Last Updated on July 22, 2022 by Rational thinking
Tail risk is a form of portfolio risk that arises when the possibility that an investment will move more than three standard deviations from the mean is greater than what is shown by a normal distribution. Tail risks include events that have a small probability of occurring, and occur at both ends of a normal distribution curve.
How can you hedge against tail risk in the stock market, the risk of suffering huge losses from totally random and unpredictable events?
Unfortunately, tail risk is very hard to hedge against. This article looks at different ways to potentially offset or neutralize tail risk in your stock portfolio. We offer three methods to hedge against tail risk in the stock market: One of them is by using Cambria’s Tail Risk ETF, the other is buying puts, and the third is having cash on the sidelines.
However, tail risk hedging comes at a cost. Any tail risk hedging and insurance mean lower expected returns.
What is tail risk? What is a fat tail?
Tail risk is something that is rare and seldom. If we look at a probability distribution, the tail risk is normally on the left side of the distribution curve and happens more frequently than a normal distribution suggests. Hence, it’s frequently referred to as left tail risk.
Read more here on this link:
What does tail mean in finance? What is tail distribution?
Why the left side? Because the left side contains the losses, while the right side has the winners. As traders and investors, we are more concerned with the losers than the winners. If we contain the losers, the winners tend to take care of themselves.
Below is a distribution that has a “fat” left tail risk and “thin” right side profits:
The strategy distribution above gives a positive expected outcome because of the many small winners. But is this strategy an accident waiting to happen because of the negatively skewed distribution?
What is tail risk protection?
Tail risk protection/hedging is when you somehow manage your portfolio to be more or less immune to left side tail risks as explained above. The left tail events are extremely unprofitable and might cause severe losses, especially if you are leveraged. It might force you out of business or make you stop trading because of a lack of confidence.
However, you still want to make sure your portfolio can participate in events that contribute to the right side events (those that are profitable).
As you can imagine, this is balancing the pros and cons. Unfortunately, there is no hard answer for this and much boils down to preferences.
How does tail hedging work? How do you hedge against left tail risk?
The aim of hedging tail risk is to hedge against losses like the GFC in 2008/09 and Covid-19. In other words, you want to insure yourself against extreme, sudden, and random moves.
How do you do this? As you’ll learn in this article, this can only be done by giving up a little return when the markets are quiet and calm. You pay for “insurance” while you are waiting for the meltdown. It’s like insuring your house: every year you pay insurance even though the chances for a fire are very low.
The problem is, the insurance in the market is much more expensive than for a house. Tail risk insurance comes with a hefty price tag that limits your compounding.
However, when having market insurance, your portfolio will perform much better than the market averages during a “meltdown”. When the meltdown is over, you start compounding again at a much higher level than you would if you had not hedged.
Why do you want to hedge against tail risk?
We are not suggesting tail risk investing, but tail risk protection, hedging, and limitation. Below are three arguments for why hedging against tail risk:
We hedge tail risk to avoid losses
No one likes to lose, and this applies to finance as well. We hedge against tail risk to avoid or limit losses in our portfolio.
Hedge against tail risk to survive
In the end, the winner might be the ones still around to fight another day. Investing is a marathon, and you want to make sure you are still running when you see the finish line in the distance.
In order to get a decent return in the markets, you want to make sure you are able to survive. Investing is mainly about surviving.
If you use leverage, a tail risk event is what makes most investors and traders bite the dust and go belly up. Excessive leverage is not something we recommend if you want to survive.
Hedge against tail risk to avoid behavioral mistakes
Even if you don’t risk losing everything, you might want to hedge.
The major risk for most investors is committing behavioral mistakes. Almost all investors are risk-averse, and thus we might make fatal and bad decisions when we face big losses.
Many investors lose their heads and sell in the middle of a meltdown, exactly the opposite of what is normally a wise thing to do. To avoid this, you should consider tail risk hedging or adjusting your portfolio to minimalize the impact of tail risk events.
Tail risk and Nassim Taleb
Nassim Nicholas Taleb has influenced my thinking and mentality tremendously, and he is by many seen as the “father” of black swans and tail-risk (for right or wrong). Tail risk is totally random and unpredictable and can’t be managed (Taleb says the Covid-19 is not a black swan, it was highly predicted). You can only prepare for it.
How can you hedge a portfolio of stocks against tail risk?
The easiest and most obvious way is to buy put options that are “out of money” on a broad market index, for example, the S&P 500. Out of money means the options are unlikely to get exercised unless the market drops a lot. If you for example buy put options 5% out of the money on a rolling basis, you stand to gain a windfall if the market drops. The downside is that you have to roll the options over many times. Thus, it comes at a cost.
Cash is a hedge against left tail risk
Having cash is not very efficient in the long term because of inflation, but cash is king when there is a meltdown in the markets. Cash is an underappreciated asset.
We are not suggesting to keep huge amounts of cash, but 5-10% can be useful.
For example, what we do with our dividends is to let them accrue and deploy them when the market drops. This might not be the most efficient investment over time, but it makes us sleep well at night. Life is too short to have unnecessary worries.
