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Soaring inflation, fast-rising interest rates and a looming recession have many investors looking more closely at the downside protection offered by tail-risk exchange-traded funds (ETFs).
Investors have long had choice among ETFs offering downside protection, says Lara Crigger, editor in chief at VettaFi LLC in New Orleans, a U.S.-based provider of investment research and analytics tools.
“There are ETFs holding treasuries, gold and alternatives to build defensive baskets,” she says. “But more recently, we have seen tail-risk ETFs launch that use put options to provide a guardrail for portfolios if, for example, losses are more than 10 per cent.”
No tail-risk ETFs trade on Canadian exchanges, but the U.S. market features five. Cambria Funds has its Global Tail Risk ETF FAIL-A for the global markets and its sister Tail Risk ETF TAIL-A for the U.S. equity market. Global X also has its Nasdaq 100 Tail Risk ETF QTR-Q and S&P 500 Tail Risk ETF XTR-A. And Simplify has its Tail Risk Strategy ETF CYA-A providing a hedge for U.S. equity exposure.
Most launched in 2021, with the exception of FAIL and TAIL, listed in 2016 and 2017, respectively.
It’s easy to see how these products pique investor interest, says Tyler Mordy, chief executive officer and chief investment officer at Forstrong Global Asset Management Inc. in Toronto.
“We are clearly living in a tail-risk world,” he says, adding that “black swan” events are supposedly rare, but “they have appeared far more frequently over the last two decades.”
Typically defined as a movement of three or more standard deviations from the mean return, tail risk is not as unusual as assumed because “traditional financial models have become less predictive, and markets have become more correlated” with globalization, he adds. “So, a problem somewhere is now a problem everywhere.”
At the same time, the world has seen growing fractures geopolitically, such as the war in Ukraine, as well as increasing market instability, and tail-risk ETFs offer a potential salve.
These funds tend to buy out-of-the-money put options to offset losses in the equity market exceeding 10 per cent, but their overall strategy can differ.
Cambria and Simplify ETFs, for instance, largely consist of put options with additional allocations to treasuries and other short-term fixed income to generate continuing returns to purchase new options as old ones expire. These are meant to complement existing equity holdings in a portfolio, and they are “essentially a hammer designed for a very specific nail,” Ms. Crigger of VettaFi says.
In contrast, Global X’s ETFs are essentially all-in-one solutions for a portfolio offering upside exposure to equity indexes while allocating a smaller portion of capital to a puts strategy, hedging downside risks.
‘Costly portfolio insurance’
Despite the equity markets falling into bear-market territory this year, these funds have yet to gain much traction with investors. Three of the five funds have less than US$10-million assets under management (AUM). Simplify’s fund has fared better with about US$69-million AUM, and Cambria’s TAIL is the market leader with about US$370-million AUM.
Rob Tetrault, investment advisor and senior portfolio manager of Tetrault Wealth Advisory Group at Canaccord Genuity Wealth Management in Winnipeg, says it’s not surprising that these funds have not seen investors flock to them in droves.
“Tail-risk ETFs are effectively costly portfolio insurance,” he says.
Consider the Cambria Tail Risk ETF (TAIL). Despite the S&P 500 being down more than 24 per cent year-to-date (YTD), TAIL is down about 6 per cent, and its best year since launching in 2017 was 2020, when it gained nearly 7 per cent. That year, during the first few weeks of the pandemic – essentially a tail-risk event – was when the ETF saw its best performance. Between Feb. 18 and April 2, it increased about 28 per cent, while the S&P 500 fell about 27 per cent.
The question, Mr. Tetrault says, is whether the TAIL’s gain would actually offset equity losses.
“So, perhaps the 5 per cent of the portfolio that is in TAIL is up 25 per cent. That’s going to add about 1.2-per-cent alpha over all,” he says.
Assuming the U.S. equity allocation encompasses 25 per cent of the portfolio and is commensurately down 25 per cent, the overall decrease in the portfolio would be about 6.25 per cent, which TAIL’s gain would only partly offset.
Ideally, TAIL’s allocation would be optimized to hedge risk entirely for the U.S. equity allocation, but Mr. Tetrault adds the problem is that the protection is so costly to keep up, given it incurs annual losses most of the time – until a black-swan event occurs.
Some advisers may find TAIL useful for short-term use when they believe tail-risk events are likely, Mr. Mordy of Forstrong says.
Then again, no tail-risk ETF has thus far mitigated losses significantly amid the recent “black swan” of 40-year-high inflation, he points out. The Nasdaq 100 Tail Risk ETF has performed best as an all-in-one strategy, down about 24 per cent versus the Nasdaq Composite, down about 34 per cent YTD.
Other options providing returns in down markets
Still, Mr. Mordy says well-thought-out portfolio diversification likely offers superior risk mitigation.
He points to how allocating capital to iShares MSCI Chile ETF ECH-A with exposure to commodities buoyed Forstrong’s portfolio, with the ETF up about 6 per cent YTD.
Covered calls are another strategy providing returns in down markets, says Chris Heakes, vice-president and portfolio manager of global structured investments at BMO Asset Management Inc. in Toronto.
“You’re essentially selling volatility for income,” he says.
Yet this strategy also involves risk. The BMO Covered Call Canadian Banks ETF ZWB-T, for example, is down 21 per cent YTD. “It’s still an equity-based strategy,” Mr. Heakes cautions.
That said, its 12-month trailing yield is nearly 7 per cent – though not guaranteed going forward.
The point is advisers have a lot of alternatives to offset steep equity market losses without as potentially high a cost as tail-risk ETFs, Mr. Tetrault says.
“Wouldn’t you rather own an asset generating positive returns while waiting for tail risk?” he says, citing private debt and equity among those investments that can provide income and growth uncorrelated to public markets.
Other advisers might also operate on their own put options strategies for their equity holdings, Ms. Crigger adds.
“But I can see how tail risk ETFs might appeal [to] advisers who want this protection but can’t or don’t want to be bothered running these often complex strategies on their own.”
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