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An interesting piece from Morningstar (“The PIMCO Approach to Avoiding ‘Black Swan’ events”) left me wondering how frontier market oriented funds can best mitigate against the rare-yet-troublingly-frequent “fat tail” distributions that have left a mounting plethora of portfolio managers in its wake?
PIMCO’s Vineer Bhansali, who runs the firm’s open-ended Global Multi-Asset mutual fund along with Mohamed El-Erian and Curtis Mewbourne, states that hedging against improbable albeit systematic shocks will add roughly 25-50 basis points to a given fund’s expenses. Moreover:
“Protection [can] be acquired through a variety of methods, such as by purchasing short-term Treasuries or Eurodollar futures. Both tend to rally during market crises, as capital seeks a flight to quality. Similarly, certain currencies, such as the U.S. dollar, Japanese yen, and Swiss franc, have traditionally been seen as safe havens.
Moreover, the fund will also use optionlike approaches on credit indexes, using deeply out-of-the-money segments of the CDX and iTraxx. Or it will use managed-futures-styled strategies. Beyond these approaches to hedging risk, the managers will simply dial down the portfolio’s level of risk when they think that the market isn’t offering attractive valuations or adequate compensation for risks.”
In addition to global calamities, frontier funds also tend to have the built-in additional drawback of country-specific risk. For example, concurrent with their generally relative low level of liquidity, most if not all frontier markets have a higher probability of political uprising, corruption, currency devaluation, and hyperinflation. In fact, it is precisely due to the higher chance of such events occurring that the risk premia is so great for such investments, making them an attractive choice for foreign institutions in particular who simply can’t find an equal risk/reward elsewhere in which to spread smaller segments of its cash. But is it high enough that investors can not also expect, and managers should not also embrace, further tail-risk strategies designed to smooth returns?