CS Axa

By Jon Sindreu and Laurence Fletcher 

In the wake of the global financial crisis, fear of such "black swan" events drove some investors into hedge funds that offered extreme insurance policies. But the swans have yet to return, and such strategies have fallen out of favor.

The patience of many investors has run out after losing money during the intervening years of mainly benign market conditions. According to data by CBOE Eurekahedge, those who invested in tail-risk funds when their performance peaked in September 2011 would have by now lost 55% of their money.

Some big names in asset management have been hit, leaving only a handful of funds that promise outsize returns should markets go into a tailspin.

Those left say that a decade after the financial crisis began, people have forgotten its lessons just as market risks are building. Market volatility is near record lows and equity markets remain resilient, but entering September, typically the weakest month of the year for the U.S. stock market, many investors and traders are looking over their shoulders. Historically high equity valuations, increased consumer leverage and unprecedented central-bank stimulus are among the factors that tail-risk managers believe make a black swan event more likely than at any time since the financial crisis sent equity, credit and commodity markets plummeting.

However, critics point to evidence suggesting that buying insurance is always a losing strategy in financial markets.

As the crisis peaked in 2008, Universa Investments LP made returns of above 100% for its clients.

Nine years later, "I don't see anyone out there doing what I do," said founder Mark Spitznagel, who defined what he does as "sort of like gold on steroids."

There is no set definition for how far markets must fall before the drop can be labeled as a black swan event. The term was popularized by writer and academic Nassim Nicholas Taleb to describe extreme events that are difficult to predict and more likely to happen than forecast.

Funds like Mr. Spitznagel's, which Mr. Taleb advises, mainly use put options to protect against dramatic moves lower. These derivatives offer an option to sell an underlying security at a particular price, so they benefit when the security's price drops below that "strike." Investors can buy cheap out-of-the-money options with a strike price way below where the security currently trades.

Tail-risk funds also invest in gold and other safe-haven assets that usually rally when other markets collapse.

But recently, markets have mainly climbed as central banks continue to flood them with liquidity and the global economy grows. The CBOE Volatility Index, known as Wall Street's "fear gauge," fell to its lowest intraday level ever in July and remains near historic lows. The S&P 500 has been on a smooth road higher since early 2009, while the bull run in bonds continues unabated.

Those results have hit these investors hard. Tail-risk funds are down 6.3% this year through July, according to data group eVestment, and have lost money in four of the five preceding years.

London hedge fund giant Man Group launched the AHL Tail Protect Fund in 2009 and has lost 45% since then, according to Man Group. Capula Investment Management's Tail Risk Fund, one of the biggest in the sector with $3.7 billion under management, is down 6.7% this year, according to an investor letter reviewed by The Wall Street Journal. The fund made 11% in 2011 but lost 14% the following year and ran up further losses in three of the four years following. Representatives of Man Group and Capula declined to comment.

Many others have given up. AXA Investment Managers wound its tail-risk fund down several years ago.

While there are still inflows into these funds, according to eVestment, many of those left in the game have changed the meaning of what they consider a "tail risk." Rather than focusing on extreme black swan events, they now offer cheaper insurance against less dramatic -- but more common -- stock selloffs.

Swiss wealth manager Unigestion SA shut down a tail-risk focused fund in 2010 but now runs a strategy to protect against bumpy days in the market. Recently, Unigestion bought the safe-haven Japanese yen and sold the Korean won, a currency pair that would move apart in dramatic fashion if the market becomes more fearful.

"The protection will be less significant," Unigestion's head of cross asset solutions, Jérôme Teiletche, said. "But the cost will be less significant as well."

It costs money to roll over put options, and if they aren't being triggered, they aren't earning anything back.

Protecting against volatility can provide returns if timed properly, but over the long term it is a losing strategy, according to a raft of academic papers and market analysis. It is similar to taking an insurance policy on your car or home. On average, it is the insured, rather than the insurer, that loses money.

A U.S.-listed volatility product called VXX, which bets on surges in volatility, is down 98% over five years.

AQR Capital Management LLC calculates that black swan events need to happen, on average, at least once every decade for tail-risk strategies to break even. The fund defines such an event as a 20% drop in the S&P 500 in one day.

But the last time the stock market suffered such a plunge was 27 years ago, on Black Monday, Oct. 19, 1987.

Mr. Spitznagel said the problem is that most funds just aren't bold enough to lose a lot of money when markets are calm, which is the price to pay for these strategies to offer gigantic returns when another Black Monday happens. The point of black swans, he said, is that they are more likely to happen than calculations suggest.

Some of these fund managers say investors are dropping their guard when they are at their most vulnerable.

"You are kind of balanced on the tip of a mountain or a hill," said Vineer Bhansali, founder of LongTail Alpha LLC. "It's not very scary to me, but it's very scary."

Write to Jon Sindreu at jon.sindreu@wsj.com and Laurence Fletcher at laurence.fletcher@wsj.com

(END) Dow Jones Newswires

September 05, 2017 05:44 ET (09:44 GMT)

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