Tail risk hedges are designed to only pay off when the markets suddenly plunge, so many investors don’t have the stomach to carry them. However, one expert on tail risk funds advises investors not to be in the market right now if they aren’t using a tail hedge.
No V-shaped recovery
Black Swan author Nassim Nicholas Taleb told CNBC in an interview that doesn't expect a V-shaped recovery like most investors seem to expect. He considers the market's continuing rise to be strange because it's been happening while the numbers of COVID-19 infections and deaths have continued to rise.
He warned that the market's rise could result in more economic pain on top of the human tragedy of the pandemic. He added that while policymakers are "printing money like there's no tomorrow," it may all come to nothing. He also said that the Federal Reserve slashed interest rates to below 0% and 0.25% in March and that it may not have much room to provide further support amid the resurgence in infections.
He expects the fears about the coronavirus to plague the economy and the market for a long time. He said even if the pandemic dies down, the virus will still be out there. That means fearful customers won't be rushing to spend money again.
“And COVID seems to be there even if the pandemic … dies down, [so] you will still have people cautious enough that it will impact a lot of industries,” he said.
Caution among consumers will still have a negative impact on many industries, he warned.
Why tail risk hedges are needed
Taleb believes investors shouldn't be in the market without a tail risk hedge because of the high degree of uncertainty about the future right now. Tail events are extreme situations that have a lower probability of happening compared to other scenarios. However, the odds of these tail events happening increases during times of uncertainty even though they remain lower than the odds of the set of standard outcomes.
"If you don’t have a tail hedge, I suggest not being in the market [as] we’re facing a huge amount of uncertainty..."
Tail risk funds benefit from such rare events because they prepare for the possibility of them. According to MarketWatch, the uncertainty around the COVID-19 pandemic has been especially good for tail risk funds.
The CBOE Eurekahedge Tail Risk Volatility Hedge Fund Index is up 48.19% year to date. The Dow Jones Industrial Average is down nearly 12%, while the S&P 500 is down 6.2% and the Nasdaq Composite is up by about 10%.
The problem with tail risk funds is that they tend to lose money during bull runs, but if uncertainty is here to say like Taleb believes it is, now could be the time to put tail risk hedges in place.
Meanwhile, Universa, managed by Mark Spitznagel, saw an eye-popping 4,000% return in his tail-risk fund during the height of the pandemic. Taleb has been an adviser on that fund.
The key is to protect your portfolio from tail risks without actually betting on them. The Wall Street Journal reported about two years ago that funds which attempted to bet solely on volatility tend to outperform because they fail to benefit when the market rebounds.