Morningstar Advisor - April/May 2009 - 55

For macro hedges to be successful, we don’t need to correctly predict exactly which tail events will happen. We simply need to protect against the range of responses to those events. Vineer Bhansali client asked Bhansali to create a distinct tail-risk hedging portfolio. Soon after, many other PIMCO clients became interested in disaggregated hedging portfolios of this kind. Of course, the current financial crisis has only intensified the demand. Meanwhile, El-Erian returned to PIMCO in January 2008. (He is now CEO and co-CIO.) His return intensified efforts to expand the strategy. PIMCO now uses the tail-risk hedging approach at open-end mutual funds PIMCO Global Multi-Asset Fund PGAIX and PIMCO RealRetirement target-date funds. The strategy is also being used at many of the firm’s institutional and separate account mandates. All in all, the tail-risk hedging part of PIMCO’s business has grown into several billion dollars in assets under management. Lessons from Science for Investing Salomon Smith Barney/Citigroup as a derivatives specialist. “I figured that if I did that for a few years, I could always return to academia,” he says. He found he enjoyed the work, and he hasn’t looked back. He later worked at Credit Suisse First Boston on the firm’s proprietary fixedincome trading desk, and he joined PIMCO in 2000. He has continued his scholarly bent and has written many scientific and financial journal articles, as well as Pricing and Managing Exotic and Hybrid Options (1998). Bhansali might have changed careers, but he has never completely left behind his previous field. In fact, Bhansali frequently finds himself returning to physics to find insights into finance—especially recently. He argues in a PIMCO research piece that in times of dramatic market stress it is often the more unorthodox viewpoints, drawn from other fields, such as the physical sciences, that can provide the most useful intellectual tools. The article draws an analogy between dramatic changes in the financial markets to the phase transitions in states of matter, such as when water goes from being a liquid to a gas when it’s boiled. Bhansali argues that, much like in the physical world, dramatic transitions in financial markets are often messy—expected patterns of cyclical change in asset classes, such as “reverting to the mean,” don’t always pan out in an orderly fashion. Instead, he says, these patterns can give way to disorderly momentum factors, and investors should not confuse the wild swings for “genuine,” or valuationbased, mean reversion. More broadly, Bhansali sees equilibrium as rarely the state of affairs in the world. Whereas someone using risk analytics based on the efficient-market hypothesis sees equilibrium as the norm, Bhansali, the particle physicist, assumes there is no norm. This perspective has profound implications for someone working on tail-risk hedging. Tail-Risk Hedging in Practice When discussing the practicalities of his approach, Bhansali likes to draw the distinction between what he calls “just-in-time” risk management and a “just-in-case” risk strategy. He argues that the former view, where investors attempt to rush into hedge positions at the start of a market downdraft, doesn’t work well. The timing can be difficult to get right, he says, and the costs of many hedging avenues spike up. Instead, he advocates the style of a long-term insurance policy, “just in case” it is required. Tail risk is always a concern, he says, and portfolios that are using the strategy employ pre-emptive hedges when they’re cheaper to obtain. Of course, during times of extreme market stress many tail-risk hedging vehicles become very pricey, but Bhansali argues that the approach PIMCO uses accounts for that problem. When addressing the issue of costs, Bhansali says that although tail-risk hedging is supposed to protect investments from rare periods of financial stress and other systemic shocks to the financial markets, these black swan events occur more frequently than we might think, and this is an important consideration when addressing the cost issue. For example, over the past three decades, Bhansali says that the Bhansali’s views on the management of investment risk and its mitigation have been informed by his unconventional background. He obtained a Ph.D. from Harvard in theoretical particle physics. In his early years as a professor, Bhansali’s reputation for high-level mathematical abilities and his rigorous thought process attracted the attention of New York investment firms, which were always looking for “rocket scientist” researchers to develop highly complex trading strategies. One of his callers, from Goldman Sachs, was Fischer Black, who is best known for his work on options pricing and the Black-Scholes equation. Black recruited Bhansali for a position on his research team. Bhansali turned him down to continue teaching physics. Many more solicitations later, however, Bhansali relented and took a position at MorningstarAdvisor.com 55

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Morningstar Advisor - April/May 2009

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