What are tail risk funds? An introduction to a niche

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Tail risk funds represent a small niche of the hedge fund industry, and there are a few different types. They essentially serve as insurance for your portfolio. They lose money most of the time, but when there is a tail risk event, they rise quite a bit when the rest of the market crashes down hard and fast.

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What are tail risk funds?

Tail risk funds hedge against tail risk, which is a type of portfolio risk that appears when there is a significant chance that any particular investment or fund will move more than three standard deviations from the mean. Tail risk events have a small probability of occurring, but they do occur from time to time, which is why many investors choose to use tail risk funds.

Traditional strategies for portfolio management usually follow a pretty normal distribution. There's nothing out of the ordinary with them. However, tail risk funds are able to normalize the returns of an entire portfolio by making up for steep declines when there is a sudden correction with no warning or time to prepare for it. Such a steep, sudden correction occurred in March 2020, and many tail risk funds made headlines with astonishing returns during the selloff.

When a tail risk event occurs, it means the distribution of returns is abnormal. The returns distribution is skewed and has fatter tails, which indicate probability that an investment will move more than three standard deviations.

It's important to note that tail risks can move in either direction. Left tail risk is what investors worry about the most because it means their returns are negative, but right tail risk means that investments have moved up by more than three standard deviations.

The term "tail" in tail risk is a reference to the end parts of the bell-shaped curve of the probability distribution of events. The left-hand side of the tail refers to the lowest returns, while the right-hand side marks the highest returns.

Distributions and hedging

Whenever you compile a portfolio of investments, there is about a 99.7% probability that the return will move up or down between the mean and three standard deviations. This is what makes tail events so rare. The possibility of such an event occurring is only 0.3%, so they happen rarely, but they do happen.

Tail events can do serious damage to a portfolio, erasing years of gains in one fell swoop. As a result, many investors choose to hedge against them even though the probability of one happening is only 0.3%.

Tail risk funds are one way to hedge against such events. Those who invest in tail risk funds should realize that the part of their portfolio that's in the tail risk fund will lose money 99.7% of the time, which means it should be just a very small part of the portfolio. In most cases, investors who buy into tail risk funds make them less than 5% of their portfolio.

If a tail risk strategy is employed successfully, it should cause an investor's portfolio returns to be at or close to flat when a tail event occurs. The tail risk fund should post enormous returns, wiping out the deep negative returns posted by the rest of the portfolio.

Tail risk strategies

Since tail risk funds are designed to hedge against steep selloffs that occur very rarely, picking the appropriate types means choosing one with a strategy that hedges against the strategy used in the rest of your portfolio. For example, investors who are long on exchange-traded funds that track the S&P 500 might look for a tail risk fund that buys derivatives on the Chicago Board Options Exchange Volatility Index or another asset that is negatively correlated with the S&P.

Investors who buy tail risk funds often use them alongside other more traditional risk management strategies. While traditional strategies may cover the portfolio during less dramatic downturns, tail risk funds will protect against steep corrections that occur swiftly with no warning.

Some common tail risk strategies include buying or shorting options. For example, managers may limit a portfolio's downside by buying puts. The benefit of this strategy is that the cost of buying puts can then be offset by selling a call on the same trade, hedging against possible downside and limiting the cost of what is essentially portfolio insurance.

Strategies can also be equity-based by purchasing stocks or sectors that are less volatile. Some strategies involve allocating risk instead of capital across the portfolio. Traditional portfolio allocations include a 60/40 mix of stocks and bonds, but an optimized beta strategy that hedges against tail risk might target a certain risk level instead.

One strategy that can provide results similar to a tail risk fund involves the use of short-term bonds. Factor Research conducted a study and found similar benefits of using short-term bonds and tail risk funds.

Tail risk fund types

While tail risk protection can be in the form of a particular trade, it is possible to buy into a specialized hedge fund geared toward providing such portfolio insurance. Many hedge funds offer this service, but investors must realize that such funds will lose money nearly 100% of the time. The only time these hedge funds will post a positive return is during a tail event.

In addition to hedge funds, some exchange-traded funds are also designed to follow tail risk strategies, providing an easy option for investors who prefer ETFs and indexing strategies. For example, the Cambria Tail Risk ETF trades using the ticker TAIL, and it's designed to mitigate major downside risk in the market. The ETF invests in a portfolio of out-of-the-money put options on the U.S. stock market.

The Cambria ETF also has the advantage of being able to purchase more puts during periods of low volatility and fewer puts during high volatility periods. Part of the ETF's assets are invested in basket of long put option premiums, although most of the assets are in intermediate term U.S. Treasuries. Cambria also emphasizes that the ETF posts negative returns during years when the markets are rising or volatility is declining.

This article first appeared on ValueWalk Premium.