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Why Tail Risk Hedging Makes Sense

Tail risk hedging is an investment strategy that involves owning an asset while also buying “insurance” on that asset. In the event of a market crash, tail risk hedging prevents extreme losses within a portfolio. The total losses during a market crash will have a severe impact on the long term return of a portfolio. A common misconception during a market crash is if a portfolio “bounces back” then no harm was caused. Unfortunately, large losses have a much greater impact on portfolio returns compared to large gains. A 10% loss needs an 11% recovery to break even, where a 30% loss needs a 43% recovery to break even. An extreme 50% loss would require 100% recovery to break even. As losses increase in percentage the recovery needed to break even increases exponentially.

When a portfolio is tail hedged, it provides a level of security and minimizes emotional based decision making. During a market crash, making financial decisions based on emotions is never favorable. When the market is performing well, it is easy to say you will not sell your position when the market dips. However, when the market crashes greater than 20%, you are likely to make an emotional decision to sell your positions. Having a tail risk hedge on at all times gives an investor the confidence knowing they are protected against an unforeseen market crash. The 5% and 10% dips are easier to withstand knowing they are protected if the market continues to sell off.

Investors can be allocated aggressively in stocks knowing they have the downside protection a tail hedge provides. Risk averse investors are not comfortable with a 100% stock position, so they look for conservative investments such as US treasuries, corporate debt, annuities and structured notes to hedge their allocation with stocks. Even though these types of investments can provide less volatility, they often dramatically decrease the long term growth of a portfolio. When an investor is hedged against a sharp market crash this provides confidence to keep a higher percentage of stocks in their portfolio.

Tail risk hedging can create a source of liquidity during a market crash. Tail risk hedging is like taking out an insurance policy on your stock portfolio; if the stocks crash, your insurance policy will pay out. When most investors are panicking because their portfolios have taken a massive loss, you now have extra cash to purchase stocks at “bargain” prices. It is a huge advantage to have the ability to buy when the majority of investors are being forced to sell.

Volatility is the rate at which the price of an asset increases or decreases over a time span. The volatility in a portfolio can be greatly reduced when carrying a tail hedge. Tesla (TSLA) is an example of a stock that is highly volatile and can see large daily price swings on both the upside or downside. A consumer staple like Coca-Cola (KO) is an example of a low volatile stock where you typically see very small daily price fluctuations. These two stocks are real world examples of how much volatility can differ between two different stocks even though they are both in the S&P 500.


Using the example below, we see how volatility directly affects the difference between two stocks. Stock A and Stock B both have the same average annual return (10%) over a three year period, even though they have different volatilities. On an annual basis, Stock B’s price fluctuates considerably more than Stock A. Even though the average annual return of both stocks are 10%, the high volatility of Stock B dragged down its total return. This drag on performance is called volatility drag. Volatility drag refers to the impact volatility has on a portfolio's compound annual growth rate. An investor can see greater returns by mitigating volatility while leveling out returns.



Asset

Starting Balance

Year 1 Return

Year 2 Return

Year 3 Return

Average Annual Return

Ending Balance

Stock A

$10,000

12%

8%

10%

10%

$13,305

Stock B

$10,000

25%

-20%

25%

10%

$12,500


Convexity Investments LLC | Naperville, IL | www.convexityinvest.com


Convexity Investments LLC is a registered investment adviser. Information presented herein is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Past performance is not a guarantee of future results.



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