Disclaimer: This article discusses unconventional strategies that are not suitable for most investors. Please consult a financial professional with specific expertise in tail hedging and derivatives if you are considering this or related strategies.
This article proposes tail risk hedging (TRH) as an alternative model for managing risk in investment portfolios. The standard approach via diversification involves significant allocations to bonds. However, this has historically reduced returns over the long term (see Asset Allocation article). Accordingly, it could be sensible to pursue an alternative approach by managing equity risk directly rather than avoiding or reducing it – thereby allowing investors to maintain higher overall equity allocations.
So how can one manage equity risk directly? Market timing has rightfully been associated with poor investment performance in many situations. In my view, however, much of this underperformance can be attributed to inefficient implementations involving uncomfortable tracking error (i.e., watch markets continue higher from the sidelines).
Instead of making wholesale changes to a portfolio, a tail risk (a.k.a. black swan) strategy might only comprise a 1-5% allocation. However, these positions would embed significant leverage to amplify their impact. Like card counting in blackjack, these strategies should only be employed opportunistically (i.e., when markets are vulnerable to tail risk). Moreover, their risk/reward profile should be extremely asymmetric with limited downside but significant upside potential (i.e., measured in multiples instead of percent returns).
Interestingly, I believe equity derivatives markets (e.g., put options, VIX products, etc.) currently offer attractive risk/reward opportunities due to price distortions resulting from the popularity of short-volatility products.