Tail Risk Hedge Funds

Fix the roof while the sun is shining.

April 2020. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Tail risk funds tend to be most in demand when they are least attractive
  • Short-term bonds provided similar benefits to tail risk funds
  • The TAIL ETF closely replicates the performance of tail risk funds

INTRODUCTION

In a year where the S&P 500 lost more than 30% in a few weeks, there are few headlines that draw as much attention as these:

  • This Black Swan Trade Saw 1,000% Profits This Week (MoneyMorning, 12 March 2020)
  • Up 3,000%: The Tail Risk Funds That Mastered Coronavirus Market Mayhem (Reuters, 18 March 2020)
  • Billionaire Bill Ackman Made 100-Fold Return On Coronavirus Hedge That Yielded $2.6 Billion (Forbes, 25 March 2020)
  • Wimbledon’s Organizers Set For A $141 Million Payout After Taking Out Pandemic Insurance (Forbes, 9 April 2020)

Unfortunately for investors, by the time they read such headlines, the severe market dislocation that allowed to generate such abnormal profits has already happened. Volatility has spiked and credit default spreads (CDS) of companies or governments are no longer trading at cheap levels, as well as insurance premia.

Naturally, this does not mean that there might not be need for additional tail risk coverage since we might be facing a long bear or sideways market ahead. Investors can still reposition their portfolios for such a scenario, but the opportunity to buy inexpensive portfolio protection has passed.

It usually takes many years after a crash for markets to feature the unique conditions that provide the fertile grounds for stellar tail risk fund performance again. Investors need to be complacent about risk and ideally believe this time it is different for the price of protection to come down. Best on an epic scale like during the tech bubble in 1999 where standard valuation metrics like PE ratios were considered obsolete or during the US housing boom in 2005 where the assumption was that house prices can never decline on a national level.

However, although it might be too late for investors to consider tail risk funds currently, recent events provide a good framework to evaluate how well these have protected portfolios historically (read