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Are Tail Risk Hedge Funds Worth The Steep Losses In Good Times To Win Big In Bad Times?

Sep 24, 2022

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Tail risk hedge funds are typically deep in the red, but they thrive when the market experiences a long-lasting, chaotic bout of volatility. In some ways, the outperformance of tail risk funds underscores just how bad things are in the stock market right now, making it even more incredible when a traditional hedge fund outperforms during this period.

Tail risk hedge funds back in the spotlight

The CBOE Eurekahedge Tail Risk Hedge Fund Index returned 6.82% for the first five months of this year. Tail risk hedge funds provide what Eurekahedge called "crisis alpha" and protection for institutional portfolios. Investors and academics alike have debated the controversies around the tail-risk strategy for years.

During "black swan events," tail risk fund managers typically generate sizable returns during market turmoil to offset the steep losses they incur the rest of the time. Eurekahedge examined the risk/ return profile of the tail-risk strategy compared to those of more traditional hedge fund strategies.

Year-to-date performance

In May, tail risk hedge funds recorded the second-best year-to-date performance after CTA/ managed futures, which have soared this year on the back of skyrocketing commodity prices. Gold, a traditional safe-haven asset, was up by only 0.45% year to date through May. Meanwhile, government bonds had plummeted by 7.86%.

Soaring inflation has driven broad-based uncertainties throughout the market, forcing central banks to raise interest rates. The result has been higher yields, which reduced the effectiveness of government bonds in serving as a safe-haven asset over the last few months.

The SP 500 was the worst performer in the first five months of the year, plunging 13.3% due to a combination of the pandemic, the war in Ukraine and the skyrocketing inflation. All these factors led the Federal Reserve to tighten its monetary policy aggressively as it sought to control inflation. The result was a negative shift in risk sentiment as investors became more and more worried about the possibility of a recession caused by the Fed's aggressiveness.

Long-term performance

Eurekahedge also assessed the impact of allocating to tail-risk strategies in an institutional portfolio. The firm studied the performance of the tail-risk strategy against other strategies since the beginning of 2008.

Over that timeframe, the CBOE Eurekahedge Tail Risk Hedge Fund Index generated an annualized return of -3.23%. That return is considered a premium for investing in those assets as insurance against massive losses during black swan events like the market crash in February and March 2020 due to the onset of the pandemic.

However, safe-haven assets like gold and global government bonds did much better than tail risk hedge funds. They returned 5.64% and 2.57% on an annualized basis, respectively.

Tail risk fund managers were up 12.58% in 2008 and 16.39% in 2011, while the SP 500 lost 38.49% in 2008 and was flat in 2011. In 2020, tail risk funds returned 34.84% due to the pandemic, which led to a market meltdown early in the year.

Long/ short portfolio with added tail risk returned 6.25% per annum over the last five years. It underperformed the pure long/ short and 60/ 40 portfolios. However, the portfolio with tail risk added generally outperformed both portfolios in terms of annualized standard deviation, which resulted in a significantly higher risk-adjusted return.

Over the last five and 10 years, the long/ short portfolio with tail risk recorded the highest Sharpe ratios of 1.11 and 1.16, respectively.

Other factors

Eurekahedge also looked at the correlations between tail risk hedge funds and three other investment vehicles. The firm found that tail risk fund managers had a strong negative correlation of -0.47 versus the SP 500. Gold and the SP had a weak correlation of 0.06, suggesting that tail risk is a better hedge against the index, especially when the stock market plummets suddenly. Tail risk funds had a -0.56 correlation against the Eurekahedge Institutional 200, which represents the average performance of the 200 largest hedge funds reporting to the firm.

The firm also examined the performance of a long/ short equities portfolio with a small allocation to tail risk and compared it to other portfolio strategies. The long/ short portfolio with some tail risk allocation recorded an annualized volatility of 5.5% since the beginning of 2008, compared to 9.43% for the pure long/ short equities portfolio and 7.82% for a traditional 60/ 40 stock/ bond portfolio.

According to the data, allocating just a small amount of the long/ short equities portfolio to a tail risk strategy reduced the portfolio's overall volatilities. The firm also found that this portfolio had a higher Sharpe ratio of 0.83, versus 0.75 for the pure long/ short portfolio. The higher Sharpe ratio indicates that the reduced volatility was higher relative to its return.

Long/ short equities and tail risk portfolios recorded significantly smaller drawdowns in February and March 2020, when risk assets dropped sharply.

Final thoughts

Of course, studies have shown how difficult or even impossible it is to time the markets, so traditional wisdom on tail risk funds is to stay invested in them at all times. The risk/ return data above shows that there are benefits to this strategy, although investors may be disappointed that the returns underperform when excluding the risk factor.

However, volatility could be here to stay for a long time. Between the war in Ukraine and the Fed's aggressive policy tightening to rein in inflation, heightened volatility has become the norm.

Of course, the Fed is expected to keep raising rates for a couple of years, which suggests that the market volatility could persist throughout the period. As a result, many investors may be searching for an alternative investment that could offer downside protection this year and in those to come.

Eurekahedge expects demand for tail risk strategies among institutional investors to increase significantly due to their ability to generate alpha during periods of heightened volatility when the usual correlations between asset classes break down, as they have this year.

HFM has been tracking institutional investors and found that pension funds, in particular, are allocating 2% to 4% of their assets under management to tail-risk strategies. This trend could attract more fund managers to the strategy and eventually drive more demand in this niche market.

Michelle Jones contributed to this report.


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