Nervous hedge funds managers are stress-testing their portfolios and searching for ways of protecting themselves against their worst nightmare -- a potential break-up of the euro zone.
With talks on restructuring Greece's debt mountain still deadlocked, and the exit of one of more countries from the euro seen as a small but definite possibility, funds are modelling scenarios ranging from a 50 percent slump in European stocks or a 45 percent fall in the oil price to a 30 percent rise in gold.
Managers are also trying to dig out old computer programmes they once used to model the behaviour of currencies such as the drachma or the deutschmark as they prepare for an event for which -- even after the 2008 collapse of Lehman Brothers -- they effectively have no precedent.
Many, having already trimmed risk, are piling into credit default swaps or deeply out-of-the-money options, hoping they pick a counterparty that can withstand the shock of a break-up.
"You can't conceive what this event will be like, but it doesn't absolve you of looking at it," said the chief risk officer at one hedge fund firm who asked not to be named.
"People are asking the questions, 'do I have the historical records on how things worked when there was a deutschmark?' and 'did I throw away those computer programmes (modelling the deutschmark)?'."
Funds are also trying to figure out how they might be affected if different asset classes that normally have a low correlation start to fall sharply at the same time.
"Anyone who's a chief risk officer is running these scenarios -- say if the euro falls 15 percent, stocks fall 25 percent, if the possibility of default increases, what if recovery rates falls, which prime brokers, administrators get hit?" said Mark Wightman, head of strategy for Asia-Pacific at specialist technology group SunGard.
"The scenarios are getting quite complicated and people are starting looking at correlations between things to understand the likely impact."
While hedge funds, which can put on short positions, have more tools at their disposal than long-only funds to cope with market falls, their performance has been patchy.
Last year they lost just over 5 percent on average, according to Hedge Fund Research, while the S&P 500 delivered a total return of 2.1 percent. That was their second calendar year of losses in just four years after heavy losses during the credit crisis in 2008.
Many hedge funds have already cut exposure to assets seen as directly in the firing line such as the euro or European stocks, insiders say, but are finding their options limited.
"We're all still trying to run our businesses right now. I'd like to say I'll put everything in U.S. dollars, but you can't," the hedge fund chief risk officer said.
"Part of it is contingency planning -- what you need to get out of first -- and part is proactive -- 'I don't need so much emphasis in a certain area right now', such as European stocks or the euro," he said.
"Certainly we are taking smaller positions in some of these markets."
Some funds also rejigged their equity short positions after major differences between stronger, core economies such as Germany and weaker peripheral economies became more apparent, said one investor who spoke on condition of anonymity.
For instance, a manager who owned shares in a German bank whilst shorting a Greek bank has switched to hedging the German bank with a short position on another German bank, after the Greek bank's shares "started to take on a life of their own" as a result of the country's debt crisis, the investor said.
However, with uncertainty over which currencies would exist after a break-up and how they would behave, funds are still unsure how far their hedges would protect them.
"A hedge fund may have a hedging programme that is very highly attuned to dealing with its positions. But the day after something happens there's no programme to deal with this and their hedge may be denominated in a new currency," the risk officer said.
Part of the dilemma is a mistrust of value at risk (VaR), a standard measure used by banks to show estimated potential loss, expressed with a certain percentage level of confidence.
"A traditional measure of risk like VaR has nothing to say on this," said Lance Smith, CEO at U.S.-based Imagine Software, which has been working with hedge funds to assess the impact of a euro zone break-up on their portfolios.
"A euro break-up could be a 7 standard deviation event. A 6.5 standard deviation event occurs once every 34 million years, while a 50 percent fall in the Eurostoxx would be a 21 standard deviation event. This just highlights the flaws in a standard statistical approach."
Credit default swaps, which are meant to pay out in the event of default, currency options or deeply out-of-the-money options, are among the favoured hedges, industry executives say, which has driven up option prices.
However, even here there is a concern over whether the counterparty can pay up.
"You watch the counterpart if (it's) OTC (over-the-counter) to avoid contagion," said Sungard's Wightman. "Thus you do your euro trades with say Japanese, U.S., Asian or Australian institutions."
Meanwhile, one hedge fund manager has structured a trade to buy German bunds whilst offsetting this with credit default swaps, one fund selector told Reuters.
"His base case is that if someone comes out of the euro, the German bund will be the place to be."
All these nervous hedge funds are wasting their time! If Greece defaults, no need to "stress-test" your portfolios, all bets are off, correlations move to 1, there will be nowhere to hide. They can buy all the insurance in the world (CDS), it won't make a difference.
Don't be deceived by the U.S. stock market's rousing start this year or the new-found stability of the euro.
After months of seizing on every incremental development in Europe as a reason to buy or sell, markets have started 2012 on a firm footing. The S&P stock index is up 4.8 percent so far this year and the euro has rebounded from recent declines on hopes the euro zone will survive a likely default by Greece.
But fund managers betting on economic armageddon say the worst is far from over as they eye the negotiations to restructure Greece's debt warily.
While well-worn measures of volatility such as the CBOE Volatility Index show relative calm, indexes that track bets on extreme outcomes are rising.
It's why "tail risk" investing - pursued by funds that bet on steep, unexpected drops in asset values - is still attracting investors eager to protect against unlikely outcomes such as a market crash. The recent decline in volatility has made these hedges cheaper.
"Tail-risk hedging has been growing quite substantially, especially in this environment where volatility is low and the price of tail risk hedges is cheaper," said Vineer Bhansali, PIMCO's managing director who runs the bond fund's tail risk strategy. "That's when we have the most interest." Newport Beach, California-based PIMCO's tail risk accounts are insuring $45 billion in assets.
