Looking for volatility/tail risk hedged equity fund or etf

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Why are there so few offerings for this type of product? Is there an easier way to achieve the same result other than buying vix futures? What am I missing?

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Because in theory, it isn't better than volatility/risk reducing strategies that in practice are less costly to implement. I don't know much about these funds/how they hedge their positions, but from a volatility/risk reduction standpoint it is hard to believe it is cost efficient. They very well may pay off, but the simplistic theory math would suggest it isn't optimal

Using simplistic CAM theory would suggest that the higher expected returns of the market are based on the increased risk premium. This increase risk premium is really referring to investment return volatility

So the pure no fee cost of reducing volatility (cost of hedge position) must have a tradeoff of reduced expected returns that would make the hedged portfolio's returns on par with a similar volatile/risk profile asset. In theory with no transaction costs, the return on say a super hedged portfolio with the same risk profile of treasury bonds should be about the same as treasury bond returns

The problems though comes in practice. There are transaction costs to buy these hedge positions + companies providing hedged position have a cost to remain in a solvent position or otherwise present counterparty risk. This makes the hedged position inefficient to create


It is more likely that the transaction costs of buying a portfolio of equities + safer asset classes like bonds for a desired volatility level is much more efficient than hedging the market


Source: I work in corporate finance and just got out of a meeting regarding how we should hedge large investment porftolios

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Otherwise the performance haircut from fees

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This. The immediate realized cost to hedge either the volatility itself or economic cost forcing reduced volatility by methods such as collaring returns


The only theoretical way these funds can make money on this hedge position compared to similar reduced volatility portfolio is if the specific fund can create an arbitrage situation to better optimize their hedge positions

Basically, do you trust that this fund is smarter and faster responding than the market. More specifically, stronger/fast enough to give returns > the offset fund + position fee costs

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It is more likely that the transaction costs of buying a portfolio of equities + safer asset classes like bonds for a desired volatility level is much more efficient than hedging the market

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Well, yes, unless a really big tail event actually occurs, in which case you would much rather own OOM put options than bonds.

There are a number of ways to hedge against tail risk: (1) classic multi-asset portfolio allocation strategies; (2) tail risk ETFs; and (3) tail risk hedge funds.

For (1), this is the most cost efficient as you said, and should definitely work the best under most normal market environments.

For (2), yeah, it's a little weird to do, because you are combining two things (bullish on stocks, but also placing a higher probability of tail risk events than the rest of the market) into a single ETF. This is unlike the covered call strategy that became so popular a few years ago, where the two things (writing calls, and buying the underlying) were more closely intertwined behind a single theory of the market. For the bullish-stocks-but-bearish-tail-risk strategy, why not just break those two views into separate ETFs for stocks and left-tail volatility, and if an investor wants to do both, then buy both? (But this assumes that you know that the market is underpricing deep-OOM put options.)

The market is still small for this stuff, but I can see why people would be attracted to it. The financial media has been commenting a lot on how cheap options are, and how low the VIX has become. People also sense (correctly, I think) that this market seems a little artificial and worrisome, and want to take advantage of all the news they hear about low VIX, while at the same time not wanting to miss out on the stock market increases (as the financial media simultaneously tells everyone that it doesn't make any sense to get out).

I think you may be overemphasizing a little bit the time decay costs of deep-OOM put options, but your larger point about it being an inefficient ETF strategy is right on the mark. To engage in this type of strategy as an investor, you would almost have to believe in an activist professional investor who could beat the market for you. But that's not what ETFs are about. Which brings us to...

For (3), it can make sense for actively managed hedge funds or large institutional investors to do this, which is why I think tail risk strategy hedge runds are more popular than tail risk strategy ETFs. First of all, the concept of "tail risk strategy" is so vague and general that it can potentially include a lot of different strategies. How deeply do you want to protect yourself? Are you talking about 1/20 probability events, or 1/1000 probability events? For what time horizon? How often will you turnover your portfolio of put options?

Plus, some hedge funds will be engaging in complex strategies where risk will be difficult for non-professionals to understand, so it might make a lot more sense to bundle the hedging of that risk within the single fund (whereas an investor in ordinary stock ETFs could simply self-hedge with ordinary bond ETFs).

Yeah. VIX would seem to have lower transaction costs. And now that I think about it some more, it might be possible to have an efficient ETF that has a certain amount of built-in insurance to it. So some of my comments above about beating the market by mixing two strategies may be a little off the mark. Still, though, each individual investor will have different risk profiles to build portfolio insurance around, and so it once again becomes a question of how deep of a left-tail risk you are talking about protecting against.

Then there is the portfolio insurance strategy of Leland and Rubinstein that is often implicated in the 1987 crash, but that's a little different...

To your point about different portfolio make ups. I've always held CVX, and would never consider COP for obvious reasons that were proven once again recently.

Here is what I learned. There is something named OVX. And there are other sector specific ones.

Now I know.

True. But VIX calls and SPX options are a little different from CDS traded OTC. For some portion of the left tail, you will find a region extreme enough for tail options to better than classic bond allocation, and not too extreme to cause significant CP risk for products traded on very liquid options markets. I tend to think we are likely to enter just such a portion of the left tail sometime before the completion of the current market cycle.

I'm actually going to reverse on myself and say that option (2) can be a pretty good deal to some investors. I think I got too caught up in seeing it as a play for those who think tail risk is underpriced, but even if it is properly priced, some people might prefer that kind of portfolio insurance. It's true that classic multi-asset-class portfolio strategies will tend to mitigate risk more cheaply, but it also doesn't catch everything. You might want to have bonds + stocks + tail risk insurance (in low-cost moderation, of course), and it might actually make some sense to do so.

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For some portion of the left tail, you will find a region extreme enough for tail options to better than classic bond allocation, and not too extreme to cause significant CP risk for products traded on very liquid options markets

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You're essentially arguing gains from a conditional tail expectation event without applying the market's probability factor for such an event though. That's a speculative argument that the likelihood of a tail event is more than current market expectations. I see you believe that, but the determination of "better" portfolio allocation is built on the believe metrics are incorrect right now

If you believe a tail even like that will happen, you probably should be buying the event and hedging that position instead of vice versa

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That's a speculative argument that the likelihood of a tail event is more than current market expectations.

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I don't think so. That's what I was saying earlier in arguing the against position, but if you see it as plain insurance, it's just somewhat more expensive insurance for a somewhat different category of risk.

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it's just somewhat more expensive insurance for a somewhat different category of risk.

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I'd just say it is just a different type of "insurance" altogether if you are pricing using identical assumptions on market condition. What's better depends on if the goal is to stabilize earnings or give a floor for downside risk

Gut response is it is basically prioritizing improving your Value at Risk or your conditional tail expectation