In theory, the Cambria Tail Risk ETF (BATS: TAIL) makes sense in a diversified portfolio. Investors should consider tail coverage like home insurance, paying annual premiums (losses) to protect against a market downturn.
In practice, tail risk strategies have not worked as announced in 2022. Part of the problem could be that there is too much money chasing the same investments, causing the behavior of the strategy to change. Investors who are concerned about market declines should consider adding cash to their portfolio rather than pursuing complex strategies that underperform.
The Cambria Tail Risk ETF seeks to provide a hedge against a significant market decline. The fund has $327 million in assets and charges an expense ratio of 0.59%.
The TAIL ETF seeks to achieve its downside protection by investing in a portfolio of ‘out-of-the-money’ (‘OTM’) put options on the US stock market while a portion of the portfolio is used to purchase options. For sale, the majority of the portfolio is invested in medium-term US Treasury bonds. The fund is designed to protect against market declines and rising volatility. The TAIL ETF expects to produce negative returns in most years when markets are up or volatility is down, but provides a hedge when markets are down.
The TAIL ETF invests in a portfolio of S&P 500 Index OTM puts as noted above. Currently, the hedge portfolio accounts for 11.1% of the fund’s assets and consists of indexed puts with strikes ranging from 3,500 to 4,100 (8% OTM to 8% ITM), and maturities ranging from December 2022 to December 2023. The rest of the assets are invested in Treasury bonds (76.8% of assets), TIPS bonds (5.6%) and cash (6.5%) (Figure 1).
The TAIL ETF has understandably underperformed over the long term, losing an average of 7.3% per year since its inception (Figure 2). This is because the strategy is like a home insurance policy, you pay the annual premium (ie annual loss) and collect a lump sum in case of fire (ie market decline). What is unclear is why the fund is down 12.5% YTD through October 31, 2022, when the S&P 500 suffered its worst bear market since the Great Financial Crisis of 2008.
TAIL worked on previous episodes of Drawdown
For credit of the TAIL ETF, its performance in the face of falling markets has been historically good. In 2018, when the S&P 500 fell nearly 20% due to a combination of Federal Reserve rate hikes and the US trade war with China, the TAIL ETF rallied 35% from lows in October 2018. 2018 to December 2018 highs, essentially offsetting the 20% drop in the S&P.
During the early days of the COVID-19 pandemic, the TAIL ETF performed even better, returning more than 40% from January 2020 lows to March 2020 highs, compared to a 34% drop in the S&P 500. So why hasn’t it worked out this year? like the S&P 500 fell more than 25% at one point?
The volatility peak is the missing ingredient
The missing ingredient so far in 2022 has been a spike in volatility. While the total market decline in 2022 has been large, it has been a gradual decline over 10 months, characterized by persistently high volatility in the 20-30 range (as measured by the VIX Index, see Figure 4).
Remember that the value of put options has a series of drivers: the underlying price in relation to the strike price, the volatility of the underlying, the risk-free rate and the time to expiration. Since the TAIL ETF typically has deep OTC put options with an underlying price well above the strike price, the value of your options portfolio is primarily determined by the volatility of the underlying and the time to expiration.
In previous episodes (2018 and 2020) volatility started at very low levels (VIX was in the low teens before both) and multiples increased in a short period of time, adding a lot of value to TAIL’s OTM portfolio. . This time VIX started in the teens (meaning protection was already a bit expensive) and only went up to 20-30. Also, a prolonged bear market is detrimental to the TAIL ETF as its put options portfolio decays over time. Finally, persistently high volatility meant that new hedges added to the portfolio (either through increased AUM or contract expiry) were done at costly levels.
The correlation between bonds and stocks was broken
To top it off, over 80% of TAIL’s ETF portfolio is invested in Treasuries and TIPS bonds, based on the historical negative correlation between bonds and stocks. As the Federal Reserve rapidly raised interest rates in response to runaway inflation, bonds suffered. worst bear market in history (Figure 5).
Too much money chasing tail hedges
The problem with tail risk hedging strategies like the TAIL ETF is that, in a perfect world, investors would allocate only a small portion of their assets to the tail strategy. When a tail event occurs, they must monetize the tail hedge to offset losses in their main portfolio.
Unfortunately, the staggering performance of tail hedging strategies in March 2020 (an investor who had allocated 3.3% to by Mark Spitznagel Universa’s tail hedge strategy would have returned 0.4% vs. -12% loss on the S&P 500) made investors fall in love with tail protection. We can deduce this through the assets under management (“AUM”) of the TAIL ETF, which exploded after the March 2020 episode, and continued to rise throughout the 2020-2021 bull market (Figure 6).
The TAIL ETF, and dozens of other public and private funds that offer tail hedging through OTM put options, caught on and investors poured money into the strategy.
What happens in finance when everyone follows the same strategy? That strategy stops working, as we are witnessing today in real time. Too much money in OTM puts means that every time we have a downturn in the market, OTM holders rush to monetize their puts, so that the emerging value is not consumed by the decline of time. This could be why we haven’t seen the spike in volatility that is usually associated with big market declines.
Peer funds perform even worse
To be fair, the TAIL ETF isn’t even the worst performing tail risk fund. exist reports (around the 11 minute mark in the attached podcast) that Artemis Capital Management, one of the biggest players and loudest promoters in the tail risk/volatility management space, is shutting down their tail risk strategies due to the low performance. Simplify ETFs it also has a Simplify Tail Risk Strategy (CYA) ETF that is down an incredible 34.3% YTD, even worse than the S&P500 it is trying to hedge against (Figure 7)!
Distribution and Yield
The TAIL ETF pays a modest quarterly distribution amounting to $0.18 over the last twelve months, giving a final distribution yield of 1.2% (Figure 8).
In theory, the TAIL ETF makes sense in a diversified portfolio. Investors should consider tail coverage like home insurance, paying annual premiums (losses) to protect against a market downturn.
In practice, the success of tail risk strategies in accumulating assets in recent years means that the behavior of the strategy may have changed, as too much money has been chasing the same investments. So far in 2022, tail risk strategies have not come remotely close to providing a hedge. Investors who are concerned about market declines should consider adding cash to their portfolio rather than pursuing complex strategies that underperform.