Investment News recently ran a story called “Black Swan Funds Duck Market Mayhem.” Since the bear market of 2008 the idea of managing the potential for extreme market downturns has become a focus for many portfolio managers—and finding the best method to do that has been a challenge.
Nassim Taleb and Mohamed El Erian at PIMCO are two of the major proponents of the tail risk management method—otherwise known as “tail insurance”—which is used to address the types of extreme downturns we’ve been seeing in the market lately. Mr. El Erian has discussed and written about tail insurance and this strategy is featured in his excellent book, When Markets Collide.
Taleb advises a hedge fund called Universa Investments that bets on extreme events like the market volatility we’ve been seeing.
Unfortunately, his performance is not made public, so it’s impossible to verify if this strategy actually worked. However, PIMCO also uses “tail insurance” as a central strategy in its Global Multi Asset Fund (PGAIX) which holds around $4.5 billion in assets, and that performance is made public. PGAIX is a ‘go anywhere’ fund that invests in a broad diversified asset allocation that includes a range of equity and bond classes, as well as real estate and commodities. PIMCO has established that the benchmark for PGAIX is 60% allocation to equities and 40% to bonds (what is typically referred to as the 60/40 portfolio).
Understanding Black Swan Market Events
For those of you not familiar with the concept of “tail insurance” it is worth explaining the key features. In its most basic form, tail insurance is a strategy that trades out-of-the-money (OTM) put options on an index in order to limit the impact of highly-volatile market events—or so-called “black swans.”
Put options are a form of financial derivative that allows you to take a bet that will pay off if a stock or index declines. OTM put options are bets that will only pay off if the stock or index declines a lot. Because OTM options only pay off in the event of large moves in the stock or index, they are fairly cheap (like betting on a long-shot and getting favorable odds). If you believe that there is a meaningful risk of a stock market crash, you can buy put options on the S&P 500 Index for example. If you buy OTM put options, you can make high returns in a major market decline. If you believe that there is a meaningful risk of a spike in inflation, you can buy put options on long-term government bonds. If you believe that Gold is way over-priced, you can buy put options on a Gold ETF such as SPDR Gold Trust (GLD), for example.
Did Tail Insurance Take Flight?
If there was ever a time that would expect tail insurance to add value in a downturn, it would be now. Tail insurance should boost performance when markets decline dramatically and volatility increases sharply.
According to one of the managers of PGAIX, their tail insurance program has added 3% to 5% to the performance of that fund this year, which sounds plausible (and impressive) in light of the stock market landscape. However, even a small allocation to out-of-the-money put options will generate substantial returns due to the market downturn and the 50% spike in the VIX that we’re now seeing.
I’m going to compare the recent performance of PGAIX to the S&P 500 Index along with the Vanguard 2015 Target Date Fund and the Target Date 2025 Folio—both “passive” allocations that hold close to a 40% bonds and 60% equities split. (Note: VTXVX holds 41% in bonds and the balance of its assets in equities. The Target Date 2025 Moderate Folio holds almost identically a 60%/40% split, with 59% of the portfolio that is not invested in fixed income in invested in a range of equity assets, along with allocations to commodities and REITs).
I chose both Target Date funds because they provide a low-cost alternative in an asset allocation that’s almost identical to PGAIX’s benchmark in terms of the portfolio’s proportional allocation to bonds.
Source: Data from Sungard’s FAME and FolioInvesting.com
Click the chart to see a bigger version
As you can see, PGAIX has a 1.1% gain for the year-to-date (through August 11th), while the Vanguard 2015 Target Date Fund has a loss of 1.5%.
But does this relative out-performance of 2.6% for the PIMCO fund vs. the simple stock/bond mix in the Vanguard 2015 fund really demonstrate the effectiveness of the tail insurance strategy? I’m not so sure.
Effective Diversification is Still the First Line of Defense
We all are painfully aware that the S&P 500 Index has dropped 11% this month and 12.3% over the most recent three-month period. This is just the type of market volatility in which “tail insurance” should really pay off.
The table above also shows the performance of the 2025 Moderate Target Date Folio. While PGAIX has outperformed this 2025 Moderate Folio over the past month, the Folio has outperformed PGAIX over the past three months, and for the one-year period. The outperformance of the Folio over the past year is a fairly substantial 3.1% (10.8% for PGAIX vs. 13.9% for the 2025 Moderate Folio). For the Year-to-Date, PGAIX and the 2025 Moderate Folio are within 0.1% of each other.
So, is the performance of PGAIX over the past year due to the success of its exotic tail insurance strategies, or due to basic risk reduction accomplished by adding fixed income allocations and skillful diversification across a wide range of asset classes? If PIMCO is correct that their tail insurance has added multiple percentage points of return this year, then the rest of their asset allocation must have performed quite poorly.
While I certainly understand the potential merits of actively mitigating the risk of extreme events using a tail insurance approach, it’s hard to effectively price and time the options needed to add return using this strategy. If anyone can make it work, however, PIMCO can.
From a philosophical standpoint, I prefer to see portfolios that manage risk as much as possible using asset allocation—as we have done with the Target Date Folios (see link to “Target Date Strategies Weather the Storm” below).
Using the past year as the test case, a well-designed and highly-diversified asset allocation has provided a very satisfactory defense in highly volatile markets. It is, as yet, unclear that the additional complexity of ‘tail insurance’ has paid off.