Idea Streams #5 – Tail Risk Hedging
Tail risk events are broadly defined as extreme market events like the 2000 dotcom bubble, 2008 financial crisis, and 2020 coronavirus crash. To protect against these events, some investors employ a tail risk hedge, but there has been a great debate on whether tail risk hedging is actually beneficial. On one hand, Nassim Nicholas Taleb argues that using a hedge to account for the tail risk events is beneficial to a portfolio because the hedge pays off in extreme times. On the other hand, Cliff Asness argues that over a long-term horizon, tail risk hedging costs more than the value it adds to the portfolio.
To understand each side of the argument, in this episode of Idea Streams, we implement a tail risk strategy and analyze the cost-benefit of including a hedge component.
There are many ways to design a tail risk hedge. In our implementation, we buy SPY and hedge with buying OTM put options on SPY. The idea is that when the price of SPY decreases, the value of the put option will increase to balance out the portfolio. When selecting a contract to use as the hedge, we look for a put option with a strike that’s 60% of the price of SPY and has an expiration 1 year into the future. To ensure the contract never expires while we’re holding it, we roll over to the next option that fits our criteria when the put option has only 6 months left to expiration.
There is no consensus on when is the best time to take advantage of the puts that become valuable during times of crisis. Without liquidating them, the options will just drag the portfolio down over the long term as SPY reaches higher prices. To ensure we capitalize on the crisis, we decided to liquidate the put contract if the contract increases in value to the point where its strike price is greater than 70% of the price of SPY. This threshold is quite arbitrary though and could be adjusted to fit the needs of investors.
To test the arguments presented in the Twitter debate, we ran three backtests in total. In order to get a long-term picture that covers 2 tail risk events, we set the start date of the backtests to January 1, 2007. The first backtest invested 100% in SPY to give us a benchmark. The second backtest invested 99% in SPY and allocated 1% to hedge with OTM put options. The final backtest only purchased OTM put options to highlight the cost of hedging. When hedging, we chose to allocate 1% of the portfolio to the put options but the appropriate weight to use is still up for debate.
Our backtests showed that at the bottom of the financial crisis in January 2009, the portfolio without the hedge was in a 40% drawdown. At the same time, the hedged portfolio was only in a 34% drawdown. Therefore, over this period, the hedge effectively reduced the portfolio drawdown. If we fast forward a few years to July 2018, the portfolio without the hedge was sitting at a 132% return from the beginning of the backtest while the hedged portfolio was lagging at only a 117% return.
By the end of the backtest, the portfolio without the hedge experienced a max drawdown of 54% while the hedged portfolio had a 48% max drawdown and a slightly higher Sharpe ratio. The backtest which only purchased the OTM put contracts had a fairly consistent negative return over the majority of the backtest. After about 10 years, the backtest that only purchased OTM put contracts lost about 10% of the portfolio’s value.
In conclusion, the backtest of our strategy had a higher Sharpe ratio when the tail risk hedge was applied. Although, there are many alternative ways to implement a tail risk hedge, so we encourage investors to test other techniques. For instance, we can adjust the contract selection logic, the rollover frequency, and the portfolio weight given to the hedge.
To get a copy of the strategy code, clone the backtest below.