Mar 25, 2023
Black Swan Funds Have a Moment as Investors Hedge Market Doom
(Bloomberg) -- Black Swan funds spend years waiting for markets to crash. Turns out, just a whiff of a crash is enough to juice performance.
These options-based strategies that benefit from volatility breakouts are having a great month while the S&P 500 is little changed in March, and widely owned bank shares have been battered, suggesting that a market-wide blowup would lead to big payouts. An actively managed exchange-traded tail-risk fund is up about 4% so far in March as banking turmoil deepens, on course for its second best month since March 2020 during the onset of the pandemic.
A modicum of calm returned to financial markets toward the end of the week, with stocks ending higher and the Cboe Volatility Index, Wall Street’s fear gauge, retreating. But investors remain on edge, as was apparent after a spike in the cost to protect against Deutsche Bank AG’s credit losses sent European bank shares into a tailspin. Policymakers from Washington to Frankfurt to Zurich continue to reassure investors about financial stability, even as confidence in a number of lenders wanes.
“The recent debacle has polarized defensive alternatives in a good way,” said Kris Sidial, co-chief investment officer at Ambrus Group LLC, whose tail-risk strategy jumped 7% last week as the VIX index spiked above 30. “Potential investors are concerned about some type of contagion hitting and their portfolios being destroyed on that.”
Investors betting that weaknesses can be spotted and contained may be in for a surprise. Central banks acted fast to shore up confidence in the system — but even Federal Reserve Chair Jerome Powell warns it’s too early to call the all-clear after the tumult of the last three weeks.
“We have seen an increase in tail hedging,” said Chris Murphy, co-head of derivatives strategy at Susquehanna International Group. “We have continued to see call buying in the VIX since the bank turmoil began.”
Trouble spots in bank balance sheets’ are cropping up at US regional lenders, and liquidity concerns forced the government-brokered acquisition of Credit Suisse Group AG.
So far, the situation is far from 2008’s chain reaction of mass consumer defaults that turned into widespread losses on securities that Wall Street had concocted around home loans. This time around, flights by depositors — not bad loans — has left small banks struggling with shortfalls.
Tail-risk hedging can deliver big payouts in sharp, sudden market contractions like March 2020 or 2008 — for investors who can stomach years of declines. They’ve lost money in 11 of the last 16 years, according to data by Eurekahedge Pte.
By comparison, US Treasuries have had four years of losses in the last 20 years, and they’re up 3.4% so far this month. Gold is up 8% so far in March.
“Most tail risk strategies should on average lose money,” said Meb Faber, chief executive officer of Cambria Investment Management which manages Cambria Tail Risk ETF (ticker TAIL) — one proxy for the industry. “That’s a feature, not a bug.”
Funds including Ambrus and 36 South Capital Advisors buy deep out-of-the-money calls on the VIX index, or deep out-of-the-money puts on the S&P 500 index among others. Each of those bets would benefit in market turmoil as stocks tumble and volatility increases.
This week, protective call options on the VIX Index signaled traders bracing for a jump in volatility months from now. Outstanding put contracts on the Invesco QQQ Trust Series 1 exchange-traded fund rose to an all-time high this week as high-flying, ostensibly high-quality tech are seen prone to a big reversal.
Read more: Hedging Demand Surges for Investors Hiding in Tech: Taking Stock
While this month’s volatility is still far off a Black Swan event, a move of more than three standard deviations from the norm, it’s been enough to stir up crisis fears and drive up interest in disaster insurance.
“Over the past few weeks we have seen a notable pick-up in investor discussions and demand,” said Diego Parrilla, principal at London-based 36 South. “Investors appear increasingly worried that the problems we are seeing might be the tip of the iceberg.”
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