My Quixotic Obsession With Tail Hedging

We all have our weird niche interests and obsessions. For instance, my quixotic obsession with tail hedging. Conventionally, that means protecting portfolios against “rare” events (the VIX doubling in a single day, for instance). I am interested in tail hedging in a less conventional sense. I am interested in actually making money off “rare” events. I use “rare” in scare quotes here because contrary to the what you might hear from boilerplate financial advice, “rare” events are surprisingly common in financial markets.

If you are interested in the philosophical and mathematical underpinnings of tail risk, you should read Taleb’s Fooled By Randomness and Lo’s Adpative Markets (review forthcoming soon). But if you prefer practical applications, check out the below table:

SP_Returns_Following_Crisis
Source: Alternative Investment Analyst Review

This is taken directly from the paper “A Comparison of Tail Risk Strategies in the US Market.” The intuition is simple: markets offer the highest expected returns when they are bombed out, when valuations are deeply discounted, when (to borrow a Buffettism) everyone is feaurful. A tail hedge not only provides excess returns in times of crisis that mitigate drawdown, but also a source of liquidity that can be redeployed into equity and/or fixed income securities at firesale prices.

So, hypothetically, you make 2% at the portfolio level off a small-ish tail hedge and reinvest it into equities at firesale prices. Over the subsequent months and years maybe that amount doubles, triples or quadruples.

Sounds great, right? What’s the catch?

The catch is the cost of the hedge and the resulting drag on returns:

Tail_Hedge_Perf_Drag_
Source: Alternative Investment Analyst Review

If you are interested in a detailed exploration of the strategies in the table, you will have to read the linked paper. However, at a high level the intuition is straightforward. When you are tail hedging you are essentially buying insurance. The person selling you the insurance wants to earn a premium for doing so.

The most common arguments against tail hedging are:

(1) there is no reason to hedge tail risk because in the long run equity markets always go up;

(2) the cost of the insurance is not offset by excess returns over time;

(3) there are better ways of mitigating tail risk.

I do not find Argument #1 compelling at all. All the data used to support this argument is subject to path dependency and survivorship bias. This is particularly true in the context of the US market, which is has been the best performing equity market in history. People tend not to respond well to my counterarguments because they imply an uncertain view of the future and they would rather extrapolate from the past (clients don’t like to face up to the uncertainty inherent in markets). People also have a difficult time with skewed payoffs–that is, understanding why a strategy with a 99% probability of a $1 loss and a 1% probability of a $100 gain is a good bet in the long run.

I do find Argument #3 compelling. AQR has a good paper on this that reaches similar conclusions to the Alternative Investment Analyst Review piece. However, AQR’s paper is focused on defensive applications of tail hedging strategies, whereas my interest is in playing offense. In full fairness, AQR addresses that in the paper:

We acknowledge that some investors might buy insurance for reasons other than reducing tail risk. For example, insurance can provide a cash buffer in times of market distress, potentially allowing investors to take advantage of fire-sales and other market dislocations. However, depending on the magnitude and frequency of the dislocations (and the manager’s ability to identify them), this opportunistic approach still might not make up for the negative expected returns from buying insurance. Other investors might occasionally have a tactical view that insurance is conditionally cheap. However, this is simply market timing in another form, and this decision should be made (and sized) in the context of other tactical views in the portfolio.

I have mixed views of Argument #2, mainly due to the issues of path dependency and survivorship bias noted above. If future equity returns look like the past 30 years or so, there is certainly no reason for long-term investors to tail hedge (assuming they have the wherewithal to stay invested in volatile markets). If the world becomes a more volatile and uncertain place over the next couple decades, investors may feel differently.

I have conducted some small experiments with real dollars over time. Most recently, I set up a long volatility trade using the VIXY ETF and ZIV ETN. It performed well during the February volatility spike, but was something of a blunt instrument (I have since closed out the position).

More recently I have been looking at Meb Faber’s TAIL ETF, which purchases a ladder of out-of-the-money put options on the S&P 500. Below is a rough scenario analysis I conducted to assess performance drag vs. crisis performance, as well as some historical monthly performance data for TAIL for context (the ETF has a short track record).

TAIL_Scenario_Analysis
Source: Demonetized calculations
TAIL_Monthly_Returns
Source: Morningstar
TAIL_Price_Chart
Source: Morningstar

A couple takeaways:

  • This exposure has to be managed actively. When volatility spiked in early February 2018 the correct move would have been to trim the position on the back of the ~10% up move.
  • There is a consideration in play for me that is not in play for many retail investors, and that is that my compensation and career prospects are highly correlated to financial markets. For people with “bond-like” compensation (teachers, doctors) there is less benefit to spending portfolio dollars on a tail hedge from a pure risk management POV.
  • The real downside to putting on a position like this is not getting 18% annualized over a decade if the market returns 20% annualized. The real downside is getting an annualized 3% if the market returns 5%.

Billionaire Doomsday Prepping As Extreme Tail Hedging

402px-Nagasakibomb
Source: Wikipedia

I sometimes laugh when I read critical articles about billionaire hedge fund managers who are also doomsday preppers (this is enough of a “thing” that it has had a material impact on real estate prices in New Zealand). Of this behavior, The New Yorker commented:

Fear of disaster is healthy if it spurs action to prevent it. But élite survivalism is not a step toward prevention; it is an act of withdrawal. Philanthropy in America is still three times as large, as a share of G.D.P., as philanthropy in the next closest country, the United Kingdom. But it is now accompanied by a gesture of surrender, a quiet disinvestment by some of America’s most successful and powerful people. Faced with evidence of frailty in the American project, in the institutions and norms from which they have benefited, some are permitting themselves to imagine failure. It is a gilded despair.

I have a dramatically different reading: billionaire doomsday prepping is just an extreme form of tail hedging.

If you have a net worth of $1 billion, why not spend even $10 million of your net worth on a hedging strategy for the total collapse of civilization? This amounts to a 1% exposure. It’s a pretty good risk/reward tradeoff, if you ask me–especially if you are estimating your max downside as being drawn and quartered by some kind of Proletarian Justice Tribunal. Obviously, a financial hedge is not going to work here. You are going to need things like guns and butter. And some kind of bunker.

I am sure not all ultra-wealthy doomsday preppers look at it this way. But I am comfortable speaking for a majority. Even that New Yorker piece contains the following observation (they buried the lede, IMO):

Yishan Wong, an early Facebook employee, was the C.E.O. of Reddit from 2012 to 2014. He, too, had eye surgery for survival purposes, eliminating his dependence, as he put it, “on a nonsustainable external aid for perfect vision.” In an e-mail, Wong told me, “Most people just assume improbable events don’t happen, but technical people tend to view risk very mathematically.” He continued, “The tech preppers do not necessarily think a collapse is likely. They consider it a remote event, but one with a very severe downside, so, given how much money they have, spending a fraction of their net worth to hedge against this . . . is a logical thing to do.”

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