An increasingly popular sales pitch on Wall Street goes like this: If you’ve insured your home against some disaster, or even a total loss, shouldn’t you do the same for your investment portfolio? In the case of a house or apartment, the danger would be fire, flooding, or perhaps a devastating storm. In the financial markets, it might be a sudden spike in volatility and a rapid decline in prices that wipes out months if not years of gains.
For investors of all stripes, from the most august institution to the scrappiest day trader, the current maelstrom of sustained inflation, never-ending pandemic, war, rapidly rising interest rates, swooning tech stocks, and crypto collapse—what economic historian Adam Tooze calls a polycrisis—feels like the equivalent of a Category 5 hurricane. So it’s no surprise the pitch is working. Everyone, it seems, is looking for a way to ride out the storm in one piece.
There’s nothing new about guarding against unlikely but catastrophic losses. The practice is sometimes called tail-risk hedging, a reference to the skinny tail on the far side of a bell curve distribution of outcomes, where really bad things happen. It’s also known as “black swan” investing, a riff on an argument by the writer and investor Nassim Taleb: Just as Europeans assumed there were no black swans until an explorer spotted one in Australia, investors have a habit of assuming catastrophes won’t happen until one does. Black swan funds are designed to make money when things go badly in ways no one saw coming.
This kind of insurance requires a constant and expensive series of complex options bets. For decades it was challenging even for mathematicians to produce, and mistakes were costly. Few beyond the most sophisticated hedge fund managers and proprietary trading desks bothered to try. But now tail-risk hedging is turning into an off-the-shelf product, thanks to advances in risk-management software and the analytical power of everyday computers.
Hedge funds offering such strategies saw their second-best year of cash inflows in 2021, according to Eurekahedge Pte Ltd., even though their portfolios lost 10%. (It was still bull market then, after all.) The $23 billion State Universities Retirement System of Illinois hired money manager LongTail Alpha in April to create a tail-risk strategy, while the $73 billion Pennsylvania Public School Employees’ Retirement System recently increased its allocation to such hedges. Even ordinary investors can choose from several products, including exchange traded funds, that promise windfall payouts when the markets tank. The biggest black swan fund available to U.S. retail investors, the $490 million Cambria Tail Risk ETF, has seen inflows of $168 million this year.
Tail-risk strategies vary, but the classic version works like this: A money manager places bets on options that are deeply “out of the money.” For example, the fund might have contracts that will pay off only if the S&P 500 drops sharply in a certain period. It will have to keep placing these bets over and over, generating costs for investors if the markets keep going up or just doesn’t fall enough. “We take losses every year, and then we hit,” says London-based Jerry Haworth of 36 South Capital Advisors, who’s been managing a tail-risk strategy for 20 years. “With tail hedges you’re really not concerned if the market is down 10%, you’re only concerned what you are going to be paid if it’s down 30% or more.” Advocates of tail-risk hedging say that over time the payoffs in a diversified portfolio are worth the cost.
The prospect of having a payout in an extremely bad year is especially tantalizing to institutions such as pension plans and university endowments, which are obliged to disburse funds no matter how well or poorly their investments are performing. And these sorts of investors are familiar with the cautionary tale of the $440 billion California Public Employees’ Retirement System, the largest US pension manager. It shows both the promise of tail-risk hedging and its biggest pitfall.
For years, Calpers had been buying tail-risk hedges from outside firms. One of those hedges was big enough to generate a $1 billion payout in the event of a market meltdown as severe as that of March 2020, when the Covid-19 pandemic hit. Except Calpers lost its patience. Just weeks before stocks crashed that month, the pension plan’s chief investment officer, who has since left, decided to remove the hedge and missed collecting the enormous payout.
By 2020 a bull market had run for a decade, and it was natural for people—including professionals who have to regularly justify their investments to clients or boards—to question paying for expensive hedges that didn’t seem to be doing anything. Or to get anxious about “negative carry,” Wall Street jargon for the drip-by-drip losses such funds produce in good times. “It’s shown time and time again that institutions that implement a negative-carry strategy to provide protection, after a period of time, particularly if we hadn’t had any crises, give up,” says Daniel Stern, senior managing director and head of hedge fund research at Cliffwater.
Cambria Tail Risk ETF shows the kind of endurance such investments can require. Over the past three tumultuous months, it’s gained about 1%, compared with a 6% loss for the S&P 500. In the first quarter of 2020, when Covid rocked the markets, it returned 24%. Over the stretch of the past five years, however, it’s lost a cumulative 24%, compared with a 72% total return for U.S. stocks. “It’s an insurance-style fund,” says Meb Faber, chief executive officer of Cambria Investment Management. “We see a lot of people using it tactically—they are trading it based on whatever is going on in the world.”
Christine Benz, director of personal finance at fund researcher Morningstar, says most people should focus on the more obvious ways of cutting their risk. “Investors will generally be better served by using simpler diversifiers—short-term high-quality bonds as well as good old-fashioned cash—rather than more complex securities to diversify equity exposure,” she says. “Cash and short-term high-quality bonds don’t offer inflation protection, which underscores the importance of not overdoing them. But they have a few key benefits: They’ve held their ground reasonably well in a variety of previous market shocks, they’re easy to understand and use, and investors can obtain exposure to these asset classes very cheaply.”
There’s also the question of whether a tail-risk fund will pay off the way you expect. The strategy works, but within specific parameters—and the catastrophe you get might not be precisely the one you insured against. Tail-risk strategies make their biggest gains in sharp, sudden market contractions, such as in March 2020 or the 2008 financial crisis. The slower bear market of 2022 has so far been a different story. Tail-risk funds have gained about 11.6% this year, according to Eurekahedge, which makes them rare winners these days, but that’s just enough to make up for last year’s losses on the funds. “Pure tail-risk strategies generally did what they were supposed to do during the Covid drawdown but are performing less well during this one,” says Dan Villalon, co-head of the portfolio solutions group at AQR Capital Management. “The longer, the more protracted the drawdown, the less benefit you usually get from those strategies.”
Tail-risk managers have been trying to broaden the appeal of the strategy by offering less extreme products. For example, Haworth’s 36 South runs one fund that aims to stay flat during calm periods, rather than losing money, but pays out less when markets fall. Similarly, LongTail Alpha offers clients strategies that bet across an array of assets in addition to equities. “You don’t sacrifice too much of the reliability of the insurance policy, but at the same time the running cost is lower,” says Vineer Bhansali, founder of LongTail Alpha.
A tempting strategy might be to try to avoid the cost of insurance by jumping into tail-risk funds only when you suspect things are about to get bad. One problem with that is hedging gets more expensive—and pays less—when everyone else thinks the world looks risky. That’s already happening now. “The easiest returns in tail hedging are past us,” says Peter van Dooijeweert, managing director of multi-asset solutions at Man Group. “We’re still staying hedged—we’re just reducing.” Of course, it also runs a bit against the idea of hedging as insurance: If you reliably knew when trouble was coming, you wouldn’t need it. “It’s exceedingly hard for anyone—tail-hedger or not—to time the market,” says Villalon.Read next: A New Prediction Market Lets Investors Bet Big on Almost Anything
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