The idea of tail risk and investor’s desire to hedge it has been floating around the blogosphere for a couple of weeks now.  Felix Salmon kicked things off with this post and we weighed in as well.  Eradicating tail risk is a worthy goal, but in all likelihood an elusive one.  That has not stopped Wall Street from seizing on the desire of investors for downside protection.

An article at Bloomberg this week summed things up quite succintly:

Wall Street’s hottest new product is fear.

The article goes on to recount the number of products firms are rolling out to protect investors from severe downside events.  Needless to say these products have high explicit and implicit costs.  The CBOE is getting into this game as well with a new skew product that will “allow investors to take positions on market expectations of extreme losses.”

One could argue that the abundant interest in the VIX index and the growing number of VIX-related products is a function of investors looking to hedge tail risks.  The question is whether any of products is much better than simply “buying puts on something” as Adam Warner has said previously.

The fact that putting on these tail risk hedges is costly and expensive tells us something.  That investors are still in a bit of denial.  Rather than de-risking their portfolios, by moving into cash or other safer assets, they desire a magic bullet to protect their portfolios.  As Joe Weisenthal writes:

Nobody wants to de-risk, in the sense that they want to actually take some money off the table. Instead..it’s all about pricing and quantifying risk, and of course hedging against it.  And hedging against risk, and actually de-risking are not the same thing.

Jared Woodard notes that these solutions are expensive in part because they provide “permanent” insurance.  That is they do not adjust based on market conditions (and prices).  In short, the naive approach is the expensive approach.

The solutions Wall Street is providing would be great if they were in any sense of the word – cheap.  James Montier notes that the costs of insurance always rise right after an untoward event.  The result of which, as Montier writes, is compounding the problem:

Buying expensive insurance is just like buying any other overpriced asset…a path to the permanent impairment of captial. Rather than wasting money on expensive insurance, holding a larger cash balance makes sense. It preserves the dry powder for times when you want to deploy capital, and limits the downside.

Wall Street has a checkered past in offering investors downside protection.  The case of portfolio insurance and the 1987 stock market crash being a perfect example.  If you interested in obtaining tail risk insurance you need to ask yourself whether you have too much risk on to start.  De-risking isn’t fun (or cool), but as noted above it may be the best solution to an intractable problem.