These strategies first garnered attention in the wake of the unexpected collapse of Lehman Brothers in 2008, when numerous global markets slumped by more than 50 percent.
Assets invested in doomsday scenarios are hard to quantify since there is no index that tracks such "Black Swan" strategies. JP Morgan Chase's global asset allocation group estimates assets in "tail risk" hedge funds have ballooned to about $38 billion in April last year from less than $500 million prior to the Lehman collapse.
London-based portfolio manager Bob Noyen thinks the market has become too sanguine about Europe's debt and banking woes. The chief investment officer at the $25.4-billion Record Currency Management expects the euro zone to collapse, and started the Record Euro Stress Fund in June to capitalize on euro zone problems.
He said the firm's models have priced in a 10 to 15 percent chance that the "euro zone will enter into a chaotic process of dissolution, and that percentage is steadily increasing."
Record Management's Euro Stress Fund was the first of its kind being solely focused on euro zone stress, Noyen said. He added, however, that Record's fund is not exactly a "Black Swan" fund because the euro zone crisis is already a known and well-telegraphed risk.
It invests in a variety of options, which amount to shorting the euro against the dollar and yen, Noyen said.
That includes bets against European currencies such as the Norwegian and Swedish crowns and the Swiss franc, which could get sucked into a European maelstrom should the euro zone break up.
Noyen's Euro Fund is down 2.26 percent so far this year, hurt by the euro's surprising strength.
WATCHING YOUR TAIL
The $50 billion London-based asset management firm GAM has bought protection on European banks in the credit-default swap market as a hedge against a euro zone collapse even though it has a more optimistic take on the region's crisis.
"If you really think about it, what would drive a crisis again will most likely involve European banks in some form of bank run," said Jack Flaherty, investment manager at GAM who helps run the firm's Absolute Return Bond Strategy.
He added that GAM has decided to use the still reasonably priced CDS as a hedge instead of out-of-the-money S&P 500 puts.
Hedge funds wishing to protect against risks in the euro zone or stock market typically purchase lower-priced, long-dated put options - contracts that give them the right to sell an underlying stock or security on expectations of a fall in price.
They usually buy these options when they are deeply "out-of-the-money" - in which the price at which they can exercise that right to sell is well below the current market level - and hope that over time market conditions change in their favor.
For example, an investor expecting a stock currently trading at $100 to fall could buy a put option at a $60 strike price. Once the stock falls through that level the option would then be "in the money."
But the "out of the money S&P puts have become very expensive, have been all year, and for quite a while because everybody is buying S&P puts especially after the financial crisis of 2008," Flaherty said.
This can be seen by looking at the CBOE Tail Hedge Index, a relatively new index that acts as a benchmark for "tail risk" hedging strategies. This index measures the price of options used for portfolio insurance, and it has been steadily rising of late, a sign of concern.
STOCK MARKET STRESS
Many investors believe the U.S. stock market is undervalued as earnings have steadily increased and the S&P 500 has remained in a range. The forward price-to-earnings ratio on the S&P is currently 14.55, below the historic average of 15.
Mark Spitznagel in Santa Monica, California, sees it differently. He specializes in protecting against extreme outcomes at hedge fund Universa Investments, which he founded with scientific advisor Nassim Taleb, who wrote the book "The Black Swan," a detailed theory on the unpredictability of very rare events.
Spitznagel says the expectation for bailouts and cheap money means U.S. stocks still trade at lofty levels when compared to the replacement cost of companies' assets. This week the U.S. Federal Reserve committed to keeping benchmark U.S. interest rates low through late 2014, and that implicit underpinning makes people overconfident.
He said expectations right now are clearly for "exceedingly high aggregate returns on tangible capital, something that is unsustainable in a competitive economy."
Spitznagel is known for his bearish value- and derivatives-based stock market investing. One of his most profitable trades was his billion-dollar bet on the stock market crash of 2008.
The Universa chief, however, would not disclose his strategy.
JP Morgan estimated Universa's returns for the year to September 2011 at between 20 and 25 percent. Universa won't confirm JP Morgan's figures but market participants say 2011 was a profitable year for most tail-risk funds.
CALM BEFORE THE STORM
Fears about the euro zone have eased temporarily given recent successful debt auctions in Spain and Italy. Greece is trying to broker a deal with creditors to reduce its massive debt pile but that story changes daily.
Noyen is undeterred. He has advised clients that investing in a worst-case euro scenario is often a long-term proposition that can pay off when many other investments are losing money.
"The funds are spent on buying out-of-the money put options. So in the event that the euro goes to parity against the dollar or to $1.10 versus the dollar, we plan to add value to the portfolio by as much as 50 to 100 percent," Noyen said.
PIMCO's Bhansali said that with the decline in implied volatility in equities, currencies and interest rates, the cost of hedging has fallen to roughly 1 to 1.5 percent from about 2 percent of the portfolio in November and provides the perfect opportunity to add more hedges.
"I don't think the market has really priced in a euro zone break-up," Bhansali said. "There are a whole bunch of technical issues that people have not figured out."
The market hasn't "priced in" a eurozone break-up for the simple reason that it won't happen. All these hedgies waiting for a "Lehman-style event" so they can score big are collecting 2 & 20, selling fear to their institutional clients.
The biggest and most powerful hedge funds in the world stand ready to pump up the jam. The black swan of 2012 remains a mild eurozone recession. When fears of a eurozone break-up dissipate, greed and massive liquidity will drive all risk assets much, much higher. That remains my prediction, and if I am wrong, God help us all!!
Below, Bob Parker, senior adviser at Credit Suisse Asset Management, talks about plans for a Greek private-sector involvement accord, the euro area firewall and the U.S. economy. He speaks with Mark Barton on Bloomberg Television's "The Pulse."