Artful Trader

A tail risk strategy: The pros and cons, By Meb Faber

During the last two bear markets in 2003 and 2019, the tail risk strategy provided the best returns, hands-down. And as noted in part three, successful market-timers could allocate in and out of tail risk assets to the significant benefit of their portfolios.
 
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.
 
You see, in a flat-to-rising market, one would expect a tail risk allocation of US government bonds and S&P 500 put options to produce muted, flat or even negative yearly returns.
 

“That means investing in a tail risk strategy has some similarities to purchasing insurance”

That’s because if the market doesn’t roll over during the life of the put option you’ve purchased (increasing its value), then the money you spent purchasing those puts will go down the drain, dragging down your overall portfolio returns. 
 
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?
 
 
The difference between the theoretical and actual 
 
To attempt to answer this question, in the chart below we add a tail risk allocation to a US stock portfolio. This is assuming this allocation is added permanently – buy and hold and rebalanced. 
 
We reference this as “tail risk” and provide four different options for the percentage amount of puts one might add to a portfolio.
So, what’s your takeaway as you examine these returns? 
 
I showed this to several people in our office, and one of the responses was “not one of the put strategy iterations provides better returns than the S&P, so why not just go buy-and-hold S&P?”.
 
That’s an understandable reaction – it might even be yours – but let’s challenge it. There’s a huge difference between the theoretical and the actual. Investors are great at examining hypothetical returns and drawdowns, and “theorising” that they’d be able to remain in the market when their portfolios are down 25%, 50%, or 75%.
 
However, when that’s “actually” happening, it’s an entirely different experience. As any investor who’s had money in the market for a while knows, it can be incredibly painful to watch your portfolio balance being gutted each month during a bear market. Seeing significant losses affects our psyche, and oftentimes leads us to make foolish investing decisions. 
 
In bull markets, we like to think that we’re somehow smarter than average, or more in control of our emotions, but when we’re awash in a sea of red, our rational mindset tends to crumble … fast.
 
So, when we look at any market strategy, it’s important to investigate not just the longer-term average returns, but certain measures of volatility – specifically, the standard deviation and the max drawdown. After all, what good is a fantastic longer-term average return, if you sold at the low point of a drawdown because you couldn’t handle it? 
 

“But when we’re awash in a sea of red, our rational mindset tends to crumble … fast"

With this in mind, look again at the chart, now paying special attention to volatility and max drawdown. See how much improvement adding the permanent tail risk strategy can offer? Lower drawdowns are much easier to stomach, and in a real-world setting, would do a vastly better job at preventing panic-selling. 
 
Given this perspective shift, I would argue the permanent hedge does help – significantly – despite the costs involved. That’s because it’s more likely to keep your money invested, working for you.
 
 
Turning a defensive strategy into an offensive strategy 
 
Some investors who are considering adding a tail risk strategy to their portfolios on a semi-permanent basis might be wondering “is there a way to reduce the cost of this insurance?”.
 
Well, it’s been long known that there exists a premium for selling insurance … hey, otherwise, why would anyone do it? 
 
So, what if we could combine the best of both worlds? Selling volatility to capture the premium, but buying volatility to protect against big down moves? Below we re-ran the simulation with the following:
 
1) The S&P 500 total return;
 
2) A tail risk strategy – the tail risk strategy we will utilise is the same one from above that buys monthly 5% out-of-the-money options on the S&P 500. We then invest 90% of the portfolio in 10-year US government bonds; and
 
3) A put write strategy – the put write strategy is designed to sell a sequence of one-month, at-the-money, S&P 500 index puts and invest cash at one- and three-month Treasury bill rates. The number of puts sold varies from month to month but is limited so that the amount held in Treasury bills can finance the maximum possible loss from final settlement of the SPX puts. On a side note, AQR has suggested that such put write returns could be slightly elevated due to the strategy’s particular rebalance schedule.
 
We replaced our prior S&P 500 allocation with the put write strategy, and lo and behold it really helped returns. Your portfolio is essentially: selling monthly S&P 500 at-the-money puts with the rest in cash, buying 5% out-of-the-money puts with the rest in 10-year bonds.And the equity curve.So, what we have is a “permanent” put strategy that, in essence, is self-funding. Historically, it outperforms the S&P while providing substantially reduced volatility and drawdown numbers.
 
This is the final chapter of a four-part series on how best to implement a tail risk strategy in an ageing bull market. 
 
 
By Meb Faber, who is the co-founder and chief investment officer at Cambria Investment Management, and creator and host of The Meb Faber Show podcast. He is the author of 'Invest with the house: hacking the top hedge funds' and 'Global asset allocation: a survey of the world’s top investment strategies’.

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