Tail Risk Funds Vs. Traditional Risk Management

By Michelle Jones

Tail risk funds have received a lot of attention since the sudden March selloff, but what role should they play in the average investor's portfolio? After all, investors generally need some risk management and hedging in their portfolios, but tail risk protection may not be appropriate for every portfolio, especially given how rare tail events are. 

By the time investors hear about tail risk funds and the splashy headlines trumpeting astonishing returns, the need for them has usually passed. What are tail risk funds?

One of the most important things investors should know about tail risk funds is the fact that they lose money most of the time. Whatever money that's allocated to them is used up throughout the year unless there is a tail risk event. 

Tail risk events are rare events that cause a sudden and extreme loss in a portfolio. There is no way to predict such events because they are so rare and occur without warning. The March selloff is a perfect example of such an event. The markets sold off suddenly and sharply after humming along for months despite the spread of the pandemic.

Tail risk funds differ from traditional risk management strategies because they go beyond managing typical amounts of risk. They're designed to take advantage of extreme volatility, which is why they don't pay off most of the time. 

Since tail risk strategies lose money unless there is a tail event, allocations usually run about 1% to 5% of the total portfolio. The point of such strategies is to offset the losses seen in the rest of the portfolio when there is a sudden, steep selloff.  

Tail risk versus traditional risk management

Since tail risk events are so rare and represent sudden selloffs, dealing with them requires different tactics than traditional risk management. Many tail risk strategies involve the use of options, with many funds buying options that are way out of the money. 

Such strategies make a high return when the market plunges without any warning because the options move into the money. However, since they are so far out of the money before the event occurs, they end up being like a lottery ticket that pays off once every 10 years. 

One popular investing and tail risk hedging strategy involves allocating most of the portfolio to the S&P 500 or a fund that tracks it and then hedging against that by allocating a small percentage to puts that are out of the money. 

Other tail risk hedging strategies involve volatility, although the conditions of the tail risk event have to be just right for this strategy to pay off. If the selloff occurs more gradually rather than amid a bout of extreme volatility, then this strategy won't work as well as buying out-of-the-money puts. VIX futures and realized volatility futures are two examples of this strategy.

Traditional risk management, on the other hand, involves portfolio diversification and holding assets like gold and other alternative investments that tend to move in the opposite direction of stocks. Traditional risk management also uses measures like alpha or beta risk to determine just how risky each investment is. Hedges can then be built into the portfolio to manage this risk.  

Tail risk funds provide an alternative way to hedge against risk in your portfolio, but they may not be suitable for all investors at all times. Whenever there is a possibility of volatility returning, it may pay off to invest in a tail risk strategy, but investors must be aware that whatever they spend on this portfolio insurance will be lost unless a tail risk event occurs.

Michelle was a television news producer for eight years. She produced the morning news programs for the NBC affiliates in Evansville, Indiana and Huntsville, Alabama and spent a short time at the CBS affiliate in Huntsville. She has experience as a writer and public relations expert for a wide variety of businesses. Michelle has been with ValueWalk since 2012 and is now our editor-in-chief. Email her at Mjones@valuewalk.com.