DGAM is an advocate of what is known in the financial industry as “tail-risk hedging”Getty Images/iStockphoto
Much of the financial world was in a panic, but Aug. 8 was a calm day in the office of Toronto-based money manager Diversified Global Asset Management.
While global markets plunged, taking the Dow Jones industrial average down 635 points and the Standard & Poor's/TSX composite index down 491, things were considerably more upbeat for DGAM. The company's hedge portfolio tripled in value, taking the sting out of the declines.
DGAM is an advocate of what is known in the financial industry as "tail-risk hedging" – or buying insurance against the worst possible days the markets can dish out. DGAM manages about $5.5-billion and specializes in choosing hedge funds for institutional investors.
The money manager uses a small portion of the returns it makes to buy things that will go up in value when markets dive – such as far-out-of-the-money put options on stocks. (A put option is a derivative instrument that gives its owner the right to sell a stock at a fixed price.) Those options are cheap when stocks are on the rise, but as share prices fall, they rocket skywards in value.
Yet despite the success for DGAM on a day like Aug. 8, there's still a spirited debate in the top echelons of the money management industry about whether such "insurance" is worth it. Like all insurance-type products, it costs money, and there are those that argue that the cost isn't worth the potential returns. In good markets, many of the options that hedgers buy expire worthless.
On one side, there's behavioural finance expert and strategist James Montier of GMO LLC, the money manager co-founded by Jeremy Grantham, who wrote recently that such hedging is in most cases an expensive fad. Critics like Mr. Montier argue that crises are unpredictable, meaning there's a risk hedges won't work – like the property owner who buys fire insurance, then is hit with a flood.
On the other side are money managers who use it, such as DGAM and Pacific Investment Management Co. and who say (as you would expect), that done right, it's well worth the cost.
The debate isn't just one for big money managers. With volatility surging back to the fore, investors big and small are looking for ways to protect against the kinds of drops that have rocked stock markets in recent weeks. And some of the investment vehicles that large-scale tail hedgers use, such as equity and index options and the ability to trade volatility, are available in some form to even retail investors.
In support of the "it's worth it" argument, DGAM chief investment officer Warren Wright points to the firm's numbers. DGAM's portfolios have a positive return so far in August, and are up for the year, in large part thanks to the hedging, even with most stock markets far in the red. In 2008, the hedge positions were up about 10 times their original cost.
"It's probably saved our tail, for lack of a better term," said Mr. Wright of DGAM, which has experience in tail hedging stretching back to the 1990s.
Not only does this kind of investment insurance protect returns, hedgers are able to turn their exotic positions into cash when markets are sliding, giving them the ability to buy assets that are on sale.
But investors holding cash can do that too, without the constant stream of premium costs going out the door and eroding returns when things are good. In a June paper, Mr. Montier wrote that "in many situations, cash is a severely underappreciated tail risk hedge" and that buying insurance against catastrophic selloffs "appears to be one of many investment fads du jour."
Instead, Mr. Montier advocates cash, saying a "safer and less costly approach" is for investors to "step away" from markets when they are too expensive relative to risks and wait for a better time to get back in.
That's not exactly easy to do in real life. Few people can time markets.
If there's a place where Mr. Montier and Mr. Wright are in agreement, it's that insuring a portfolio only works if you buy most of the coverage when nobody else wants it, meaning there's an element of market timing there too. When the insurance is in demand, the price rises.
"It's too expensive, today, certainly," Mr. Wright said.
Should markets go back to sleep for a while, and volatility drop, the price of hedging will come down. Even then, investors who choose to insure have to reconcile themselves to giving up some of their returns in the form of premiums, all the while hoping they never have to collect a payout.
Despite DGAM's performance, Mr. Wright would rather not see days like Aug. 8.
"On a relative basis, we look great, but these types of events don't help anyone," he said. "We'd much prefer to burn through premiums and never have these hedges pay off."