As the name of our Tail Reaper program implies, it is
designed to benefit from tail events. It did so (+20.07%) during
August-December, 2015’s Chinese stock market crash (even though it trades only
the E-mini S&P 500 index futures), it did so (+18.38%) during
February-March, 2018’s “volmageddon”, and now it did it again (+12.98%) during
February, 2020’s Covid-19 crisis. (As of this writing, March is up over 21%
gross.) There are many names to this strategy: some call it “crisis alpha”, others
call it “convex”, “long gamma” or “long vega” (even though no options are
involved), “long volatility”, “tail hedge”, or just plain old “trend-following”.
Whatever the name or description, it usually enjoys outsize return when there
is real panic. (But of course, PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE
OF FUTURE RESULTS.) Furthermore, our strategy did so without holding any
overnight positions.
Why is a trend-following strategy profitable in a crisis? A
simple example will suffice. If a short trade is triggered when the return
(from some chosen benchmark) exceeds -1%, then the trade will be very profitable
if the market ends up dropping -4%. Vice versa for a long trade. (As recent
market actions have demonstrated, prices exhibit both left and right tail
movements in a crisis.) The trick, of course, is to find the right benchmark for
the entry, and to find the right exit condition.
Naturally, insurance against market crash isn’t completely
free. Our goal is to prevent the insurance cost, which is essentially the loss
that the strategy suffers during a stretch of bull market, from being too high.
After all, if insurance were all we want, we could have just bought put options
on the market index, and watched it lost premium every month in “good” times.
To prevent the loss of insurance premium requires a dose of market timing,
assisted by our machine learning program that utilizes many, many factors to
predict whether the market will suffer extreme movements in the next day. In
most years, the cost (loss) is negligible despite the long bull market, except
in 2019 when we lost 8.13%. That year, which seems a long time ago, the SPY was
up 30.9%. (It was in the August of that year that we added the machine learning
risk management layer.) But most investors have a substantial long exposure. A
proper asset allocation to both Tail Reaper and to a long-only portfolio will
smooth out the annual returns and hopefully eliminate any losing year. (Again, PAST
PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.)
But why should we worry about a losing year? Isnt’ total
return all investors should care about? Recently, Mark Spitznagel (who
co-founded Empirica Capital with Nassim Nicholas Taleb) wrote a series of
interesting articles. It argued that even if a tail hedge strategy like ours
returns an arithmetic average return of 0%, as long as it provides outsize
positive returns during a market crisis, it will be able to significantly
improves the compound growth rate of a portfolio that includes both an index
fund and the tail hedge strategy. I have previously written a somewhat
technical blog post on this mathematical curiosity. The gist of the argument is that the
compound growth rate of a portfolio is m-s^2/2, where m is the arithmetic
mean return and s is the standard deviation of returns. Hedging tail risk is
not just for the psychological comfort of having no losing years - it is
mathematically proven to improve long-term compound growth rate overall.
For further reading on convex strategies, please see the papers by Paul Jusselin et al “Understanding the Momentum Risk Premium: An In-Depth Journey Through Trend-Following Strategies” and Dao et al “Tail protection for long investors: Trend convexity at work” (Hat tip to Corey Hoffstein for leading me to them!)
