You’re Doing It Wrong: A Tail-Risk Hedger Calls Out His Industry

Ari Bergmann/Illustration by II

Ari Bergmann/Illustration by II

Tail hedge managers have been their own worst enemies, argues Ari Bergmann, founder of Penso Advisors.

Portfolio hedges aren’t insurance, Ari Bergmann wants to point out.

Bergmann created some of the first derivatives while at Bankers Trust in the 1990s, and he is passionate that tail hedge managers are shooting themselves in the foot by trying to get investors to see the strategies as insurance with a small annual cost. “If you make money on insurance, you are an arsonist,” he said.

During an interview, Bergmann, who founded Penso Advisors in 2010 to provide risk mitigation strategies, got on a roll. “Why do you need insurance? The market came back. That tells you that you don’t need insurance. Insurance doesn’t help. Between the Federal Reserve and the government, you have the best insurance. That’s for free and the taxpayers are paying you.”

Brevan Howard owns a minority stake in Penso.

Tail-risk hedging funds are designed to profit from rare episodes like the global financial crisis or March’s Covid Crash. They took off in 2008 as they generated profits even as stock and bond markets fell around the world. Nassim Nicholas Taleb’s 2007 bestseller The Black Swan, which argued that unexpected events are more common than most people think, gave these hedge funds added tail wind.

Their huge winnings in crashes are essentially meant to make up for small losses investors incur when markets are steady or rising. Historically, institutional investors have used bonds to temper the swings in their portfolios. But as fixed income lost some of its hedging power, investors have looked elsewhere for portfolio protection.

In March, when COVID-19 shut down global economies and the markets declined by levels not seen since the financial crisis or even the Great Depression, tail hedge funds racked up huge profits and were in the news for the first time since 2008. Firms like Capstone Investment Advisors, LongTail Alpha in California’s Newport Beach, Saba Capital Management, and Taleb-advised Universa Investments posted spectacular returns. According to a client letter obtained by Institutional Investor, Universa had a net return on capital of 4,144 percent return this year through March.

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At the same time, tail hedge funds starred in a pension controversy. It became known that the California Public Employees’ Retirement System liquidated a tail hedge position in Universa Investments in January, just months before the position would have yielded about $1 billion. The pension fund’s chief investment officer and Universa then started trading barbs over the costs of tail hedging and potential alternatives.

Bergmann — who managed various hedge funds including the Citadel Master Fund, a derivatives arbitrage strategy, before founding Penso — said tail risk hedgers are hurting themselves by offering opaque strategies that payoff so rarely, just as investors have finally realized that they need permanent protection against during market downturns.

“Worse than being unhedged is being mis-hedged,” said Bergmann. “The tail hedge industry is opaque. Claims need to be looked at over a full market cycle from after the ’08 crisis to Covid-19. How did they provide accretive returns?” he stressed.

He also criticized tail hedgers for what he calls market timing. “A hedging strategy that requires perfect timing is not a hedging strategy. If you’re buying equity protection, you have to get the timing right.”

Instead, Bergmann argued for a multi-asset derivatives approach that hedges smaller and more frequent downturns. Investors then use the cash generated from these strategies after volatility spikes to reinvest.

Jon Caplis, CEO of hedge fund research and data firm PivotalPath, said that historically bank swaps desks would create structured products to ameliorate very specific risks for big investors. “Those were difficult and expensive to manage,” he said. Although speciality hedge funds have emerged to take their place, it’s an idiosyncratic category. “There’s not a lot of agreement on what a tail hedge fund is. If it’s truly insurance, most investment committees are not well suited to see losses of 30 or 40 basis points over years and years.”

Universa has also argued that tail hedge strategies are misunderstood. Universa measures its risk mitigation performance by its portfolio effect — the impact it has on the compound annual growth rate of an investor’s entire portfolio. In the letter to clients, Universa recommended a 3.33 percent allocation to the Universa tail risk strategy, coupled with a 96.67 percent position in the Standard & Poor’s 500 stock index, a proxy for the risk being mitigated. The standalone tail hedge strategy has life-to-date returned an average 76 percent per year on invested capital, net of fees. “During this period, as a reminder, the SPX has gained 151 percent. Are [we] really such an ‘uber-bearish’ strategy?” wrote Mark Spitznagel, chief investment officer, in the letter.

“There is so much misinformation and murkiness about hedging strategies, especially tail hedges. How do you evaluate a good hedging strategy?” He went on, “My view is that it can’t depend on timing. In fact, you should assume you have the worst timing. It has to be accretive. It’s an asset class like anything else. Has to be evaluated/measured like any hedge fund strategy: apples to apples.”