Tail-risk insurance strategies

A tail-risk hedge fund advised by Nassim Taleb, author of “The Black Swan,” returned 3,612% in March, paying off massively for clients who invested in it as protection against a plunge in stock prices. […] Spitznagel included a chart in his letter showing that a portfolio invested 96.7% in the S&P 500 and 3.3% in Universa’s fund would have been unscathed in March, a month in which the U.S. equity benchmark fell 12.4%. The same portfolio would have produced a compounded return of 11.5% a year since March of 2008 versus 7.9% for the index.

https://www.bloomberg.com/news/articles/2020-04-08/taleb-advised-universa-tail-risk-fund-returned-3-600-in-march

Does anyone know what kind of investments a fund like that does, and whether there’s a simplified version of that which retail investors such as us can replicate? I guess returns of 3,612% can only be achieved by buying far out-of-the-money put options? You can protect against tail risks by always holding (say) far out-of-the-money SPY puts, but presumably that’s too costly to be worth it, and if you can’t accept the tail risk you should just invest less?

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  1. This type of investement is not available to the public
  2. Comparison of benchmarks is ok, but the real comparison should be after fees. I don’t think that this hedge fund has a magic formula, it will use derivatives of other alternative products.
  3. Investing in hedge funds and/or derivatives imply more risks. (and counterparty risks)

You could use TMF which is an ETF (3x the Daily 20-Yr Treasury). But you would need a lot more than 3.3% to mitigate the risk.

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Fascinating

Here’s one investor’s impression of what they do: buying 60-90D, ~30% OOM (delta ~0.01) puts

I’d love to backtest it on Feb-Mar data, but historical options data is not exactly easy to get. Anyone knows a good free/cheap data source or perhaps would love to chip in to buy some quality data to share?

One thing though for sure, the strategy’s going to be much more expensive / less performant than in February due to elevated volatility, VIX now at 40 vs 10-ish before corona.

And IMO you’ll need to have the patience to wait for a few quarters to see it play out, as I doubt that any bad news, even disastrous earning reports next week will crash the market further again, f*d up Q1 & Q2 are expected by everyone. You’ll need at least to wait for the wave of bankruptcies and second order effects in next quarters.

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Bill Ackman at PSH claims to have used CDS to hedge their portfolios (check out here and read all the way through the end for a brief explanation on how CDS work).

Ruffer, on the other hand claims to have used volatility [call] options and stock market put options (see here).

I don’t know if there are any options for retail investors to trade CDSs and volatility options, but stock options are available to trade. However, I think that now all these products have become much more expensive, but as Taleb mentioned in that interview, “the worst thing with insurance is trying to time it; you have to have your insurance at all times”…

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Thanks all!

@pandas

Here’s one investor’s impression of what they do: buying 60-90D, ~30% OOM (delta ~0.01) puts

Thanks a lot, so that’s roughly what I guessed.

I’d love to backtest it on Feb-Mar data, but historical options data is not exactly easy to get.

In case you glanced over it, the investor from your link mentions Think or Swim.

Fundamentally, I think there are several related reasons that speak against the strategy of insuring ones portfolio with 30% OOM puts.

  • The market maker who sells the options to you is almost certainly better at estimating the chance of tail risks than you are – that’s their job after all. You’d have to believe that these market makers are somehow biased towards systematically underestimating tail risks (maybe that’s what Taleb actually believes?), and also that they’re not learning from what happened during the past months.
  • There’s a lot of natural demand for OOM puts (i.e. people looking to insure their portfolios) but no/few natural sellers of such puts, meaning the market makers can sell them at a premium.
  • Relatedly, the market makers’ position (being short an OOM put) is particularly unattractive and risky, which also means you’ll have to pay a premium for them to take that position.

Isn’t it the holy grail of passive investing? Finding a combination of asset types to maximise return and minimise volatility? There are many experts suggesting their own mix of stocks/bonds/gold/natural resources. Yet, I have never heard of some leveraged options, CDS, or whatever as an insurance policy.

If they say you need to keep 4% at all times, then I expect there is either a very high fee of keeping them, or they deliver a constant loss during bull market and you have to constantly rebalance. It would be indeed interesting to see a backtested CAGR comparison between 100% stock and 96% stock + 4% “insurance policy”, over a long period of time.

But Ben Felix says, quoting research, that you only can achieve return by being exposed to risk. And you can reduce volatility by being exposed to diverse independent risk factors. So far, there are 5 broadly acknowledged factors, which explain over 90% of differences in returns between products. How does this “insurance policy” make sense under these conditions?

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@Bojack

It would be indeed interesting to see a backtested CAGR comparison between 100% stock and 96% stock + 4% “insurance policy”, over a long period of time.

I think that’s very hard to do well, since the kinds of periods during which far-OOM puts massively pay off, like in Feb/Mar this year, only happen once a decade or so. So the results of your backtests will for example be very sensitive to whether your study period ends in Dec 2019 or in Apr 2020. If you want any kind of reasonable sample size, you’ll have to go back half a century or so, but then you have the issue that the markets were very different 50 years ago. For these reasons, I think a bottom-up analysis is more helpful to address this question than historical backtests.

How does this “insurance policy” make sense under these conditions?

I think it only makes sense if you have reason to believe that other market participants underestimate tail risks – which is a form of active investment.

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