bfinance: Hedge Funds and Tail Protection

August 9, 2024

The concept of using overlays for tail risk protection—whether more active or passive in style—is a well-established technique in the institutional investor’s toolkit. Less familiar to many, however, are the hedge fund strategies whose primary goal is to offer portfolio protection, but who often seek to do so with an ‘all-weather’ profile so that investors are not losing money during benign periods.

These all-weather ‘tail protection hedge funds’ (for want of an established industry term) overlap quite significantly with the cohort defined by Eurekahedge as ‘Long Volatility’ hedge funds, though it is important to differentiate between volatility strategies with greater focus on protection and those with a stronger focus on return (Volatility Arbitrage and Relative Value). They also share common ground with dynamic risk overlay strategies.

It is helpful to think of these and other sources of heroic diversification—positive performers during market downturns—on a spectrum. ‘Convexity’ is increasingly viewed as a necessity rather than a luxury for many long-term investors: periods such as H1 2020 and 2022 challenged the traditional portfolio diversification paradigm and highlighted the benefits of strategies that can throw out positive performance in risk-off environments and/or when liquidity becomes constrained.

There are several reasons why investors may prefer to use hedge funds rather than employing an active or passive overlay. In some cases, the choice may be due to the structure of the institution: for Wealth Managers handling portfolios for multiple underlying investors and certain Defined Contribution pension structures, a risk overlay on a multi-client portfolio may be unfeasible. More broadly, many investors are unable or unwilling to tolerate the ‘cost of carry’ associated with overlays, which traditionally lose money in non-volatile or bull market regimes.

Nearly ten new hedge funds have been launched in this group since January 2022, including two new firms: this takes the manager universe to a varied group of more than 20, providing plenty of choice for investors that seek improved portfolio protection in a non-overlay construct.

We hope that this concise report—part of bfinance’s educational ‘sector in brief’ series—helps readers to gain a clearer understanding of this evolving niche of the investment universe, including key issues to consider when implementing allocations and selecting asset managers.

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