Everything You Need to Know About Tail Risk

With global equity markets at all-time highs, it makes sense to revisit tail risks which are easy to ignore in good times.



Tail risk is the risk (or probability) of rare events. With many global equity markets at all-time highs, it makes sense to revisit tail risks which are so easy to ignore in the good times. Low rates mean many parts of the market are priced almost to perfection which increases the risk that unpredictable tail events could spoil the party. Here are some to watch out for:

  1. Retail/OTC/Crypto volumes

  2. COVID-19 Mutations

  3. Debt / Moratoriums / Defaults

  4. US/Australia/China Tensions

  5. ETF Bubble

Whether or not these particular risks come to pass, having a well-balanced, diversified portfolio and being prepared with a plan in the event of an unexpected outcome are keys to successful investing.


Retail/OTC/Crypto volumes1

In the typical boom stage of a bubble, fear of missing out on what could be a once-in-a-lifetime opportunity spurs more speculation, drawing an increasing number of investors and traders into the fold. Often these new speculators are new market entrants.

 The COVID-19 pandemic has led to millions of new investors discovering the stock market. Cancelled sporting and racing events meant speculators had to find new pastimes with many discovering investing.

Retail brokerage firms like Robinhood have seen an influx of customers and trading volumes, and stimulus checks from the government also helped boost trading volumes.

The surge in retail investors over the past year has led to a boom in speculative OTC/penny stock and cryptocurrency trading.

On February 21, there were 1.9 trillion transactions on the over-the-counter markets, which is where most penny stocks trade. Last year, that number stood at less than 200 billion a 20x increase.

But the risk in buying low-priced penny stocks is considerably higher than buying an exchange-listed stock because regulations and oversight is extremely lax on the OTC markets.  Penny stocks are also more prone to being the subject of pump-and-dump schemes. The same can be said for a large proportion of the cryptocurrency markets.

It is also unlikely that price discovery is informed by fundamental security level analysis with many new retail investors following the crowd on social media and forums like Reddit.


COVID-19 Mutations2,3

Since the COVID-19 pandemic began, the virus that causes the disease, SARS-CoV-2, has mutated multiple times, with some strains being more infectious and deadlier than others.

Currently, the World Health Organization (WHO) has classified four of those mutations as variants of concern: Alpha, Beta, Gamma, and Delta.

Four others – Eta, Iota, Kappa, and Lambda – have been designated as variants of interest, and in recent weeks the rapid spread of the Lambda strain, first detected in Peru, has caught the attention of various experts after spreading to 28 countries.

 It is believed that the Delta mutation originally surfaced in India. The first Delta case was identified in Dec 2020, and the strain spread rapidly, soon becoming the dominant strain of the virus in both India and then Great Britain. By the end of July, Delta was the cause of more than 80% of new U.S. COVID-19 cases, according to Centers for Disease Control and Prevention (CDC) estimates.

The World Health Organization (WHO) has called this version of the virus “the fastest and fittest.” Delta is estimated to be spreading 50% faster and be 50% more contagious than the original strain Alpha.

The World Health Organization’s (WHO) 20 July 21 weekly COVID-19 update reported cases of the Delta variant in 124 countries, along with 3.4 million new cases of COVID-19 around the world, 12 percent higher than the previous week.

There are distressing scenes in Indonesia as the Delta variant spreads across the nation. On Wednesday, July 14, the total number of cases across the country hit more than 54,000 making Indonesia the new epicentre of the pandemic in Asia. The Delta variant has been detected in 94 percent of the tests carried out in Indonesia over the past two weeks, according to the monitoring site, Our World In Data (OWID), and this is against a backdrop of a country that has only fully vaccinated 6 percent of its population against COVID-19.

There have been real concerns that the healthcare system is on the brink of collapse as beds and oxygen are in short supply in many hospitals. There is also concern that many of Indonesia’s healthcare workers are becoming seriously unwell with new COVID-19 infections despite being vaccinated.

Thailand is also seeing a rise in COVID-19 cases where, according to the chief of the Department of Medical Sciences, Dr Supakit Sirilak, Delta has overtaken Alpha as the dominant variant, accounting for 63 percent of new cases. Thailand’s government has now announced a lockdown in Bangkok and other high-risk regions. The country, which heavily depends on the tourist industry, had only recently opened up to visitors but is now re-introducing restrictions to help curb the spread of infections.

As of today, there is not enough data to tell the potential impact of Lambda, since it’s a strain that has shown primarily in South America, a place that doesn’t have all the resources to execute the needed research.


Debt / Moratoriums / Defaults4,5,6,7

The impact of stimulus and government relief measures continue to prop up sectors of the market. In the US, a federal moratorium on evictions is set to expire on July 21 meaning 15 million people owing landlords an estimated $21.3b are on the brink of eviction.

