The failure of tail hedging, and why barbell strategies are misleading

Early in an interview with Tim Ferriss, Nassim Taleb discusses the closure of his old Fund, Empirica Capital, and the launch of his new fund, Universa:

Not surprisingly Taleb glosses over why Empirica closed, nor does Mr. Ferriss press him on the matter. If I had to guess, it closed due to poor performance, until catching a break in 2008-2020 with his subsequent fund, Universa, launched in 2007.

To recap, Black swan funds benefit from major, unforeseen spikes in volatility. This is can be visualized as a lopsided barbell. The idea is to allocate a small percentage of a portfolio, typically 1-2%–analogous to a light weight–to out-of-money put options or some other hedging instrument that pays an outsized return when said black swan happens, and the rest is invested in the S&P 500 or other conservative investment such as treasury bonds. The hedge can be thought of as insurance and is a recurring cost to protect the much larger part of the portfolio (the heavier side of the barbell).

During Empirica’s short existence, this hedging strategy failed to be profitable. Even 911, despite meeting Taleb’s criteria of being a black swan event, was not enough, nor was the 2000-2002 ‘tech bust’ or the 2001 recession. Combined with negative performance of the S&P 500, Empirica likely experienced a steady and significant bleed owing to its unprofitable barbell hedging strategy and was eventually shut down. This is what I am sure happened.

Soon after, taking advantage of the 2007 mortgage crisis and fawning media coverage of his new book The Black Swan, Taleb rebooted the strategy under a new fund named Universa, but it’s headed by friend and close business associate Mark Spitznagel, with Taleb as the ‘pitchman’. But Taleb is careful to avoid the direct promotion of Universa, using his platform to obliquely make reference to it (e.g. links to cartoons, articles, etc.) but not actually telling his Twitter followers to invest. This is likely for legal reasons: when investors see they lost money due to the fund’s near-certain poor post-Covid returns, they cannot blame him: he was only reporting about it and sharing links about it, not recommending it.

This is not to say tail hedging is always a losing strategy. Between 2010-2020 there were many notable volatility events, which Universa likely profited from, such as the May 6th 2010 ‘flash crash‘, the Summer 2011 European debt crisis/contagion, the August 24th 2015 crash, the 2016 Brexit vote and Trump win volatility spikes, the February 5th 2018 ‘Volpocalypse‘ in which the VIX index inexplicably nearly doubled in a day and causing the destruction of several volatility-linked ETFs, and finally, in 2020, Covid, which briefly saw tail-hedging strategies post huge returns.

But it’s possible we’re in a new regime of low volatility, which if history is any guide may last for a decade. Indeed, after the ‘Black Monday’ crash in October 1987, it would be a decade until another major spike in volatility, in 1997/1998 during the Asian financial crisis, which soon segued to the Russian default crisis. And then another decade of subdued volatility until the ‘global financial crisis’ in 2007-2010. So if Covid was the ‘bookend’ of the 2010-2020 regime, we could be looking at low volatility until 2030, which bodes very poorly for anyone using a barbell hedging strategy.

As I argue in my 2022 article Tail Hedging Strategies Are Struggling During the 2022 Bear Market, Universa’s fund’s post-Covid performance–following it’s alleged 3,000% return from Feb-March 2020 during ‘peak Covid’ (from the hedge portion of the fund, not the entire fund)– has been abysmal. A year and a half after my article, tail hedging continues to be a loser as volatility remains low. Even the recent conflict between Iran and Israel, despite the spectre of another World War, resulted in a muted volatility reaction, and stocks quickly recovered. In Taleb’s defense, this is how it’s supposed to be–that is to say–tail hedging is expected to pay off infrequently, but big when it does.

However, as per my article, tail hedging likely fared poorly during the 2022 bear market due to the failure of volatility to spike much despite large declines in the S&P 500. This meant investors in 2022 using a barbell approach lost money twice: first from the nominal decline of the stock market and then from the hedge itself also failing. It’s like paying for fire insurance and your home burns down, but the insurance company refuses to pay because the damage was not severe enough. Gee, thanks!

During the late ’90s and early 2000s, volatility as indicated by the CBOE Vix index above, was elevated but did not spike much. Even 911 only saw volatility double, from 20 to 40. By comparison, the failure of Lehman Brothers and Covid saw volatility more than quadruple from its local minimum. This is the worst possible condition for tail hedging because the high background volatility makes out-of-money put options more expensive and reduces the explosiveness of such puts, unlike the persistently low volatility from 2004-2006 leading up to the 2007-2008 crisis, which was more like a compressed coil or spring that had been released. After 2008 until 2020 there were many notable spikes, but zero spikes after Covid, except for occasional blip:

So in the subsequent four years after Covid, Universa likely incurred a 25-30% accumulated lag relative to ‘buy and hold’ of the S&P 500 due to the cost of continuously rolling losing tail hedging positions. This is because such hedges, as per the methodology disclosed by Taleb of buying out-of-money puts that expire in 60-70 days, MUST be rolled over monthly, NOT yearly. It’s misleading when Universa’s sales pitch says it only needs to allocate 1-2% of capital to the barbell hedge portion (it’s not only Universa but I have seen many sources espouse this “1-2%” claim). It’s only 1-2% at any given time, but this needs to be rolled over monthly. The math works out to anywhere between a 8-12% annual loss, which is roughly a 25-30% loss or lag compounded over 4 years compared to unhedged buy and hold of the S&P 500. Ouch…way worse than the often touted 1-2%. This shows the dangers of falling for slick sales pitches and media hype about tail hedging.

This can also explain why the first fund closed. Who wants to underperform the S&P 500 by 30-40%+ waiting for a black swan that may never happen, and even if it does, it may still not be good enough to negate the years of accumulated underperformance. Maybe tail hedging isn’t necessary. History and evidence shows that attempts at market timing or beating the market are unsuccessful.

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