Tail-hedging with market makers

Most retail investors are heavily exposed to equities because of accessibility, it is cheap to trade equities, and it is an asset class most investors understand. Or at least we know the companies and can create simple, and sometimes powerful, heuristics about these companies based on the changes in society we observe or products we engage with (think green transformation or your iPhone device).

But occasionally the equity market experience a drawdown from peak to bottom of somewhere between 30-50% depending on the nature of the recession (2000-2001), financial crisis (2008), or exogenous shocks (the 2020 pandemic). Most retail investors are not designing fancy portfolios using correlation structures and portfolio optimization. Position concentration is often high and specific themes have a high exposure. This often leads to larger drawdowns than the equity market also called high beta (the portfolio falls and rises more than the market) leading to severe tail-risk losses (often defined as the portfolio’s average return in the 5% worst trading days). Like insurance on your house in case of a fire, would it not be smart to limit the losses of a financial fire?

Trend-following, complex option strategies, and long VIX futures

Smart investors have written many papers on this subject. As AQR notes in their Tail-Hedging Strategies paper from Q4 2012, the typical hedging method is buying put options on the equity market which gives the investor the right to sell an equity index or a stock at a predefined price (called the strike price), which means that if the equity market falls you can then sell the instrument at the higher agreed price and make a profit which will offset some of the losses in your main long position (a portfolio of equities). This option is like a typical insurance on your house and cost a premium. This premium is often high and constantly buying insurance against losses in your equity portfolio leads to a negative expected return (also called a negative carry). AQR argues in their paper that a constant buying of put options is inefficient and investors end up with an inferior return stream. They propose that investors hedge portfolio by engaging in trend-following strategies which is essentially buying assets that are going up or have recently broken higher beyond a recent high price.

Ari Bergmann says in this Institutional Investor article from July 2020 that many in the tail-hedging industry are their own worst enemy because they set up strategies with a negative expected return and a few times deliver a big return. These return streams are difficult for pension funds to accept and ironically the California Public Employees’ Retirement System liquidated its tail-hedging position with Universa Investments in January 2020 just before the position would have netted a $1bn during the market crash in February and March 2020 due to the unfolding pandemic.

In a research paper, Corey Hoffstein CIO at Newfound Research argues that options strategies for hedging the tail-risk in portfolio can work if they are managed more actively instead of the option positions being held to maturity. Another way to tail-hedging the portfolio is the one used in our CIO Steen Jakobsen’s 100-year portfolio where the hedging is done being long VIX futures a bit out on the VIX futures curve. It sound complicated but essentially it means that if equities plunge then the VIX (an index measuring the implied volatility on the S&P 500 based on underlying options prices) goes up and the investor profits on the long VIX position; in other words the investor is long volatility because the position benefits from volatility increasing and equities falling. But this strategy has a negative expected return as with buying put options causing it to be a drag portfolio returns.

Market makers are naturally tail-hedging with positive drift

There is a completely different option to investors. In recent years two pure market makers have been listed; Virtu Financial in the US and Flow Traders in the Netherlands. Virtu and Flow Traders are among the largest market makers in their respective markets and thus offer a broad-based exposure to many asset classes and thus volatility profiles. A market maker is a financial technology firm that quotes a bid-offer spread on any instrument and thus providing liquidity to investors. In terms of financial stress bid-offer spreads widen dramatically increasing profits for astute market makers. Virtu made $1.38bn in operating income in 2020 up from $121mn in 2019 showing the upside potential for market makers when markets become very volatile. Market makers are thus benefitting when volatility goes cross-asset making it a good “insurance asset” to consider tail-hedging the portfolio.

As the performance table shows adding market makers as tail-hedging, in this case 10% and 20% of the portfolio, improves the annualized Sharpe ratio. Adding 10% exposure to market makers improve the Sharpe ratio from 0.79 to 0.98 which is an improvement of 24%, and it also increases the annualized return from 5.9% to 6.8% while reducing the worst monthly return from -7.9% to -5.3%. Adding 20% exposure to market maker reduces the Sharpe ratio a bit but improves the annualized return to 7.8% and the worst monthly return to only -3.7%. We also looked at hedging a market equity portfolio consisting of the MSCI World. Here a 20% exposure to market makers improves the Sharpe ratio from 1.01 to 1.18, a 17% improvement in risk-adjusted returns, and reduces the worst monthly return from -13.2% to -6.9% while maintaining the annualized return.