Hedging tail risk: ETFs with crash protection

What is tail risk?

Imagine somehow you were able to construct a probability distribution of all the possible future returns/losses an investment (say, the S&P 500) could produce. The end result would look something like the diagram below from PIMCO:

The "arch" in the middle of the distribution for both the blue and yellow lines with the dotted line represent the mean, or average return received by most investors (e.g., a 10% CAGR). We say "most" because the area under this portion of the distribution is the largest. 

If we move to the right based on the blue line, we see that the area under the curve gets progressively smaller. This is to illustrate that the probability of experiencing a large gain is less. The same goes if we move to the left of the blue line, with the area under that representing the exponentially decreasing probability of experiencing a massive loss. 

These are called "tails," and an investor who experiences one of those big, unlikely losses on the left side has experienced a "tail risk." To get technical, a tail risk occurs when the price of an asset moves three standard deviations left of its historical average. For the S&P 500, a standard deviation is around 15%, so a left tail risk would be a 55% loss. 

Now, that’s just the blue line with narrow, or "thin" tails. If we look at the yellow line, we see that the area under each tail is significantly bigger than with the blue line, meaning that the probability of either of those outcomes occurring is higher than normal. These are called "fat tails."

What's important to understand here is that most investors peg the probability of a tail risk as low, when in reality, tails tend to be far fatter than what we expect. This causes most investors to take more risk than is prudent. Moreover, the consequences of a tail risk event are often outsized – think along the lines of losing 50% or more of your portfolio. 

Hedging tail risk: VIX futures

The first and most effective way of hedging against a tail risk (like the 2008 market crash) is by using long VIX futures. These are derivative contracts that bet on the future anticipated value of the VIX. I recommend reading this article to understand how they work, but for now, it's sufficient to note that when markets crash, volatility usually spikes and the VIX goes up. 

VIX futures are an effective hedge because they have a high negative correlation (around -0.80) with the S&P 500 – they move fairly reliably in the opposite direction. However, they're not a reliable hedge because of two things: mean reversion and contango. The aforementioned article explains this in detail, but it's sufficient to know here that over time, they lose value. 

This makes using VIX futures a market-timing exercise, and we all know how bad the average investor (including myself) is at that. If you have a reliable trading strategy however, the following ETFs could work:

• ProShares VIX Short-Term Futures ETF (VIXY): 0.85% expense ratio.
• ProShares VIX Mid-Term Futures ETF (VIXM): 0.85% expense ratio. 

Hedging tail risk: Put options

Put options are derivatives that give the buyer the right, but not the obligation, to sell an asset (in this case, the S&P 500) at a certain price, known as the strike before an expiry date. Their exact mechanics are a complex mathematical formula involving a whole lot of variables ("the Greeks"). For now, it’s enough to understand that if the S&P 500 crashes, put options will usually increase in value. 

Moreover, put options with strike prices that are out-of-the-money (OTM) possess greater convexity, meaning that the bigger the crash, the better the payout will be. However, put options cost a premium to buy and will generally decay in value over time, a mechanic known as Theta. Think of puts as an insurance policy that you have to renew periodically and that becomes less effective as the expiry date draws near. 

Unlike VIX futures, put options can be sustained over the long-term, but with some drag on portfolio performance. The following ETFs use a "ladder" of put options as a market crash hedge:

• Simplify U.S. Equity PLUS Downside Convexity ETF (SPD): 0.53% expense ratio. 
• Cambria Tail Risk ETF (TAIL): 0.59% expense ratio. 

Please note this article is for information purposes only and does not constitute investment advice.