TAIL ETF: Failure To Hedge Downside

In concept, the Cambria Tail Threat ETF (BATS:TAIL) is smart in a diversified portfolio. Buyers ought to view tail hedging like residence insurance coverage, paying annual premiums (losses) to guard in opposition to a market drawdown.

In apply, tail threat methods haven’t carried out as marketed in 2022. A part of the difficulty may very well be there may be an excessive amount of cash chasing the identical investments, inflicting the technique behaviour to alter. Buyers who’re nervous about market drawdowns ought to think about elevating money of their portfolio as an alternative of chasing advanced methods that underperform.

Fund Overview

The Cambria Tail Threat ETF seeks to offer a hedge in opposition to vital market draw back. The fund has $327 million in belongings and fees a 0.59% expense ratio.

Technique

The TAIL ETF seeks to attain its draw back safety by investing in a portfolio of ‘out of the cash’ (“OTM”) put choices on the U.S. inventory market. Whereas a portion of the portfolio is used to purchase put choices, the vast majority of the portfolio is invested in intermediate time period U.S. treasuries. The fund is designed to hedge in opposition to market declines and rising volatility. The TAIL ETF expects to provide adverse returns in most years when markets are rising or volatility is declining, however present a hedge when markets decline.

Portfolio Holdings

The TAIL ETF invests in a portfolio of S&P 500 Index OTM places as indicated above. At present, the hedge portfolio has 11.1% of the fund’s belongings and include index places with strikes starting from 3,500 to 4,100 (8% OTM to eight% ITM), and expiries starting from December 2022 to December 2023. The remainder of the belongings are invested in treasuries (76.8% of belongings), TIPS bonds (5.6%), and money (6.5%) (Determine 1).

Returns

Understandably, the TAIL ETF has had poor long run efficiency, dropping a mean of seven.3% each year since inception (Determine 2). It’s because the technique is sort of a residence insurance coverage coverage, you pay the annual premium (i.e. annual loss) and accumulate a lump sum payout within the occasion of a hearth (i.e. market drawdown). What will not be clear is why the fund is down 12.5% YTD to October 31, 2022, when the S&P 500 has suffered the more severe bear market because the 2008 Nice Monetary Disaster.

TAIL Labored In Prior Drawdown Episodes

To the TAIL ETF’s credit score, its efficiency in opposition to market drawdown had traditionally been good. In 2018, when the S&P 500 declined virtually 20% because of a mixture of Fed charge hikes and the U.S. commerce battle with China, the TAIL ETF rallied 35% from October 2018 lows to December 2018 highs, primarily offsetting the S&P’s 20% decline.

Through the early days of the COVID-19 pandemic, the TAIL ETF labored even higher, returning over 40% from January 2020 lows to March 2020 highs in comparison with a 34% decline within the S&P 500. So why has it not labored this yr, because the S&P 500 declined over 25% at one level?

Volatility Spike Is The Lacking Ingredient

The lacking ingredient up to now in 2022 has been a volatility spike. Whereas the full market decline in 2022 have been giant, it has been a gradual grind decrease over 10 months, characterised by persistently excessive volatility within the 20-30 vary (as measured by the VIX Index, see Determine 4).

Recall the worth of put choices have a variety of drivers: the underlying value relative to the strike value, the volatility of the underlying, the danger free charge, and the time to expiry. For the reason that TAIL ETF sometimes maintain deep OTM put choices with the underlying value far above the strike value, the worth of its choice portfolio is mainly decided by the volatility of the underlying and the time to expiry.

Previous episodes (2018 and 2020) noticed volatility start at very low ranges (VIX was within the low teenagers previous to each), and spike multiples larger in a brief time frame, which added numerous worth to TAIL’s portfolio of OTM places. This time round, VIX began within the excessive teenagers (which means the safety was already mildly costly), and solely rallied to 20-30. Moreover, an extended drawn out bear market is detrimental to the TAIL ETF as its portfolio of put choices decay over time. Lastly, persistently excessive volatility meant that new hedges added to the portfolio (both by way of enhance in AUM or expiring contracts) have been accomplished at costly ranges.

Bond / Inventory Correlation Broke Down

To prime it off, greater than 80% of the TAIL ETF portfolio is invested in treasury bonds and TIPS bonds, counting on the historic adverse correlation between bonds and shares. Because the Fed have quickly elevated rates of interest in response to hovering inflation, bonds have suffered the worst bear market in historical past (Determine 5).

Too A lot Cash Chasing Tail Hedges

The issue with tail threat hedging methods just like the TAIL ETF is that in an ideal world, traders ought to allocate solely a small portion of their belongings to the tail technique. When a tail occasion happens, they need to monetize the tail hedge to offset losses of their core portfolio.

Sadly, tail hedging methods’ wonderful efficiency in March 2020 (an investor who had allotted 3.3% to Mark Spitznagel’s Universa Tail Hedge Technique would have returned 0.4% vs. a -12% loss within the S&P 500) triggered traders to fall in love with tail safety. We will deduce this by way of the Property Below Administration (“AUM”) of the TAIL ETF, which exploded after the March 2020 episode, and continued to climb all through the bull market of 2020 to 2021 (Determine 6).

The TAIL ETF, and dozens of different private and non-private funds providing tail hedging by way of OTM put choices, turned modern and traders threw cash on the technique.

What occurs in finance when everybody pursues the identical technique? That technique stops working, as we’re witnessing in actual time at present. An excessive amount of cash in OTM places imply that at any time when we’ve got a market downdraft, there’s a rush by OTM put holders to monetize their places, lest the pop in worth is eaten away by time decay. This may very well be the rationale why we’ve got not seen the volatility spike that’s normally related to giant market drawdowns.

Peer Funds Doing Even Worse

To be honest, the TAIL ETF is not even the worst performing tail threat fund. There are reviews (across the 11 minute mark within the connected podcast) that Artemis Capital Administration, one of many largest participant and loudest promoter within the volatility administration/tail threat area, is shutting down their tail threat methods because of poor efficiency. Simplify ETFs even have a Simplify Tail Threat Technique ETF (CYA) that’s down an unbelievable 34.3% YTD, even worse than the S&P500 it’s making an attempt to hedge in opposition to (Determine 7)!

Distribution & Yield

The TAIL ETF pays a modest quarterly distribution that amounted to $0.18 previously twelve months, giving a trailing distribution yield of 1.2% (Determine 8).

Conclusion

In concept, the TAIL ETF is smart in a diversified portfolio. Buyers ought to view tail hedging like residence insurance coverage, paying annual premiums (losses) to guard in opposition to a market drawdown.

In apply, the success of tail threat methods in gathering belongings previously few years imply that the behaviour of the technique might have modified, as an excessive amount of cash has been chasing the identical investments. Thus far in 2022, tail threat methods haven’t come even remotely near offering a hedge. Buyers who’re nervous about market drawdowns ought to think about elevating money of their portfolio as an alternative of chasing advanced methods that underperform.