perfectly? Good luck. By definition, a black swan cannot be foreseen.