Tail Risk Hedging: Using Black Swan Events to generate returns

Following the COVID-19 global lockdowns in early March, the abrupt market selloff challenged many asset managers, including renowned investors. With stocks, commodities (oil, silver, and gold), and bonds (apart from U.S. treasuries) falling simultaneously, asset managers had to question the validity of established asset correlations and the status of assets seen as a haven. Moreover, as investment strategies aimed at performing well in any environment performed poorly, many investors have started to look at tail-risk hedging as a better alternative for protecting portfolio downsize during extreme market events.

In this paper, we will first take a closer look at the meaning of tail-risk and how investors can use derivatives such as options, futures, or other instruments to engage in tail-risk hedging in order to improve portfolio performance and generate absolute returns.

Then, we will analyze the historical performance of a 100% allocation to tail-risk and compare it with partial allocations. Also, we will compare the performance of tail-risk investing in strategies such as Trend, 60/40, and risk-parity during different scenarios.

In addition, we will also consider the main critics of tail-risk hedging, which are mainly associated with timing, high overall insurance costs during times of uncertainty, and lower long-term performance.

In the third part of the paper, we will dive into the most popular tail-risk strategies using options and look to assess their investment performance and hedging effectiveness. Lastly, we will analyze which tail-risk allocation seems to be the most effective for the long-term performance of a portfolio.