Meb Faber and tail risk
Luckily, Meb Faber has already done the research on the potential cost of “insuring” your portfolio. In October 2019 I came across this article by Mr. Faber, which I strongly recommend.
Faber looked into several ways to “neutralize” bear markets: by using bonds, foreign stocks, commodities, REITs, gold, and tail risk:
For the periods evaluated above, the tail-risk strategy provided the best returns, hands-down. The tail risk strategy is simply out of the money puts on the S&P 500. But the strategy comes at a cost, as Faber concludes:
But remember, this strategy comes at a cost. You’re paying for the protection. That means investing in a tail risk strategy has some similarities to purchasing insurance. And that’s going to affect overall portfolio returns for those of us who aren’t perfect market-timers…..In the same manner, if you are able to avoid a car crash for a year, then your auto-insurance premium can be viewed as having gone down the drain (but we nonetheless renew our auto-insurance each year)…..So, the big question for non-market-timers is “do the strong returns in bear markets balance out the poor returns in rising markets?” Does the insurance premium cover the cost of insurance?
Pretty much as expected, the overall returns fall significantly. Based on this, I assume most investors will reject such a strategy. However, we know most investors are not infallible and make behavioral mistakes: buying market tops and selling market bottoms. By having put options you offset some of the unrealized losses and this might make it easier to hold onto your positions.
An example of how to hedge against tail risk
Meb Faber and his asset firm, Cambria, offers a fund that has the sole purpose of offering tail risk protection. It’s an ETF and has the appropriate ticker code “TAIL”.
This is what they write on their website:
The Cambria Tail Risk ETF seeks to mitigate significant downside market risk. The Fund intends to invest in a portfolio of “out of the money” put options purchased on the U.S. stock market. TAIL strategy offers the potential advantage of buying more puts when volatility is low and fewer puts when volatility is high. While a portion of the fund’s assets will be invested in the basket of long put option premiums, the majority of fund assets will be invested in intermediate term US Treasuries. As the fund is designed to be a hedge against market declines and rising volatility, Cambria expects the fund to produce negative returns in the most years with rising markets or declining volatility.
(We marked in bold.)
As of March 2021, the main holdings were:
- US ten-year Treasury Bond 86.6%
- TIPS 5.5%
- Long SPX put options 4.2%
- Cash 3.7%
How has the performance been? As the prospectus indicated, the return has been negative: Since inception (April 2017) the CAGR has been -5.92%.
How has Cambria’s Tail Risk ETF performed during a crisis?
The chart below from yahoo!finance shows Cambria’s Tail Risk ETF since inception:
Cambria’s Tail Risk ETF did what it was supposed to do during the weak market in the 4th quarter of 2018 and during the pandemic in March 2020. If you had allocated for example 5% to Cambria’s Tail Risk ETF, this position would have contributed 1.28% to the upside during the Covid-19 mess. If you had allocated ten percent, it would have been 2.56%.
The price you pay for this insurance is lower overall returns in the other years.
An alternative way of “hedging” against tail risk
Some years back we published a “simple” momentum/rotation strategy that switched between the S&P 500 and Treasury Bonds. In the test, we used the ETFs SPY and TLT. This strategy has produced market-beating returns while at the same time reducing the drawdown substantially:
It’s a very simple strategy, but it’s of course no guarantee that it will perform just as well in the future.
My own experience of tail risk hedging
During 2019 I hedged my portfolio against tail-risk by buying out of the money puts on the ETF SPY (S&P 500), much like the tail-risk strategy described by Meb Faber.
I gave up in October 2019, because the pain of seeing the options expire worthlessly is too high to bear.
In practice, this strategy slowly bleeds you for funds until you hit the rare big payday. I believe very few investors can tolerate such ongoing pain. Unfortunately for me, just some months after I stopped, the Covid-19 sent the index into a steep fall.
We react opposite to losses and gains: we are risk-averse
Think about this: If you make 500 000 in year one and nothing in the following nine, you will most likely be a lot unhappier compared to receiving 50 000 evenly in all ten years.
Behavioral experiments suggest our happiness depends far more on the number of positive feelings than on the amount when they hit. This means any payment is much more important than the size of it. In order to have a pleasant life, most people should thus spread these payments evenly.
Even worse is if you make 500 000 in year one and give back 400 000 over the next nine years. It most likely feels better to receive nothing because you have nine miserable years.
Conclusion: how to hedge against tail risk
Risk is a fact of life and something you can’t avoid. Life is a risk. The same is the stock market. In order to get the long-term returns offered by the stock market, you have to accept drawdowns in your portfolio. If you are young and have decades before you need the savings, it’s probably better to just invest and do nothing (forget about it).
However, if you are getting closer to retirement, you might buy Cambria’sa tail risk ETF to reduce tail risk impact. The second option is buying puts on a broad market index like the S&P 500. The third option is to have some cash on the sidelines. But it comes at a cost in lower future returns.
The trade-off can only be judged by yourself.