2023-03-22 04:50:44 ET
Summary
- High-profile bank failures have introduced some volatility back to markets.
- I re-visit the performance of several tail risk and convexity ETFs against the return of the S&P 500 index.
- I analyze whether these products are worth holding given what we have experienced in 2022 and 2023 thus far.
Introduction and Review
Before the recent black swan event surrounding banks such as Silicon Valley Bank ( SIVB ) and Credit Suisse ( CS ), stock market volatility had been relatively suppressed in 2023 due to the return of a risk-on environment. This was likely due to the January effect and popularity of 0 days-to-expiration ((DTE)) calls forcing the market higher. We saw a huge bear market rally in equities and Bitcoin/crypto. This all occurred despite the U.S. Federal Reserve raising the Federal Funds Rate from near zero to 4.5% and potentially higher. We could certainly see volatility continue in the next few weeks and months, though it is likely larger banks and institutions will continue stepping in to backstop smaller banks. If the market considers these actions in a positive light, volatility will once again be suppressed. From my perspective, what's been happening is not good news, but the market is cheering on the fact that the Federal Reserve may have to slow down rate hikes and reverse quantitative tightening (QT).
Two years ago, I wrote an article about tail risk and convexity hedging products that are just as easy to trade as any US-listed stock or ETF. I would like to re-visit their performance with respect to the bear market of 2022 and recent events.
2022 was a rough year for both equities and bonds. The S&P 500 index returned -18% when taking dividends into account, and a core U.S. bond index returned -12.9% (Morningstar). Ideally, owning tail risk or convexity funds ought to have helped. But most tail risk funds actually did poorly, because by design, they hold sizable portions of U.S. Treasuries. When interest rates go up, the price of bonds go down - even U.S. Treasury bonds with AAA credit ratings. Incidentally, this is why a bank run on Silicon Valley Bank caused them to fail, as they were forced to sell long-term U.S. Treasuries at below par value in order to meet bank customer withdrawals en masse.
Convexity funds surprisingly did not do better - these are funds that track indices like the S&P 500, but with exposure at the tail ends (see figure below). However, as I'll illustrate later, the market did not fall nearly enough for the gain on put options to overcome losses on the bond/equity side of these fund portfolios. Below is a visual representation of a convexity fund's hypothetical performance (y-axis) for a given market level (x-axis).
Visual representation of convexity (Simplify Asset Management)
Let's take a look at the performance of some of these funds vs. a popular S&P 500 index fund ( SPY ). In my last article, I tried to compare as many as I could, but the charts were overcrowded. Below I've selected just a few to highlight.
For a 1-year timeframe, we can see the Cambria Tail Risk ETF (TAIL) outperformed for most of the year, but it is still a -9.52% return when the SPY returned -10.01%. It did well during the worst of the broad market decline last summer. If you held TAIL, you would have had to take profits before bond prices really started dropping when the Fed began hiking above 2% But it is actually somewhat disappointing as a tail risk hedge when there was practically no difference owning an index ETF like SPY. Further, an ETF composed of quality companies such as those in the S&P Dividend Aristocrats ( NOBL ) only fell -5% taking dividends into account. Or an intermediate bond ETF like IEF, which is relatively low risk and has an expense ratio of only 0.15%, versus the 0.59% for TAIL.
Even more disappointing is the Simplify US Equity PLUS Convexity ETF ( SPYC ), of which I personally bought 400 shares in March 2021 for about $28 a share. I sold in late Jan 2023, partway through the furious rally for $27 a share - I also collected $275 in dividends - for a -1.7% overall return. Even though I lost some money (especially to inflation), I'm still glad I went through the exercise and the experience, especially having written an article highlighting the fund. It's not that these tail risk and convexity funds don't ever work. The problem is the market didn't fall (or rise) drastically enough for the tail positions to pay out.
It is easier to understand if we take the analogy of homeowner's insurance. You pay a premium each year on your insurance policy, but typically you don't get the premium back if nothing happens to your house. You can suffer a minor event, like a broken window where the insurance isn't going to pay out. A catastrophic event like a house fire must occur before you get a substantial pay out. The same thing is happening here - option puts and calls are bought at out-of-the-money (OTM) strikes but the market price doesn't get close enough to these strikes to offset the loss in value due to theta - time decay.
When volatility remains relatively low, funds' open option positions lose most of their value and must be rolled to future dates at non-trivial cost. Relatively lower volatility is the default scenario for the market (see VIX chart below) and is a major cause for why tail risk funds underperform. You need a 2008 or 2020 type of severe crash for these to be highly effective. When you have a Federal Reserve and Treasury Dept. that is so accommodating and fearful of contagion, the tail risk is essentially mitigated by them, although we know they are just "kicking the can down the road." While the COVID-19 related crash in March of 2020 was a true black swan event, the immediate response from central banks and governments turned the market around quickly.
A Look Under the Hood
In this section, we'll take a close look at a convexity fund's portfolio. As illustrated in the convexity graph earlier, there is exposure at both tail ends in the form of call and put options on SPX, the S&P 500 index. The majority of the fund invests in an ETF ( IVV ) that tracks the index.
