For anyone who was on vacation and missed the market updates during the last week, volatility is back with a vengeance. Thanks to the pro-leave Brexit vote, the world’s financial markets have been upended once again. U.S. stock markets saw over 600 point drops one day and 300 point recoveries the next. The return of wild volatility to global markets renews the need for Tail Risk Fund protection for any savvy investor portfolio.
What is a Tail Risk Fund?
Tail risk funds arose in the wake of the Lehman Brothers collapse, the financial crisis of 2008, and all of the chaotic volatility that ensued. These special hedge funds were designed to safeguard investors against unpredictable and catastrophic global Black Swan type events. Lebanese investor turned academic Nassim Nicholas Taleb described these unusual doomsday scenarios in his Black Swan Event theory books. Tail risk funds were the answer to the increasingly destructive Black Swans that presented themselves over the last fifteen years.
These tail risk funds set out to hedge against catastrophic global stock market declines. They are as much a type of insurance product as an investment. There are a variety of ways in which these funds protect you from market shaking events. In their most straightforward form, they purchase put options on bonds and/or stocks. Such put options give holders the ability to sell the underlying index or individual stock or other security when the price declines. When these are covered by the underlying position, they offset losses in the stock or market index fund. When they are held as stand alone insurance, they gain substantially in value as the market or stock declines. Other tail risk funds buy calls on market volatility. The idea behind this insurance is that as markets sell broadly and wildly off, volatility will rise apace and these calls will gain massively in value.
These funds were extremely popular for a few years following the financial crisis. Investors who had taken severe losses in the events of 2008 were desperate to protect themselves against further market volatility. The problem with them in stable markets is that they lose money when markets are level and even larger amounts when stock prices and markets go up. When markets fall dramatically, they can earn enormous amounts of money. As an example of the costs investors incurred holding them when volatility became low, consider American-based PIne River Capital. This fund was set up intentionally to lose 2.5% every month when markets are flat or rising. Their fund dropped 36% over the years 2012-2013 and saw its assets decline from $300 million to $200 million. Fortunately the fund does not charge any performance fees for this critical form of insurance.
Tail Risk Funds Lost Popularity After the Financial Crisis Subsided
Not surprisingly, when the volatility disappeared from markets in 2012-2014, these tail risk funds fell out of favor with many investors. Central banks were acting aggressively to backstop troubled banks, sovereign debt issues, and even stock markets. In 2012, Mario Draghi the European Central Bank head pledged he would do whatever it took to protect the euro, while policy makers from Japan to the United States undertook bold measures as necessary to support their economies. Many investors became falsely convinced that the global central banking cabal could effectively eliminate the risk of stock market meltdowns from the Black Swan events. This severely undermined the purpose of the tail risk funds. Yet these unpredictable and often devastating events have continued to strike at random in the last few years, ranging from the messy bailin of the Cyprus banking system to the occasionally erupting crisis in the euro zone to the nuclear standoffs with North Korea and Iran.
Some investors who were short term oriented abandoned the tail risk insurance idea over the last few years. Swiss investment company Unigestion established a tail risk fund shortly after the financial crisis erupted yet had to close it down by 2010 when markets rallied hard. As recently as 2012 they contemplated reopening it but gave up on the idea. It became obvious last week that the risks have not at all disappeared. Markets only needed a catalyst to return to painful and gyrating volatility. Last Thursday night/Friday, Brexit provided the catalyst for the return of the wild and unpredictable volatility. With a two year protracted separation period for Britain and the EU in the cards, volatility is back to stay long term.
PIMCO Offers Name Brand Tail Risk Fund Protection
Sophisticated investors understand anew the need for high quality tail risk protection. The name brand in the bond markets, PIMCO, has a wide variety of these tail risk insurance products they offer. Their tail risk funds in 2009 started with around $10 billion but quickly grew to $50 billion by 2013, when many other such competing funds were already closing up shop. PIMCO offers several hedge overlay portfolios that can help you to manage the downside risk to your portfolio. They construct these for both non traditional and traditional styles of portfolios which hold assets, liabilities, or blends of the two. If you are going to go with an insurance product against market volatility and crashes, you should consider a leader in size and experience with such products.