Analyzing Tail Risk Using Crisis Utility Rankings

Badon Hill White Paper, 2010

16 Pages Posted: 18 Nov 2010 Last revised: 17 Jan 2011

Date Written: August 17, 2010

Abstract

In this paper, we put forth the notion of “Crisis Utility” as a way of estimating the tail risk of an asset or investment strategy. We believe that Crisis Utility is more functional than traditional, narrowly defined definitions of tail risk since it incorporates the concept of “resiliency,” or recovery rate, as well as the traditional concept of maximum loss potential. Our argument for the inclusion of resiliency comes from our observations of the recent credit crisis. During the depths of the crisis we observed (1) that allocations, particularly institutional allocations, were “sticky,” which is to say that investors either had trouble adjusting asset allocations or were not inclined to do so, and (2) high water marks, or the arrangement that allows investors to recoup losses before a manager can charge additional performance fees, proved to be a significant benefit for resilient strategies. In an environment of sticky allocations and high water marks, we feel that the resiliency of a strategy becomes an important allocation point, particularly for institutions seeking to make long-term, strategic allocations as opposed to short-term, tactical allocations. Our study shows that lower volatility, low correlation strategies have a demonstrably higher Crisis Utility Rating than higher volatility, high correlation strategies. Specifically, using the HFR dataset, we found the strategies with the highest Crisis Utility Ranking were Short Bias, Equity Market Neutral, our bond proxy, Relative Value (Total), Systematic Diversified, Merger Arbitrage, Convertible Arbitrage and Fund of Funds: Defensive. We anticipate that these strategies will receive a relative increase in allocations as investors adjust their allocation models to account for tail risk, all else being equal and free of constraint. We also analyze the VIX Index within our Crisis Utility framework and find that it handily outscores all other strategies in our study. Although it is currently difficult to find active long volatility managers, we conclude that this is an important area for growth.

Keywords: Tail Risk, Asset Allocation, Hedge Fund Risk, Crisis Utility, Investment Risk, Convertible Arbitrage, Equity Market Neutral

JEL Classification: G11

Suggested Citation

Wakeman, Kendrick, Analyzing Tail Risk Using Crisis Utility Rankings (August 17, 2010). Badon Hill White Paper, 2010, Available at SSRN: https://ssrn.com/abstract=1710705 or http://dx.doi.org/10.2139/ssrn.1710705

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