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How tail risk funds work

Tail risk funds have gotten a lot of attention since the sudden selloff that struck the markets in March, so many wonder how they work. Several tail risk funds reported returns in excess of 1,000%, causing questions about how such a return is even possible. It has to do with the way they go about investing and the way they report their returns.

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What is the point of a tail risk fund?

The first thing that's important to understand is that tail risk funds act as portfolio insurance. As a result, allocations to them are very small, usually no more than 5% of the total portfolio. You should always assume that the money you invest in a tail risk fund will be lost because most of the time, it will be. The only time tail risk funds will pay off is when there is a tail risk event that causes a sudden plunge in asset prices.

For this reason, money is injected into a tail risk fund on a regular basis like quarterly or monthly. Investors don't put the entire amount they plan to allocate to the fund for the year in at the same time because the money will almost certainly be lost. Typically, investors will inject a set amount of money every month or quarter, and that money will be used up unless there is a tail risk event.

Such funds serve as portfolio insurance because when there is a sudden plunge in asset prices, the tail risk fund offers protection by posting a significant positive return, which offsets the plunge in the rest of the portfolio. Allocations are kept small enough that it's OK if the money is lost but large enough to offset damage done in the rest of the portfolio from a sudden, steep selloff.

The goal of investing in a tail risk strategy is to protect against loss-making events while still participating in profit-making events. Various strategies can be employed to do this.

What types of investments do they hold?

The way tail risk funds work relies heavily on the types of investments they hold. One common strategy involves selling out of the money puts and then buying puts that are even further out of the money. Tail risk funds use this strategy because it tends to be very cheap to buy deep out of the money puts. The trade almost never pays off, but when it does, it pays off in a big way because the puts move into the money. The strategy can include short-dated put spreads over three months.

The reason these put spreads pay off so much is because of how they are structured. If you buy a stock for $100, and the stock rises to $110, then it increased 10%. On the other hand, if you bought a call option for $1, the option would rise from $1 to $10, meaning an increase of 10 times instead of just 10%. High-volatility periods tend to make options worth more. They've been cheap for quite a while because volatility has been so low for so long. Thus, when volatility took hold in March, those options became very valuable.

In some cases, a tail risk strategy can involve investing in VIX futures if the timing makes sense to do so. This enables investors to own volatility while turning it into a hedge for their portfolio. Other tail risk hedges can be as simple as buying low-volatility sectors. Still others can involve buying credit default spreads in such a way that the portfolio is structured against a major market downturn.

Some tail risk funds employ a combination of strategies, leaning more heavily on one or more strategies depending on what's happening in the market.

When is it time to invest in tail risk funds?

Tail risk funds have gotten a lot of attention since the March selloff, but Factor Research noted one big issue with them recently. Such funds tend to be most in demand at times when they are least attractive. The reason is because they attract a lot of attention with headlines trumpeting returns in excess of 1,000%, but the event that caused that 1,000+% return is past. Ideally, it won't be repeated any time soon.

By the time such returns are reported and headlines are made, volatility has spiked. Credit default spreads of governments or companies are no longer so cheap. The odds of another tail event occurring may vary widely. During a period of extreme volatility, additional tail events could be coming soon, but that often isn't the case.

The best time to buy a tail risk fund is when volatility is low. It serves as portfolio insurance, which means you must buy it before you need it. Like other insurance policies, the money you pay for them is lost most of the time.

In most cases, tail risk funds are not suitable for retail investors because they lose money most of the time, but they do have a place in the investing world.

This article first appeared on ValueWalk Premium.