Does Tail Hedging Work? It Depends

Lately there has been a lot of discussion about finance, and people want to know how to ‘protect themselves’ in a market crash, so as to be expected buzzwords such as ‘black swans’, ‘fat tails’, and ‘tail hedging’ are mentioned, topics popularized by Nassim Taleb, who became something of a legend akin to the 21st. century equivalent of Jesse Livermore for supposedly making a lot of money in the 2008 stock market crash using ‘black swan’ trading methods such as buying out of money put options, which his firm, Universa, allegedly sold for a huge profit as the market plunged.

Although Taleb is the pitchman, who constantly rials against journalists (who he calls ‘journos’) and the ‘financial media’ yet is an inveterate self-promoter on the media circuit, the founder and ‘brains’ behind Universa is quantitative analyst Mark Spitznagel, who founded Universa in 2007.

The problem is most people, including experts, seldom question anything told to them…they just assume on face value that Taleb and Spitznagel have somehow found the holy grail of risk management through this ‘tail hedging’ strategy that few, if anyone, has actually bothered to verify. Just like Madoff’s fund, for decades everyone – just save one person, Marco Kopolos, who actually crunched the numbers and determined that purposed returns were impossible – just assumed Madoff was legit. I’m not saying Universa is a fraud, but very few people actually bother investigating anything they read and just blindly accept things as told.

Here is Taleb on Yahoo Finance conversing with those ‘journos’ he so despises to promote tail hedging:

Yahoo Finance: You’re the Distinguished Scientific Advisor at the hedge fund of your longtime friend Mark Spitznagel, Universa Investments, a pioneer in tail risk hedging for institutional clients. What is tail risk hedging?

The idea at Universa is protecting clients against extreme events, those that are rare and traumatic and can threaten their survival. Counter-intuitively, by minimizing clients’ vulnerability to extreme losses through things like put options, they tend to do much better over the long run.

The whole ‘article’ is pretty much a sales pitch for Universa.

Occasionally Spitznagel will don the role of pitchman, extolling the efficacy of tail hedging, predictably with plugs for Universa too. Here is one of his articles: Capital asset pricing mistakes, in which he argues that Harry Markowitz’s efficient frontier, the cornerstone of CAPM is wrong, and that the strategy of tail hedging yields superior risk adjusted returns. And here is a video sales pitch from Universa, too, where Spitznagel describes how ‘allocating a tiny sliver of the portfolio to tail hedging generates more returns for less risk’. Here is some more information about tail hedging Worried About A Stock Market Crash? Here’s How You Can ‘Tail Hedge’ Your Portfolio.

Fro the pionline article, he writes:

Being conservative, let’s assume that the tail-hedged portfolio has similar risk properties as the benchmark portfolio. Using Figure 3, we can see that not only does the tail-hedged portfolio perform better than our benchmark (since the inclusion of options in the portfolio clips the fat left tail and allows us to take more equity risk and invest in the S&P 500), it also has a roughly 7% annualized outperformance over the S&P 500 itself.

And the performance of tail hedging compared to other strategies:

16% annual returns and 3.5% percent variance seems too good to be true.

Neither on the Universa website or anywhere else does he break down the returns by year, but instead takes the average return. This suggests only one or two years out of a dozen or more accounted for the abnormally high returns, indicating that mean is higher than the median (a lot of losing or flat years and may be one or two big winners that boosts the entire average).

Also his fund was launched in 2007, a year before the biggest financial meltdown since the Great Depression, so the timing couldn’t have been better.

Part 2

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