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Tail risk funds represent a small niche of the hedge fund industry, and there are a few different types. They essentially serve as insurance for your portfolio. They lose money most of the time, but when there is a tail risk event, they rise quite a bit when the rest of the market crashes down hard and fast.
Tail risk funds hedge against tail risk, which is a type of portfolio risk that appears when there is a significant chance that any particular investment or fund will move more than three standard deviations from the mean. Tail risk events have a small probability of occurring, but they do occur from time to time, which is why many investors choose to use tail risk funds.
Traditional strategies for portfolio management usually follow a pretty normal distribution. There’s nothing out of the ordinary with them. However, tail risk funds are able to normalize the returns of an entire portfolio by making up for steep declines when there is a sudden correction with no warning or time to prepare for it. Such a steep, sudden correction occurred in March 2020, and many tail risk funds made headlines with astonishing returns during the selloff.
If you thought all the major indexes moved together, think again. Between June 8 and the close on Friday June 26, the Nasdaq beat the Dow in 11 of 14 trading days. During 8 of those days the gap was half a percent point or more. The end result was that by the close on Friday, June 26th the Nasdaq was down only 1.7% while the Dow fell 9.3%. Although not as pronounced as the recent behavior, the Dow has lagged the NASDAQ during most of the pandemic.
Whereas the Dow contains only 30 members, the NASDAQ is made up of over 2,700 companies. To be clear, the term “The Nasdaq” refers the Nasdaq Composite Index which contains roughly 90% of the companies that trade on the Nasdaq Stock Exchange. One common confusion is between the Nasdaq 100 Index and the Nasdaq Composite Index. The Nasdaq 100 and the highly traded fund that tracks it (QQQ) is made up of only the Nasdaq stock exchange’s top 100 companies by market cap.
Following Trump’s election win, I read two books to better understand him and his behavior: Games of Strategy: Theory and Application and The Art of the Deal. The game theory book was intended to understand how Trump thinks. However, he is extremely volatile and that makes it difficult to predict his behavior thus it was difficult to apply theories to his decision making. The Art of the Deal, however, was much more insightful. In an old email I characterized him as:
“He (Trump) is a winner. Looking strong is important. He’s also incredibly sneaky and untrustworthy (whatever it takes to win…)…In other words Trump uses last minute tactics to: A) strengthen his position and B) ensure his position is not weakened…As an options trader he’s a wing buyer that bullies the market to make his position in the money.”
In the nearly four months since the Covid-19 outbreak reached the United States the market has experienced an historic crash and equally historic recovery. Last week the S&P 500 closed within 5% of it’s pre-Covid-19 high and the NASDAQ reached a new all time high. The market’s bounce has largely been driven by big tech, including stocks included in the Cornell Capital Group Quarantine Index which has dramatically outperformed the market. While tech has outperformed, companies in the travel sector, many of which are included in the CCG Anti Quarantine Index, have largely missed out on much of the market recovery. One member of the CCG Anti Quarantine Index, Hertz Car Rental, has filed for bankruptcy. Typically, bankruptcy is the end of the line for equity investors but for Hertz Global Holdings Inc (NYSE:HTZ) bankruptcy was the beginning of new chapter in the Hertz story.