BijaAdvisors

Macro Radar
Cognitive Science Meets Economic Analysis

Better Decisions, Better Results

Issue 15-1
Jan 9, 2015

The Fiduciary Folly of Tail-Risk Funds

They say necessity is the mother of all inventions, but some things are created to satisfy wants
too. Take the tail-risk fund, for instance. Its a fantastic concept, a marketers dream, designed to
appeal to those who must take risk, but fear the downside that inherently accompanies it. Theres
just one problem with them. At best, they are little more than expensive placebos.
For fiduciaries entrusted with overseeing the capital of others, I can imagine just how tempting
they must be. The ultimate CYA product, allowing for the outsourcing of career risk. So long as
there is no ailment, a placebo does a great job and the cost associated with it is palatable.
However, when the malady inevitably surfaces and the worthless promises are exposed, you
quickly realize the very thing meant to protect you, is likely to have made you more vulnerable.
Unfortunately, before you can catch your breath, the pitchman who sold it to you has packed up
and moved on to his next product. If this sounds like hyperbole, you'll want to read on.

You can take risk, just dont lose money.

Yes, thats an actual quote, said to me by a former boss, with a straight face. Being well removed
from that moment it is easy to find the humor in such a paradoxical comment, but sadly it wasnt
the only time such sentiment has been expressed to me over the years. In fact, quite a few who
giggled with me when I first relayed the quote to them would themselves express a similar
thought later in our relationship.
Even more ironic, when I pitched a new alternative asset management business to the higher ups
at AIG Financial Products back in 2003, the response was, Very interesting, but it would require
taking risk. We are the most profitable business unit perhaps in the world, and all without taking
risk. So why start now? Yes, AIG-FP is the unit that triggered the collapse of the parent a few
years later.

Myth #1
Although Im not the smartest person in the world, I do know that there are some inescapable
truths, and no amount of wishful thinking can change them. One is that it simply isnt possible to
beat the risk-free rate without taking risk. For clarity's sake and in full disclosure, by risk I mean
a risk of losses. Can you hedge your risk? Certainly, but there are costs associated with hedging,
and there is no way around it. There are the real costs, like premium payments and management
fees, and opportunity costs, such as a realized loss on the hedge which offsets gains in the core
portfolio.
This brings me to the first question a potential tail-risk fund investor should be able to answer.
Do you mean to provide insurance against p&l volatility or extreme price action that would be
detrimental to the core portfolios positions?

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You would be forgiven if you believed they were one in the same. After all, if you are long
equities and you invest in a tail-risk fund, intuitively youd think that your hedge would also
benefit to some degree even on a fairly muted selloff in say, the S&P 500. However, you could
be very wrong in that assumption. Truth is, due to the use of options in many tail-risk portfolios,
there is a decent chance that it would actually compound your p&l volatility, particularly over
time.

Myth #2
There is a commonly held belief that there is but one tail-risk event to protect against, with the
one most often considered being a collapse in the stock market. With so much time, energy and
money invested in equities, its only natural it would be a focal point. Equities are also a
commonly held retail investment vehicle, so mainstream medias coverage of selloffs in stock
markets gives them additional weight in our minds. Plus, even when stocks dont necessarily
trigger mayhem across markets, there is the perception that there exists a high correlation
between market chaos and stock market selloffs. Unfortunately, this is more myth than truth.
How else would you explain why it is that hedge fund managers run so many stress tests? At the
firms in which I have been a partner, we would run 20 or more unique stress tests based on actual
historical scenarios, often with dramatically different results. So dramatic, in fact, that very often
some scenarios would produce positive returns, while others were negative, yet all represented
actual tail-risk events. Therefore, a potential tail-risk fund investor must be able to answer,
Specifically, which tail-risk event is it you are attempting to purchase insurance
against? (Hint: The answer should not be as generic as, an equity selloff or rates higher.)

