Just as globalization allows investors to ride the growth surges of emerging markets, they also must share in financial catastrophes caused by events halfway around the world, but a recent survey suggests institutional investors are not ready for those contingencies.
It’s not for lack of awareness: Institutional investors are increasingly worried that tail-risk events, like the bursting of a new asset bubble or an oil-price shock, are becoming more frequent due to the globalization of financial markets, according to the third annual Global Risk Monitor Survey.
The study, sponsored by Munich, Germany-based Allianz Global Investors, found that two-thirds (66 percent) of respondents think that tail risk has become an increasing worry since the global financial crisis, but many have not changed their portfolio construction strategies to address the risk.
“The risk of a correction in the markets is growing with valuations continuing to rise, geo-political tensions festering and U.S. monetary policy tightening on the horizon,” says Kristina Hooper, AllianzGI U.S. investment strategist. “In general, institutional investors’ current asset allocations make sense, but the problem is that many of these investors are not incorporating the proper risk management tools to protect these investments from market volatility.”
Tail risk is the chance that a portfolio’s value moves more than three standard deviations from its current price. Under the familiar normal distribution bell curve, there is only a .03 percent chance for such a movement, however, tail risk suggests that the distribution of prices is a skewed ‘fat-tailed’ distribution, implying a greater probability that an investment’s price will move beyond three standard deviations.
In the survey, a majority of respondents relied on traditional strategies to mitigate risk, with 61 percent using asset-class diversification and 56 percent using geographic diversification. Allianz reports that these risk management measures will produce diminishing benefits as markets continue to globalize.
Only 36 percent of the respondents thought they had access to the appropriate tools to deal with tail risk, and just 27 percent make use of strategies to hedge against tail risk.