(Bloomberg) – Black swan funds spend years waiting for markets to collapse. It turns out that just a touch of Crash is enough to boost performance.
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These options-based strategies that capitalize on bursts of volatility are having a great month, while the S&P 500 was little changed in March and widespread bank stocks took a hit, suggesting a market-wide explosion would lead to large payouts. An actively managed tail-risk exchange-traded fund is up about 4% so far in March as the banking turmoil deepens and is on track for its second-best month since March 2020 during the pandemic outbreak.
Towards the end of the week, some calm returned to financial markets, stocks closed higher and the Cboe Volatility Index, Wall Street’s fear gauge, fell. But investors remain nervous, it became clear after a rise in Deutsche Bank AG’s loan protection costs sent European bank stocks into a tailspin. Policymakers from Washington to Frankfurt to Zurich continue to reassure investors about financial stability, even as confidence in a number of lenders dwindles.
“The recent debacle has positively polarized defensive alternatives,” said Kris Sidial, co-chief investment officer at Ambrus Group LLC, whose tail risk strategy surged 7% last week as the VIX rose above 30. “Potential investors are concerned that some kind of contagion will strike and their portfolios will be destroyed as a result.”
Investors betting that weaknesses can be identified and contained might be surprised. Central banks have acted quickly to bolster confidence in the system – but even Federal Reserve Chair Jerome Powell warns that after the turmoil of the past three weeks it’s too early to sound the all-clear.
The story goes on
“We’ve seen an increase in tail hedging,” said Chris Murphy, co-head of derivatives strategy at Susquehanna International Group. “We have continued to see call buying in the VIX since the beginning of the banking turmoil.”
Bank balance sheet problems are emerging at US regional lenders, and liquidity concerns forced the state-brokered takeover of Credit Suisse Group AG.
So far, the situation is a far cry from the 2008 chain reaction of mass consumer defaults that led to widespread losses in securities that Wall Street invented around home loans. This time, small banks are struggling because of depositor flights – not bad loans.
Tail risk hedging can yield big gains during sharp, sudden market downturns like March 2020 or 2008 for investors who can weather years of declines. According to data from Eurekahedge Pte. have lost money in 11 of the last 16 years.
For comparison, US Treasuries have lost four years of the past 20 years and are up 3.4% so far this month. Gold is up 8% so far in March.
“Most tail risk strategies should lose money, on average,” said Meb Faber, chief executive officer of Cambria Investment Management, which manages the Cambria Tail Risk ETF (Ticker TAIL) — an industry proxy. “This is a feature, not a bug.”
Funds like Ambrus and 36 South Capital Advisors buy deep-out-of-the-money calls on the VIX index or deep-out-of-the-money puts on the S&P 500 index, among other things. Any of these bets would benefit from market turmoil as stocks fall and volatility increases.
This week, protective call options on the VIX index signaled traders that they are bracing for months to come in volatility. Outstanding put contracts on exchange-traded fund Invesco QQQ Trust Series 1 surged to an all-time high this week as high-flying, supposedly high-value tech is vulnerable to a major reversal.
Read more: Hedging Demand Surges for Investors Hiding in Tech: Taking Stock
While this month’s volatility is still far from a black swan event, a move of more than three standard deviations from the norm, it was enough to stoke crisis fears and boost interest in catastrophe insurance.
“In recent weeks we have seen a remarkable pick-up in investor talk and demand,” said Diego Parrilla, director at 36 South, based in London. “Investors seem increasingly concerned that the issues we’re seeing could be the tip of the iceberg.”
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