November 10, 2009

The Tale of Tail Risk

If you think “tail risk” is what happens if you grab a cat by the tail, well, that’s not far off. Did you know that an entire institutional subset is focused on the risk relative to theoretically ending up with a handful of grabbed cat? We’ll come to that in a minute, and how it might affect your stock.

First, these markets. Real, or more statistical arbitrage? Checking the data, something very unusual occurred last week. On November 4 in our data, the volumes we call electronic and speculative were dead, spot-on, even, at 35.8% of the total, each. That day, divergence in major market measures ceased, and volumes turned bullish. It stood out to us.

Now maybe it’s coincidence. Or it may be that risk-management systems that statistical arbitragers had rocking like a boat twice last month found harmonics. Think of a guitar string coming into tune and your music teacher nodding approval. You may think this stuff is so much financial balderdash. Well, it’s responsible for a very great portion of daily volume. So don’t brush it off like dandruff. But bottom line, money felt more confident, and it showed up on electronic platforms, not in programs. But it’s more like betting than investing.

In general, we’ve observed a return to normal market structure across the bulk of our client base. Twice in October (Oct 1-2, and October 28-30) markets were in danger of swinging wildly out of whack, but healed themselves. It’s disconcerting that it happened twice so quickly. It’s comforting that it happened. Still, market structure is in constant flux. A graph can turn positive for a few days and then develop instant weaknesses. This happens for one undeniable reason: trading is reactive, not committed. That condition remains a deep-seated threat that regulators seem not to recognize.

You might gather now that “tail risk” has something to do with hedging. Vineer Bhansali at PIMCO funds, an expert on tail risk, says it’s “risk posed by rare events.” How institutions manage for these outliers on the edges of bell curves – tail risk management – affects vast clusters of equities.

Now, stay with me, IROs. What we’re getting to here is another reason why your stock may lack staying power on good results or news, seeming instead to constantly fluctuate. Bhansali explains that traditional risk-management techniques often fail to accurately estimate the frequency and size of “left tails,” or catastrophic events. Since everybody is acutely aware of bell curves and trend following, and not wanting to be the one who lost the institutional jewels to a bad hedge, we find that trading stays in the heart of bell curves and spends less time playing around the edges of the curve where the tail can lash left suddenly and leave you in the soup line.

So part of what happens is this: your results produce an immediate stock bounce, followed by an immediate retreat, as everybody supposes their investment is in the middle of the bell curve now, and it’s time to take profits. This is a new phenomenon. It did not exist a year ago, before Lehman’s demise. And if Lehman and all the rest had in fact demised as they should have, we probably wouldn’t be experiencing this phenomenon now.

All hedging reflects value uncertainty. When it occurs every other day, the degree of uncertainty is so great as to constitute an almost complete absence of any certainty at all.

That’s meant to make you chuckle. How do we fix it? U-turn back the other direction, away from whatever we’ve been rushing at for a year, like a vortex down a drain. And by the way, this does not mean markets will falter. We can continue on for some time. But sooner or later some little tail will flick left, right in the heart of the bell curve. And no one will be expecting it.

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