Was CalPERS Right to Unwind Its Tail-Risk Program?

MSCI researchers argue that the hedging strategy usually costs more than it pays out.

Alex Kraus/Bloomberg

Alex Kraus/Bloomberg

Hedging strategies can pay off big when markets crash — but that eventual pay-off is “more than offset by their cost,” according to MSCI Research.

Tail-risk hedging strategies are investments designed to protect portfolios in the event of a downturn, typically through the purchase of derivatives, such as put options, that will profit when stocks plummet. This protection, however, comes at a price.

“Like other kinds of insurance, many tail-hedging strategies require regularly spending and losing money in order to avoid the worst losses,” wrote MSCI Research executives Peter Shepard and John Burke, who authored the research. Their research suggests that these costs have “typically been high” — and likely outweigh the benefits.

Comparing the tail-risk strategies to stock portfolios with 30 percent allocations to bonds or cash, the MSCI researchers found that all three strategies protected against equity losses — but the “high costs of maintaining tail insurance eroded performance” of the hedging strategies.

“Unless very well-timed before crises, our hypothetical tail-hedging strategies have lagged simulated portfolios that simply reduced exposure to risky assets,” they said.

The conclusion echoes the recent and controversial decision by the California Public Employees’ Retirement System to terminate its tail-risk hedging program in October. The timing of the decision meant that one of two strategies was fully unwound in January — causing CalPERS to miss out on a payout of more than $1 billion when markets crashed in March.


[II Deep Dive: The Inside Story of CalPERS’ Untimely Tail-Hedge Unwind]

“We terminated explicit tail-risk hedging options strategies because of their high cost, lack of scalability, and the fact that there are better alternatives available to CalPERS,” Ben Meng, chief investment officer for the nation’s largest public pension fund, told Institutional Investor in early April. “At times like this, we need to strongly resist ‘resulting bias’ — looking at recent results and then using those results to judge the merits of a decision.”

The MSCI research does not refer to CalPERS or its hedging strategies specifically. Instead, the authors addressed investors who are “considering strategies for hedging tail risk to protect against further losses” following March’s sell-off.

They warned that the cost of tail-risk hedging strategies is “especially expensive right now,” with investors worrying about the economic fallout of the coronavirus pandemic.

“Recent events have reminded market participants of the risk of large market drawdowns,” Shepard and Burke wrote. “While it may seem like the best possible time to have insurance, it is also an expensive time to buy insurance.”