People are excited about tail risk. On the institutional side, banks and asset managers are packaging up complex, multi-asset hedging products and selling them to pension funds, endowments, and other natural longs. On the retail side, Barclays and others are getting great traction with products like VXX, VXZ, VXX options and now XXV (see Bill’s helpful overview of this space). I’m hoping to join the fray, too, with a managed account program and subscription product set to launch in the next month or two, so I’m hardly critical of the desire to give people ways to hedge away tail risk.
But I think it bears repeating that none of the retail products on offer is all that attractive as a buy-and-hold candidate for hedging tail risk, and it sounds like some of the managed institutional products aren’t all that nuanced, either:
About 20% of the 30 large institutional clients served by Russell Implementation Services are explicitly managing tail risk through dynamic asset allocation approaches, while the rest “wrestle” with the considerable cost of tail-risk hedging, said Michael Thomas, chief investment officer of Russell Implementation Services…
Mr. Thomas’ group recently priced an options overlay that would provide protection for the next 12 months for a decline greater than 10% of the Standard & Poor’s 500 index at a cost of 6.7% of the assets to be protected. [link, h/t World Beta]
Whether you’re hedging risk with VIX-based products or with conventional options strategies, any heavy-handed “always on” approach to hedging is going to be too expensive to be worth the trouble. One tail-risk fund mentioned in the article above “could lose a minimum of between 1% and 1.5% per month or between 12% and 18% per year just from the cost of the options strategy.” That’s a pretty steep hurdle to clear. If you like those kinds of costs but manage less capital, you can achieve similar portfolio-crushing protection by buying a full allocation of VXX and sitting on it.
Where cumbersome and expensive strategies fail, light-footed and cheaper alternatives might prevail. I’ve already alluded to a teaser alternative using VIX futures with a little more allocation nuance, and I think that’s really the key. As Adam mentions, overpaying for hedges when premiums are historically elevated is a bad idea; better to take a small portion here (so that your core portfolio isn’t completely exposed) and then scale into your hedge position as either a) the cost of protection becomes historically cheap, or b) actual market volatility gives a warrant to increased long volatility exposure. At the moment, the market is offering neither cheap protection nor sufficient historical volatility.
Another notion about which I’m skeptical is the idea that investors need protection in numerous asset classes, i.e. equities, credit, commodities, currencies, etc., especially under the auspices of one managed product. I’m not even talking about scenario-based protection, which is another matter entirely (who could possibly know the timing and extent of these Michael Bay scripts yet-to-be-written, sufficient to overcome the expenses and opportunity costs to have hedges waiting around for them to come true?). I just mean that, in most crises, correlations spike and there are few places to hide, so why pay for what is essentially the same bet many times over in different asset classes? It makes sense to me that a bond fund might seek credit protection and ignore equities; what I don’t understand are these all-in-one packaged products.