Ticker | Name | Quantity | Weight |
---|---|---|---|
IVV | ISHARES S+P 500 INDEX FUND | 194881 | 99.67% |
SPXW US 04/21/23 P3965 | SPXW Apr 2023 3965 Put | 12 | 0.19% |
SPXW US 04/21/23 C4200 | SPXW Apr 2023 4200 Call | 16 | 0.02% |
SPXW US 05/19/23 P3625 | SPXW May 2023 3625 Put | 40 | 0.30% |
SPXW US 05/19/23 C4270 | SPXW May 2023 4270 Call | 15 | 0.03% |
SPXW US 05/19/23 P3430 | SPXW May 2023 3430 Put | -40 | -0.17% |
SPXW US 06/16/23 C4120 | SPXW Jun 2023 4120 Call | 18 | 0.19% |
SPX US 06/16/23 C5600 | S&P 500 Index Jun 2023 5600 Call | 120 | 0.00% |
SPXW US 06/16/23 C4310 | SPXW Jun 2023 4310 Call | -18 | -0.06% |
Estimated Cash | -139983 | -0.18% |
(source: Simplify US Equity PLUS Convexity ETF holdings as of 3/17/23)
I used my broker's analysis tools to plot a P/L chart (below) about one month out using the above positions, but it doesn't look as nice as the convexity example graph from earlier. In fact, I couldn't get the line to be convex at all on the downside tail until I nearly doubled the number of April put positions. This can be explained by SPYC only allocating an annual budget of 0.5% for put options and 1.5% for calls. Simplify also offers a downside Simplify US Equity PLUS Downside Convexity ETF ( SPD ) that only hedges using put options (up to 20% of the fund), but that has not performed well either. When I look at SPD's current portfolio, there is not nearly enough put exposure to hedge against its 99.3% position in an S&P 500 index fund. It too, does not appear to exhibit convexity when looking at its current portfolio.
P/L chart of SPYC portfolio as of 3/17/23 (ThinkOrSwim Analyze Trade Risk Profile)
From the nicer looking example graph from earlier, I've added notation to help visualize the function of the puts and calls in the fund's holdings, though the actual convexity is nearly non-existent.
A reader asked me in the last article, when would a fund like SPYC outperform the market? Based on the P/L estimate, the S&P 500 index would have to drop 16% or more within a short timeframe - a month or less, for current put options to profit before expiration. This also assumes such a fund has double the put exposure as what I see in SPYC's current holdings.
As you can see, the cost of the options weighs on performance when markets don't move drastically, and this is why performance has lagged the index recently. Coming back to the Cambria Tail ETF ( TAIL ), which has done better than the Simplify ETFs in the 2021-2023 period, we can see key differences in the fund holdings. 90% of the fund is in U.S. Treasury bonds (majority 10-year USTs with some TIPS). The remaining 10% are SPX put options - far more than what SPD currently holds. These put options also expire much later than those in the SPYC portfolio. If I were fearful of a market sell-off in the near-term, I would be far more comfortable buying and holding TAIL at this time. However, TAIL's performance would lag if the stock market were to go up from here. Below is a snapshot of recent holdings in the Cambria Tail Risk fund portfolio.
PERCENTAGE OF NET ASSETS | NAME | SHARES HELD |
---|---|---|
2.30% | Cash Equivalent | 4,391,787 |
2.40% | S&P 500 INDEX-SPX US 03/15/24 P3600 | 239 |
0.89% | S&P 500 INDEX-SPX US 03/15/24 P3800 | 69 |
1.08% | S&P 500 INDEX-SPX US 06/16/23 P3800 | 171 |
1.04% | S&P 500 INDEX-SPX US 06/21/24 P3500 | 103 |
1.80% | S&P 500 INDEX-SPX US 09/15/23 P3500 | 326 |
2.02% | S&P 500 INDEX-SPX US 12/15/23 P3600 | 235 |
82.53% | U.S. Treasury Bond 4.125 11/15/2032 | 149,188,000 |
5.94% | United States Treasury Inflation Indexed Bonds 0.125 07/15/2030 | 12,345,531 |
( Cambria Tail Risk ETF holdings as of 3/17/23)
Conclusion
When we have central banks and government entities ready and willing to step in quickly and backstop banks, we could be forgiven for thinking there's no need for tail risk hedging, particularly given that these funds underperform the market even when stocks are declining (albeit in a slow fashion, as we saw in 2022). At some point, the stock market will see a true black swan that even the Fed won't be able to overcome. So it is up to each investor to determine if they want to pay for insurance in the form of tail risk or convexity funds. My deep dive into convexity funds was a good exercise, and I am personally comfortable that I don't need to buy these funds going forward.
If I were retiring in the next few years, or needed to rely access invested funds in the near future, I would certainly look at a product like TAIL to offset risk against a long stock portfolio.
Another alternative is just to buy low-risk investments like U.S. Treasury bonds and CDs that are now yielding 4-5% and higher. Since it is likely that the Fed won't be able to raise rates much higher, there is less interest rate risk going forward. These may be boring, but you eliminate the losses that come from paying for tail risk fund option hedges. U.S. Treasury bonds also have tax benefits at the state/local level (disclosure: I am not a tax expert). For those who have a longer investing time horizon and stronger risk tolerance, I think value investing and some interest-bearing cash equivalents on the sidelines to take advantage of market dips will be the way to beat the market over the next few years.
For further details see:
Re-Visiting Tail Risk ETF Performance During Recent Black Swan Event Surrounding Banks