Anyone who’s been investing in the markets regularly over the last several years has probably noticed that things have changed, and it’s not entirely due to the pandemic. In a recent whitepaper, one fund manager explained why he believes structural changes have made the equity markets increasingly fragile.
Kris Sidial of tail risk fund Ambrus Group noted that it’s no longer uncommon to see days with extreme volatility. However, investors who buy the dip are continually rewarded, which he believes gives a false impression of stability. He believes we are in “a market with immense amounts of dry kindling just waiting to explode.
As a result, he invests with the view that, because of the structural changes that have occurred in the market over the last five years, we’re going to start seeing more and more cyclical tail risk events. Kris believes that what previously would’ve occurred every 10 years or every market cycle will now double.
More cyclical tail risk events to come
In a recent interview with ValueWalk, Sidial emphasizes that he isn’t saying that the stock market is going to crash or go to zero. Instead, he’s saying that the structural changes of the last five years will cause more bursts of volatility when tail risk events occur.
“The way we run our portfolio for clients, they don’t come to us to generate returns outside volatility,” Sidial opines. “They’re coming for a protectionary hedge. When they come to us, they have their investments in all different areas, but they’re worried about a bomb. If a war goes off overnight, they want to be able to sleep peacefully, knowing that they’re not going to lose everything they had for retirement.”
He added that many investment advisors place their clients’ assets in 60/40 portfolios or defensive names, but historically, those are some of the worst-performing hedges during severe crashes. It’s easy to see how a traditional 60/40 portfolio has gotten demolished this year. Bonds and stocks are both down because they’re not inversely correlated like they are traditionally expected to be.
In March 2020, defensive and cyclical names crashed along with all other stocks. The fund manager explains that their clients invest with Ambrus Group to have a safety net so that when the markets crash, they may lose money on their other investments with other managers. However, they don’t lose everything because their tail risk protection with Ambrus may offset the losses in the other areas of their portfolio.
Why more tail risk events are expected
Providing just a taste of what he said in his whitepaper, Sidial explained that gamma hedging has gotten extremely convoluted due to a confluence of several factors. Gamma hedging is a strategy aimed at reducing an options position’s exposure to sizable movements in the underlying security.
“The microstructure over the last five years has changed a slew of things,” Kris states. “The growth of passive investing, so more passive, systematic investing. The growth of target-date funds, inverse-levered ETFs [and] the concentration risk between the large market makers. These things impact the microstructure in the equity space. The final one is the growth of derivative exposure, specifically, options in the U.S., in the last three to four years. All these factors combined structurally change the profile of the market and enhance its reflexivity.”
Sidial gave an example of how these factors have impacted gamma hedging in recent years. If an investor buys a call option, the market maker that sold it to them will buy the underlying stock to remain delta neutral. When these actions occur aggressively enough with a large enough size, it creates a dynamic that drives asset prices higher.
“As investors buy more calls, the stock rises higher and higher,” Sidial adds. “The same way that works to the upside also works with the downside. To buy puts, they have to sell more stock against those puts. I experienced firsthand on a large institutional desk what this does to the market and how these sorts of things lead to more frequent, cascading effects because when everybody looks to hedge at the same time, there’s a liquidity pull that harms [the] markets.”
Viewing the entire market cycle
Kris decided to start a tail risk fund due to all these factors leading to increased volatility. He was working on the exotics desk at a large Canadian investment bank during the March 2020 selloff, and he saw how well certain exotic structures performed during that steep, unexpected drawdown. He co-founded Ambrus Group with William Wise and Sal Abbasi in August 2020, basing their strategy on using derivatives to deal with tail risk events.
Sidial feels it’s critical that investors understand the benefits they’re getting from a tail risk fund. He advised investors to invest with the understanding that allocating a small part of their portfolio to a tail risk fund will likely generate higher returns in the long run.
“What happens in the investing world is that people get so focused on the small, month-over-month returns, and they can’t separate themselves from their investment philosophy over the full market cycle,” he explains.
He added that young investment professionals are taught Modern Portfolio Theory. For example, say you have three return streams in a portfolio. The first two returns are 10% each, and the third return is -5%. Sidial questions how they would optimize that portfolio.
Investors often believe that if they remove the -5% return, they have a more optimized portfolio. However, Sidial adds that they don’t understand that the -5% return could make multiples during a crash and that each investment has a goal in a portfolio. Using a hedge like a tail risk fund offers protection for the entire portfolio by investing in volatility because that hedge generally makes money when the market drops.
Why tail risk holdings are a continuous need
It’s also a good idea for investors to keep their hedges in place at all times rather than trying to time the market. Generally, by the time they realize they need a hedge, the moment is past, and they missed the opportunity to protect their returns.
“A lot of people try to time this,” he states. “They try to get fancy and time the market or try to time their allocation in a tail risk fund. After a crash or after they lost everything, they want to allocate to a tail risk fund. For us, it can be frustrating because when you look at history, this happens over and over in every market. So for advisors that say it’s not going to happen, you’re being irresponsible as a fiduciary to your clients, thinking the S&P 500 can’t drop 30% in a month.”
