Recent market events have highlighted the reality of tail risks - infrequent, high-impact events that can seriously dent portfolio performance.
This is a topic that we’ve been highlighting extensively to clients over the past year and one that I wrote about last winter.
In general, particularly where investors take a long term view and can withstand volatility, we’re strong advocates of taking equity risk and see it as a key component of growth portfolios.
There are however institutions that have a lower tolerance for shorter-term volatility. Where this is the case, there are multiple options that we’ve been raising with our clients (other than wholesale removal of equity or growth exposure) – in this article I provide a brief introduction to three of these.
The benefits of taking equity risk
At moments of market stress and uncertainty, it can be tempting to pull out of equities altogether - however, taking equity risk frequently pays off over the very long term - even if downturns test our patience.
This article helps to help put this into perspective, as well as showing why making snap decisions in times of market stress can often turn out poorly.
Chart 1: Taking a long-term view
Putting money to work has historically been more important than getting timing “right”. A notable example – money deployed into global equity markets immediately prior to the global financial crisis would still have delivered 8% pa to date.
Chart 2: Downturns are part of the experience
The sea of green of the prior chart may give the impression of a smooth journey. The reality is quite the opposite – the next chart shows the falls you would have experienced (from the most recent prior peak equity value) as an investor over the past 25 years.
Chart 3: Strong returns often follow downturns
Strong equity market returns frequently immediately follow periods of downturns – trying to time the market (eg taking wholesale exposure off the table because of uncertainty) and getting it wrong can have negative consequences. With the exception of the dot com bubble starting in spanning 2000-2003, the chart below shows that since 1990 all calendar years of negative returns have been followed by a calendar year delivering returns in excess of 15%.
For institutions that have lower tolerance for equity volatility
Some institutions that we work that can’t withstand the short-term volatility associated with a long-biased (and unadjusted) equity allocation – be that institutions with balance sheets that are under public scrutiny, pension schemes targeting short-term insurance transactions, or balancing other objectives that require the preservation of assets.
We’ve been raising a wide range of options with our clients that fall into these categories over the past year, designed to help them retain risk on the table, whilst limiting the impact of a tail risk event. I’ve provided a brief introduction to three of these below.
Tail-risk diversifying strategies
In early 2024 LCP worked with a specialist investment manager to design and support the launch a bespoke tail risk solution - encompassing six funds designed to benefit during periods of market downturns. For the avoidance of doubt – we have no financial interest in this product – we undertook this exercise to help close a gap in the marketplace that we believed would benefit our clients.
These funds provide exposure to various securities that are designed to benefit from stress in equity, credit and other markets. The strategies are actively managed to:
- minimise the cost of protection (ie performance drag) in more benign market environments;
- create asymmetric and convex return profiles (ie in broad terms the upswings outweigh the downswings, and become more pronounced during the most extreme events);
- retain appropriate liquidity and therefore nimbleness during turbulent times.
Pleasingly for us, and our clients that introduced an allocation, the fund performed as expected moving into the recent tariff turbulence, with strong positive returns experienced in 2025 to date.
Over 2024 the seed investors in this new fund (whose circumstances mean that a tail risk event would put their continued viability into question) replaced part of their growth asset holdings with an allocation to this.
Allocating to private market assets
Where clients are seeking balance sheet stability and can lock assets away for an extended period of time, we frequently recommend private market assets. The valuation methodology means there is typically price stability over short- and medium-time periods (and access to an illiquidity premium can enhance returns).
In recent years we’ve been putting forward secondary market funds. In this approach, the manager builds a portfolio by purchasing holdings in existing private market funds from other investors, typically at a meaningful discount.
This approach offers a range of benefits, including having sight of the underlying portfolio companies, which meaningfully reduces the dispersion of long-term outcomes (illustrated by this chart).
Structured equity solutions
Where our clients have an existing equity portfolio and are looking to introduce explicit limits on potential losses over a short period one option is to “shape” the exposure to equity markets using derivative contracts.
There are lots of options, but one solution we help clients implement is a “zero cost” structure where potential upside is sold in return for purchasing downside protection (such as the chart below).
This can provide certainty over short-term client-specific events whilst not necessitating the sale of physical equities. However, we generally only recommend this approach where there are specific time horizons and desired outcomes at play (eg the potential for a large upcoming cashflow requirement).
Conclusion
Meaningful market swings can be concerning, particularly when even well-diversified portfolios are losing value. In general, we don’t view periods of significant volatility as the ideal occasion to make wholesale changes to investment strategy, and our clients have generally been rewarded for remaining patient as equity investors.
However, where there is a structural need reduce exposure to tail risk events, there are a range of options that we’ve been discussing with our clients based on their specific circumstances.
Please speak with your usual LCP contact or reach out directly to Joel to learn more.
