Tail Risk Strategies Versus Buy and Hedge Retirement?

by | Oct 2, 2017 | Buy & Hedge, S&P 500/SPX

Source: CBOE Eurekahedge Tail Risk Hedge Fund Index

A couple weeks ago I got a question around what black swan risk or tail risk protection funds do and how they compare with ZEGA’s Buy and Hedge Retirement Strategy. Black Swan risk is a term that re-emerged during the 2008 financial crisis when markets experienced severe downturns thought to be historically improbable based on financial models. Black Swans are considered unknowns that could not be predicted but when they occur they cause shocks to the markets. Tail Risk is also a term we hear a lot.  These models look for results that are outside of the normal probability curve, they reside in the tails to the left or right side.

After the 2008-2009 period, we started to see strategies which reported to be able to profit from unlikely events. They might purchase very far out of the money put options that would appreciate in value should shocks occur. Luckily there is an index called the CBOE Eurekahedge Tail Risk Hedge Fund Index shown above in the graph.

From the Eurekahedge website: Click here

The CBOE Eurekahedge Tail Risk Index is an equally weighted index of 7 constituent funds. The index is designed to provide a broad measure of the performance of underlying hedge fund managers that specifically seek to achieve capital appreciation during periods of extreme market stress”

Now it is worth mentioning that hedge funds may not be accessible to non-qualified or non-accredited investors and can contain higher fees. But as a proxy we can compare the total return of the S&P 500 Index versus the CBOE Eurekahedge Tail Risk Index from full year 2008 through Q3 of 2017 illustrated below.

Source Eurekahedge and NYU Stern School of Business

Tail or Black Swan protection often has a cost as well if the markets do not experience “extreme market stress”.  The money needed to buy insurance becomes a loss. Think about buying car insurance where month after month the premiums paid may never pay off. We can see in the first graph how the value of the index has depreciated during the bull run in stocks. In the table above we also get a feel for the representative performance relative to the total return of the S&P 500 Index. When I had shared the website link with the person originally asking the question they wondered how much would an investor have to divert within their asset base to provide meaningful protection?

In other words, if say an investor was in Large Cap US stocks and wanted meaningful protection, what percent would they need to place in each basket. This is one of the challenges of systematically purchasing disaster protection on a continuing basis. If one took 5% or 10% and sought tail risk insurance, would that necessarily cover losses in the other buckets? If the investor was rebalancing annually wouldn’t more and more equity be required?

The challenge with how much to allocate is real.  If a client was to invest too little into a black swan tail risk fund the returns may not overcome losses, even if a black swan event occurred.  If a client put too much of a percentage of assets in a fund, the capital would degrade in a bull market (no black swan effect) and would create too much of a drag on returns.

Even if the fund eventually did see a black swan event after an extended bull market, it might not be enough to recover previous losses that occurred during that bull market.  For example, from 2008 through the end of Q3 2017, the index is down around 41%.  It would take a gain of approximately 69% to break even.  If markets don’t experience a black swan event over longer stretches, an event might only recover a portion of the losses, and not protect the entire equity allocation.

In answering the original question, how do these funds compare with ZEGA’s Buy and Hedge Retirement Strategy.   Buy and Hedge Retirement seeks to give up some of the upside (our cost of hedging), generate income to help offset that cost, and put in a hard floor to equity downside of the portfolio. This allows for a higher percentage of the account to be participating in the bull markets. We know that while there has not been a recession or material downturn for a while, at some point there may be. We simply don’t know exactly when. Too often money remains on the sidelines because of fear. Strategies like Buy and Hedge Retirement that can let investors sleep a little better while still participate can be appealing. Especially for those with a shorter window prior to retirement that can least afford deterioration in their balances meant to provide long term retirement income.





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