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.”

The Bill Gross Dilemma

A few days ago I was talking with a colleague about what I have come to think of as The Bill Gross Dilemma. If you are not familiar with Bill Gross suffice it to say he is one of the better known investment managers of recent decades. Bill Gross ran the PIMCO Total Return fund until September 2014. At the time the fund was approaching $300bn in assets under management. In September 2014 Bill Gross had an acrimonious split with PIMCO. He was more or less ousted from the firm (which he had co-founded).

Now for the dilemma.

When you are an institutional investor you have predetermined policies and procedures for situations like this where there is a sudden manager change. The policies vary. Usually at a minimum the investment policy will require the fund in question to be placed on a watch list for a period of time. In some cases the investment policy may mandate an immediate redemption from the strategy followed by a cooling off period. So in this case most institutions were either forced to fire PIMCO or eventually chose to fire PIMCO after putting the situation under review. The proof is in the pudding: over $100bn left the fund in 2014.

Now in my opinion in the instance of PIMCO Total Return the results have not been particularly awful in the years since Bill Gross’s departure. One could argue that Bill Gross had gotten the macro picture wrong (or was at least carried out by central bank intervention) in the latter years of his tenure. So was it right or wrong to fire PIMCO? What would you do as a Chief Investment Officer?

My comment to my colleague was that I think you have to fire PIMCO.

The reason you have to fire PIMCO is that as CIO you face an asymmetric risk/reward proposition. In the absolute best case scenario you stay with the fund and it goes on to shoot the lights out. What do you get for your trouble? A pat on the back and maybe a few dozen basis points worth of net performance contribution?

Now say you stay with the fund and it goes very badly. Like bottom quartile performance for three years running and massive outflows. You will come under a great deal of scrutiny. You may even be replaced as CIO. The performance detraction will probably not be so terrible in the grand scheme of things — again maybe a few dozen basis points net of fees — but you still might lose your job. You deliberately looked past a red flag and made an embarrassing mistake. The embarrassment to your employer is worse than the performance detraction. Embarrassment even more than weak performance is something an asset manager cannot afford. Particularly in a situation like this where the story is getting mainstream media attention.

In the business we call this “career risk.” Career risk is best understood through John Maynard Keynes’ observation that your career is often better served by conventional failures than unconventional successes.

Here is another example.

I have a friend who works as a portfolio manager at a reasonably large asset management firm. Like all reasonably large asset management firms his firm has strategists and economists who develop economic forecasts and capital market expectations. The firm would prefer you build your portfolio in line with this “house view.” Critically, you are not forced to do so. However, my friend explained, if you break with the firm’s view in your portfolio and underperform as a result, you are almost certain to lose your job.

As for Bill Gross, I still follow his commentary at Janus Henderson. He remains deeply pessimistic regarding monetary authorities’ interventions in global markets and the ultimate impact on the global economy. I believe much of the money he manages today is his own. After all, to allocate to the erstwhile Bond King in size today would entail a not-insignificant dose of career risk.