A euro zone breakup would be a once-in-a-lifetime shock sowing unprecedented financial chaos but investors seeking to protect against the threat are acting in prosaic fashion, looking to the traditional havens of gold or U.S. Treasuries.
Buying equity volatility or derivatives on non-euro currencies may look like tempting strategies to protect portfolios from the whirlwind that would surround any fracturing of the 12-year-old single currency.
But concern about liquidity, which determines the ability to get in and out of securities quickly, counterparty risks in a period where financial firms would be under great stress, and the sky-high cost of insurance mean many asset managers are keen to stick to more orthodox hedging products.
You can imagine the effect of an EMU breakup on the European financial system -- it would be at best paralysis, at worst collapse. From that perspective you may want to be more cautious about embedded counterparty risks, said Kieron Launder, chief investment officer at Schroders Private Banking.
If there is a systemic issue, you probably don't want too many non-vanilla instruments because you are less certain about them being paid out. If you are theoretically hedged, i.e. it works on paper, but you don't get your money back, it's not a hedge.
The importance of tail risks -- a low probability event that would cause violent market moves -- has grown after Lehman Brothers went bankrupt in September 2008 almost out of the blue.
Fund managers polled by Bank of America Merrill Lynch this month overwhelmingly chose the euro zone sovereign debt crisis as the biggest tail risk of the moment.
Launder at Schroders said credit default swaps, one of the popular hedges for sovereign default, risked being ineffective as a voluntary agreement with bank creditors to write off half the value of Greek bonds means CDS-type insurance may not now pay out on that debt.
When investing or tail-risk hedging, political will, subsequent implications and national/regulatory interventions have to be considered, he said.
It is possibly the scale of the crisis itself which is preventing money managers from examining more esoteric, or out-of-the-box strategies.
In the foreign exchange market, the U.S. dollar remains the default option for those seeking safety and liquidity.
In times of crisis, people pack up their U.S. dollars and gold, and nothing else -- not the Norwegian crown, Australian dollars, etc, said Stephen Jen, managing partner at SLJ Macro Partners.
Jen said volatility of G10 currencies is now five times higher than average, making it costly to develop strategies via options. What's more, a lot of leveraged money worldwide is still denominated in dollars and so financial stress tends to see natural hedge flows back to dollars.
One could try to be fancy but the safest thing is to be simple. You reach for things that have worked in the past. So, no out-of-the-box thinking, particularly in a crisis, he said.
One of the most popular hedging plays for a sharp equity price decline has been buying of the VIX equity volatility index via Exchange Traded Funds (ETFs) which track the index. However, the strategy is already very popular and now costly as a result, and the risk is huge when stocks do go up.
It's the most expensive tail risk strategy I'm aware of. People will find it very painful to run these positions over long periods, said Sandy Rattray, who runs a tail risk protection fund at hedge fund firm Man Group.
VXX, one of the VIX futures traded on ETF, fell 23 percent in October alone as stocks rallied. Last year, it was down 73 percent as world stocks rose more than 10 percent.
Instead, Man uses variance swaps -- an over-the-counter financial derivative provided by brokers -- in major indexes such as S&P 500, Eurostoxx or the Nikkei.
Variance swaps essentially allow investors to play the difference between current and future levels of equity volatility rather than passively being long or short an ETF. They are also seen as liquid enough to meet investor redemption demands in times of crisis.
Man's specially-designed tail protection fund aims to return 20-40 percent during a poor month for risky assets. It expects to be down 5-10 percent per annum during a good year for risk.
Investors are generally unable to forecast tail events. Track records show people who did particularly well in 2008 did very poorly in 2011. It's hard to separate luck from skill at forecasting these extreme events, Rattray said.
History clearly shows a stress period comes in a different way. Trying to position yourself for all the risks is an impossible objective.
The cost is an important consideration when it comes to choosing different hedges.
One of the challenges with different tail risk hedges is to determine effectively how much insurance premium you are paying. You don't always get a great payoff, said Scott Wolle, chief investment officer of Invesco Global Asset Allocation.
Wolle is sticking to high quality government bonds with hedged currency exposure in the United States, Britain, Germany, Australia and Canada.
What is useful about using government bonds is that you get term premium and they do well during bad times. We want to make sure assets we own make returns relative to cash, he said.
Liquidity is also one of the biggest concerns. Even if something is theoretically a good hedge, you have to consider if you can trade it in a timely fashion to take advantage of a full profit that would be available.
(Editing by Mike Peacock)