In a new paper, GMO’s James Montier argues that it is, writes Russel Kinnel of Morningstar FundInvestor.
I’ve written about the appeal of PIMCO Global Multi Asset (PGAIX) and its use of tail-risk protection. But could cash be a better source of protection?
Certainly, cash wins on the score of simplicity. While tail-risk insurance is complex, cash is simple and time-tested.
Montier said tail-risk insurance is expensive when everyone wants it. You have to wait for those rare moments when it’s cheap…and, by most accounts, it hasn’t been cheap since 2007. That high cost will hurt returns.
With those costs in mind, he wrote “the surge of tail-risk products may well not be the hoped-for panacea. Indeed, they may even contain the seeds of their own destruction (something we often encounter in finance—witness portfolio insurance, etc.). If the price of tail-risk insurance is driven up too high, it simply won’t benefit its purchasers.”
Also, he points out, there are many risks and time periods to be sorted out for tail risk. Some managers favor relatively broad hedges—such as hedges against equity-market volatility—yet other managers have used cash for a similar purpose for decades.
Finally, Montier observes that you need a lot of tail-risk insurance for it to do much good. The tricky thing with the PIMCO fund is that, while it’s providing insurance for the rest of its portfolio, you’d have to make it a pretty large position if you want it to help out your entire portfolio.
Montier modeled four different portfolios to see how they would have fared in the past six years, which of course would include 2008’s swan dive:
- Portfolio 1: 100% S&P
- Portfolio 2: 100% S&P with 10% tail risk and negative 10% cash
- Portfolio 3: 75% S&P with 25% cash
- Portfolio 4: 70% S&P 500 with 30% tail risk
In the test, Portfolio 4, with 30% tail risk, didn’t lose any money in 2008. Portfolio 2, with some tail risk, lost more than Portfolio 3, holding a 25% cash position. Montier’s point is that you need quite a lot of tail-risk protection to protect against losses.
Interestingly, the returns for the total time period were best for Portfolios 1 and 3—those without any tail-risk protection—while Portfolio 4, with the hefty tail-risk protection, came in last.
Montier then goes on to sing the praises of cash as a “severely underappreciated tail-risk hedge.” He points out that, besides holding up well in bear markets, it also holds up well when inflation spikes or deflation bites. With duration (a measure of interest-rate sensitivity) at zero, it will beat bond funds when inflation spikes. It more than holds its own during deflation.
Does all this condemn tail-risk protection and the funds that use it? Not exactly.
The PIMCO fund has a widely diversified portfolio on the long side that can help in many downturns. The 2000 to 2002 bear market was one in which many stock and bond types actually gained money even as the S&P 500 was plummeting.
Moreover, PIMCO’s tail-risk insurance is sure to be more sophisticated than Montier uses in his hypothetical example, and PIMCO actively manages its hedges to take profits when possible.
On the other hand, his point about the size of tail-risk insurance is important. While it will limit the harm to the fund in a bear market, we don’t know yet if it will be as solid as cash in the next market crisis.
In addition, it illustrates the challenge of running this strategy in an open-end fund, where flows might come in when tail-risk insurance is pricey. Lastly, the risk that greater investor interest in tail-risk strategies could crowd the market and drive prices up further is a potent one.
In any case, Montier’s argument is a good reminder that humble, almost yieldless cash is still one of the best and simplest forms of downside protection.
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