Myth #3
The third flaw in the tail-risk fund fallacy is the question of when. This is such an important
factor, because most tail-risk protection schemes employ options and other time sensitive
vehicles. When you think of option structures, especially when I mention time as a factor, often
people think about time decay, or theta. Yes, time decay is a factor that must be considered, but
there are numerous other concerns that must be factored in when using options and other
derivatives to provide protection. Time decay immediately springs to mind because it is so
tangible, like a running meter which shows the steady decline in value of a perishable asset.
There are other factors that go into determining the value of an option, though.
Delta and gamma explain the sensitivity to a change in the underlying assets price. Vega is a
measure of sensitivity to changes in implied volatility. Rho and phi do the same for interest rate
shifts. When nothing is happening, or your underlying portfolio is doing well, you may want to
invest just a small premium, to get big bang for your buck with low delta protection. A lottery
ticket of sorts. However, those low delta options can quickly become irrelevant with the simple
passage of time. With time can also come moves in the underlying assets that are positive for the
overall portfolio, moving the strike into irrelevant territory. In other words, the option you buy
today, to protect your portfolio today, is very dynamic. Its sensitivity to implied vols, spot,
interest rates and time, change over the life of an option. While greeks like vega, theta, gamma,
rho and phi tell you what you can expect from a move in each of those individual factors, they do
little to help you understand how it will respond to a simultaneous shift in more than one of them
at a time.
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What typically happens to tail-risk insurance is that it eats away at the performance of the
underlying portfolio. Performance that is especially difficult to come by these days. As time goes
by, you begin to question the need for it. You elect to go with lower delta, lower premium
strategies, but thats little more than a Jedi mind trick you are playing on yourself. Gradually, you
reduce your allocation to protection. This phenomenon isnt unique to portfolio and investment
managers. Demand for flood insurance spikes with each flood and then wanes again over time,
until the next catastrophe.
With time being such a factor in the performance and level of protection provided, any investor
considering an allocation to a tail-risk fund, must be able to answer the question, When do you
think this protection will be necessary? Yes, I am saying that as much as you may want to and
believe you can, it is not possible to outsource the timing of protection, regardless of what the
tail-risk marketer would have you believe. However, it gets worse, for there is one very
important additional caveat to consider here. The composition of a tail-risk fund exists almost in
a vacuum, with investors jumping in and out of them. Unless you are a very sizable addition to
an ongoing tail-risk fund, you risk taking on remnant protection. The risk of this is greater in a
tail-risk fund than any other type of pooled investment vehicle, because portfolio turnover isnt
driven by performance like it is in all others. Therefore, there is no logical trigger for stopping
out of one position, in exchange for a new one.

Myth #4
Tail-risk fund managers understand the dynamics of recency bias. In fact, it is fundamental to
their business model. They must rapidly accumulate as many assets as possible, while fear is at
fever pitch. They charge seemingly small management fees, say 1% and for good measure, very
small incentive fees of say 5%. Truth is, the discounted incentive fee is a gimmick.
You see, incentive fees were meant to be bonuses for generating alpha. In other words, an
investment manager has the ability to go long or short, sit in cash or go all in. With that freedom,
the ability to outperform rests with her. She is providing what she believes to be a competitive
advantage in all market environments. The incentive fee is meant to allow her to share in the
upside of the edge she is providing. It incentivizes her to invest in a manner that is aligned with
her expectations.
A tail-risk fund manager is different. They are essentially providing the service of a long-only
vehicle, but in reverse. So, we could effectively call it a short-only vehicle. The manager doesnt
necessarily believe in the direction of their portfolio, and in fact, since tail events by their nature
are very rare, a tail-risk fund manager would be crazy to want the bulk of their income to be tied
to the performance of the fund. After all, other than during the outlier moment in history, a tailrisk fund should be expected to lose money. Therefore, they should want all of their fees to be
tied to the AuM they accumulate, just like a long-only fund.
As an investor, since I am paying not just the ongoing management fee, but the cost of carrying
this protection on my books during a potentially extended period between tail-risk events, the
idea that I should pay the manager an incentive fee to essentially execute my plan (going short),
borders on offensive. So, when considering an investment in a short-only fund, ask yourself,
Would I pay these fees to a long-only fund manager?