The majority of the nation’s landlords are individual investors and without income are struggling themselves relying on bank loan moratoriums and government support.

Similarly in the US, $1.8 trillion dollars of student debt from 40 million student loans are likely to resume principal and interest payments in Oct 2021.

If China offers any insight into the future, Chinese defaults are growing at a record pace with more than $25 billion in onshore and offshore payment failures by June 21. That compares to $29.9 billion for all of 2020. Defaults in the private sector in China dropped early last year, largely due to pandemic-related pressure valves such as delaying repayments, swapping bonds or cancelling early repayment. However, the year ended with 140.1 billion yuan ($21.6 billion) in onshore defaults, almost matching the record of more than 143.6 billion yuan in 2019. The 2018 total of 122 billion yuan was itself more than quadruple the level in 2017. Chinese banks are trading at around 0.5x book value and PE multiples of 4-5x which is telling of what investors think of future defaults.


US/Australia/China Tensions8,9

Australia/China tensions have been building since Australia banned Huawei from participating in its 5G rollout and intensified last year after Australia called for an independent inquiry into the source of coronavirus, and China put bans and tariffs on various imports from Australia. More recently the Federal Government cancelled Victoria’s Belt and Road Initiative with China. So far these have not had a major macroeconomic impact with the impact relatively swamped by the strength in iron ore exports and prices. With Australia accounting for approx. 50% of iron ore exports globally, there is currently no alternative supply for China. Prominent Australian fund manager Christopher Joye has a view that China’s stockpiling of iron ore “is being driven by foreign stockpiling in preparation for military conflict -- you need steel to make guns, bullets, naval vessels, tanks etc”

Trump’s China tariffs have not been reduced and Biden has maintained a hard line on China reflecting US public opinion. Tensions are heating up again as the US is preparing to sell weapons to Taiwan with military exercises in the Taiwan Strait and the South China Sea, and some in China threatening to reunify Taiwan by force. The issue is compounded by US restrictions on semiconductor sales to China and, of course, Taiwan has a state-of-the-art semiconductor industry. It’s hard to see China reunifying Taiwan by force but the risks have gone up.


ETF Bubble?10

Dr Michael Burry, the investor immortalised in Hollywood film, “The Big Short”, has stated publicly that he sees the frenzy around passive investing as another dangerous bubble, and that when the massive inflows eventually reverse, “it will be ugly.”

“The simple theses and the models that get people into sectors, factors, indexes, or ETFs and mutual funds mimicking those strategies – these do not require the security-level analysis that is required for true price discovery,” Burry said

“This is very much like the bubble in synthetic asset-backed CDOs before the great financial crisis in that price-setting in that market was not done by fundamental security-level analysis, but by massive capital flows,” Burry continued.

Burry’s bearish stance on index investing and ETFs centers around the assumption that, after decades of net inflows to passive investing strategies, eventually the tides will turn, and outflows will cause issues.

Burry’s key assumption is that these must become outflows eventually. In his interview with Bloomberg, Burry noted that 266 of the 500 stocks in the S&P 500 had less than $150 million in trading volume that day.

“That sounds like a lot, but trillions of dollars in assets globally are indexed to these stocks. The theatre keeps getting more crowded, but the exit door is the same as it always was,” Burry said. 


  1. https://markets.businessinsider.com/news/stocks/penny-stock-trading-volume-soars-2000-amid-retail-trading-boom-2021-3

  2. https://www.aljazeera.com/news/2021/7/27/explainer-what-is-the-lambda-coronavirus-variant

  3. https://www.yalemedicine.org/news/5-things-to-know-delta-variant-covid

  4. https://www.bloomberg.com/news/storythreads/2020-12-03/the-ticking-debt-bomb-in-china-s-15-trillion-bond-market?srnd=premium-asia

  5. https://www.bloomberg.com/news/articles/2021-07-26/-unprecedented-spike-in-u-s-evictions-looming-as-ban-expires

  6. https://www.newsweek.com/eviction-moratorium-expires-americans-owe-20-billion-unpaid-rent-1613866

  7. https://www.cnbc.com/2021/06/25/the-eviction-moratorium-is-killing-small-landlords-says-one.html

  8. https://www.ampcapital.com/asia/en/insights-hub/articles/2021/may/the-return-of-geopolitical-risk-what-to-watch-over-the-remainder-of-2021

  9. https://twitter.com/cjoye/status/1391934989869060100

  10. https://www.bloomberg.com/news/articles/2019-09-04/michael-burry-explains-why-index-funds-are-like-subprime-cdos 

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