He emphasized that investors should understand that a tail risk fund isn’t something they’re going to trade in and out of. Kris compares tail risk protection to car or home insurance. People pay for it every month and don’t think twice about it. They don’t want to run the risk of their home burning down, so they buy insurance.
“Sophisticated investors understand it’s not something like regular equity allocations,” the fund manager explains. “It isn’t one of those investments you pull in and pull out. This is your life jacket. Don’t try to time it. Always keep it under the seat.”
He recalled an analogy involving a soccer team that one of his friends uses. Of course, coaches would never judge their goalie on the number of goals he scores. In the same way, investors shouldn’t think about the financial metrics of tail risk funds. Instead of judging them on how many goals they score, investors should judge them on their ability to save goals.
“You don’t care if they can score goals,” Sidial explains. “That’s what the other players are for. In terms of investing in a tail risk fund, people are more accepting of it in the same way.”
He noted that for decades, the traditional way of thinking was a generic 60/40 portfolio of stocks and bonds. However, Sidial says that they have to educate investors to let them know that bonds might no longer be defensive. Instead, they should be thinking about investing in volatility as a defensive position to protect against a crash.
Common tail risk strategies
Many tail risk fund managers are secretive about the strategies they use, but Kris has studied up on the most common strategies. He said many tail risk managers buy puts on the S&P 500 or calls on the VIX that are way out of the money.
Some managers even claim to operate a tail risk fund, but they’re shorting futures. He doesn’t believe that’s a real tail risk strategy. Of course, there are many different ways to implement tail risk strategies.
“The important thing is how they’re able to add uncorrelated alpha to minimize the bleed because if somebody came to you and said, ‘I’m going to run a tail risk fund and I’m just going to buy puts,’ there is no value-add in that outside execution,” Sidial states. “They say they can have great execution, and their puts are efficiently cheap, but they still bleed 20% to 30% a year. There’s a fine line between value-add or being a hazard for the client. You want to be adding real value by minimizing that bleed by doing other uncorrelated things that don’t compromise the purpose of the fund.”
How Ambrus Group’s tail risk strategy differs
Over the long term, Kris hopes Ambrus Group will be flat to slightly down during regular market periods and steeply up during tail risk events. Many other tail risk funds do things like short Treasury volatility and fund that position by buying S&P 500 volatility.
However, he doesn’t believe in that mentality because in a real tail risk event, there’s no way to know which trade will go higher than the other. Such a strategy could lead to steep losses during the types of drawdowns that such tail risk strategies are supposed to protect against.
As a result, the fund manager focuses on active, short-term order flow trading to offset the bleed of being long those tails. While other funds are short and long volatility, Ambrus focuses more on order flow trading to make money to fund the tails.
Limiting bleed while maximizing returns in a crash
Sidial also offers advice for investors weighing the returns of various tail risk funds. He explained that tail risk funds that bleed too much during regular market times when there’s no crash weigh heavily on an investor’s overall portfolio. According to him, Ambrus Group has so far been able to limit its bleed during regular market periods while still providing exposure to a significant payout during market crashes.
He advised investors who are looking at tail risk funds to consider the expected annual bleed, divided by the expected return in a crash. Sidial defines a crash as the S&P 500 and Dow Jones Industrial Average plummeting 20% in a month or the VIX sitting at around 70.
“I think if I came to you and told you I’m going to bleed nothing, zero bleed, I’m a tail risk fund with zero bleed, and when a crash happens, I’m only going to generate 10%, that’s not that efficient,” he said. “Another tail risk fund, when a crash happens, returns 500%, but they bleed 70% a year. That’s not great either. The key for an investor is finding a fund that gives a unique balance of the two.”
He emphasized that investors must calculate the true ratio of a tail risk fund, which again, is the expected annual bleed, divided by the expected return in a crash. It means having a large enough return to keep the portfolio from losing huge piles of money in a crash without bleeding so much that it weighs heavily on the portfolio the rest of the time.
Beware problematic reporting by some tail risk funds
One final issue with tail risk funds is how they report their returns. In the past, some tail risk funds have trumpeted returns of 4,000% or even more during steep market drawdowns, but investors should be wary of such returns. Sidial explains that investors shouldn’t expect a 4,000% return in a crash because it doesn’t work that way, even on the most convex structures.
He added that funds that do tout such returns are typically quoting their performance on the amount of capital they invested. For example, an investor may give a tail risk fund $100,000, and the fund invests $1,000 of that total in puts on the S&P 500. The S&P drops, and those puts are then valued at $10,000.
The return on that would be 10%, but some tail risk funds might report a 1,000% return based on the $1,000 rather than the total 10% return on the $100,000. Reporting a return in this way is incorrect because it’s not about the amount of capital deployed on a particular trade. It’s about the total allocation the investor made to the fund.
Michelle Jones contributed to this report.