Myth #5
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Lets suppose for a moment that you knew exactly what risk you were protecting against, found a
tail-risk fund that was tailored specifically to the exact characteristics of your underlying
portfolio, made adjustments to it anytime you made adjustments to yours, you timed your entry
into it perfectly, the funds portfolio had just been realigned and you had negotiated the fees
down to something commensurate with a long-only investment vehicle. There is another very
important factor that is unique to an investment in a tail-risk fund that you must consider. How
do you define a tail-risk event? Do not underestimate just how important this is.
I am making a giant assumption, presupposing that you nailed every other stumbling block along
this hazard filled path and even given all of that, by answering this very straightforward question
incorrectly, there remains a very big risk that what you expected to achieve with this expensive
insurance, wont be realized. I believe its so important, that Ill ask it again, but in a slightly
different way. When do you take profit on an insurance policy? You see, the fact that you need to
time your exit from a tail-risk fund is what makes it not an insurance policy. With an insurance
policy, you experience the disaster, take the time to assess the damage and then receive a
commensurate reimbursement. With a tail-risk fund, you must time the peak of the disaster itself
and take action at that precise moment. Get out too soon, without unwinding your core portfolio
and you leave yourself exposed at the exact moment you had hoped to be protected. Wait too
long after locking in your losses on the underlying and you could wind up compounding the
damage.
Should you take profit on the tail-risk fund when the S&P is down 10%? 15%? 25%? 40%?
What if their is a lag between what is in your core portfolio and the tail-risk fund? What if there
isnt any liquidity for the contents of the tail-risk fund at the moment when you want to take
profit on it? What if you have liquidity in your core investments, but not in the tail-risk fund?
What if other investors in your fund want to unwind, but you dont? All of these familiar
problems weve always had to consider when investing in hedge funds become amplified when
we invest in a tail-risk fund, because profit taking occurs at the moment when we should expect
liquidity to be at its worst. So, during the great majority of our time invested in a tail-risk fund,
we should expect to lose money and in those very rare moments when we would expect it to
perform well, we should anticipate experiencing difficulty in locking in profit. Talk about having
the odds stacked against you.
If youre thinking that market makers will be leaping at the opportunity to buy your profitable
positions in the midst of a panic, because they will all be in dire need of what you have to offer,
think again. When you attempt to sell a deep in-the-money option, they will know your
intentions immediately, allowing them to exact as much pain as possible. In those moments, it is
the side that needs to trade that will feel the pain. Whether you are stopping out or taking profit is
inconsequential.

Final Thoughts
The issues I have mentioned in this piece represent the big concerns I have regarding short-only
funds, but they are by no means the only ones. As I said at the start, I understand why these
products are offered and why they attract assets. While this piece may not sway a single investor
away from making what I believe to be a fiduciary mistake, I felt a moral obligation to at least
make my concerns a matter of public record.
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About the Author

For nearly three decades, Stephen Duneier has applied cognitive science to investment
management, and life itself. The result has been top tier returns with near zero correlation to any
major index, the development of a billion dollar hedge fund, a burgeoning career as an artist and
a rapidly shrinking bucket list.
Mr. Duneier teaches Decision Analysis in the College of Engineering at the University of
California Santa Barbara. Through Bija Advisors' publications and consulting practice, he helps
portfolio managers and business leaders improve performance by applying proven decisionmaking skills to their own processes.
As a speaker, Stephen has delivered informative and inspirational talks on global macro
economic themes, how cognitive science can improve performance, and the keys to living a more
deliberate life, to audiences around the world for more than 20 years. Each is delivered via
highly entertaining stories that inevitably lead to furthermore conversation, and ultimately, better
results.
Stephen Duneier was formerly Global Head of Currency Option Trading at Bank of America and
Managing Director of Emerging Markets at AIG International. His artwork is represented by the
world renowned gallery, Sullivan Goss. He received his master's degree in finance and
economics from New York University's Stern School of Business.

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Copyright 2015 by Bija Advisors LLC.; BijaAdvisorsLLC.com
Reproduction or retransmission in any form, without written permission, is a violation of Federal Statute