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The return of market volatility on the back of the ongoing COVID-19 pandemic around the globe and the retail trading frenzy of meme stocks like GameStop and AMC Entertainment has pushed two particular niche hedge fund strategies back into the spotlight; the CBOE Eurekahedge Long Volatility Hedge Fund Index and the CBOE Eurekahedge Tail Risk Hedge Fund Index returned 25.41% and 34.84% respectively in 2020. The two strategies which provide crisis alpha and protection for institutional portfolios have long since generated debates among asset owners and academics alike. While these fund managers are capable of generating substantial returns to offset losses during black swan events, these strategies may often act as performance detractors during bull market runs resulting in a drag on portfolio returns. In this report we will take a look at the risk-return profile of these strategies as opposed to more traditional hedging instruments and assess the impact of allocation into long volatility and tail risk strategies in an institutional portfolio of hedge funds.

Figure 1 below compares the performance of the Eurekahedge Long Volatility/Tail Risk Composite against the global equity market as represented by the MSCI ACWI IMI (Local), the government bond market as represented by the Bank of America Merrill Lynch Global Government Bond Index II and gold price in US dollar. The Eurekahedge Long Volatility/Tail Risk Composite is a custom equal-weighted index comprising hedge funds utilising long volatility and tail risk strategies. Long volatility fund managers take a net long view on implied volatility with the goal of positive absolute return, while tail risk fund managers specifically aim to generate substantial returns during periods of market distress.

Figure 1: Eurekahedge Long Volatility/Tail Risk Composite performance since the end of 2007

As observed in Figure 1 the Eurekahedge Long Volatility/Tail Risk Composite has managed to generate strong returns during the 2008 global financial crisis, the 2011 Eurozone debt crisis and the COVID-19 stock market crash thereby providing a hedge for institutional portfolios during a black swan event.

Table 1: Risk-return statistics of the Eurekahedge Long Volatility/Tail Risk Composite against other investment vehicles

Source: Eurekahedge

Table 1 provides the detailed risk return statistics of the four indices shown in the figure above. Key takeaways include:

1. The Eurekahedge Long Volatility/Tail Risk Composite was down 3.25% over the first four months of 2021 as the strong performance of the global equity market, as seen in the 9.91% return of the MSCI ACWI IMI (Local) served as headwinds for the index. Gold and the Bank of America Merrill Lynch Global Government Bond Index II were down 6.81% and 3.02% respectively over the same period.
2. Fund managers utilising long volatility and tail risk strategies returned 44.04% in 2008, 13.86% in 2011 and 25.59% in 2020, outperforming gold and the Bank of America Merrill Lynch Global Government Bond Index II during the three years. On the other hand, the Eurekahedge Long Volatility/Tail Risk Composite Index has performed the worst over the last five and 10 years as they recorded 5Y annualised return of -1.23% and 10Y annualised return of -1.29%, exemplifying the cost investors must pay in exchange for the tail risk protection afforded by these funds.
3. The Eurekahedge Long Volatility/Tail Risk Composite has generated a 3Y annualised return of 3.94% despite the strong performance of the global equity market which generated a 3Y annualised return of 11.26%. In addition, Gold has significantly outperformed the composite with a 3Y annualised return of 10.38%, exemplifying the increased demand for safe haven assets from investors amidst the economic uncertainties over the past 3 years.

Table 2 provides the correlation values between the Eurekahedge Long Volatility/Tail Risk Composite, Gold, the Bank of America Merrill Lynch Global Government Bond Index II as well as the MSCI ACWI AC since the end of 2007. As observed in Table 2, the Eurekahedge Long Volatility/Tail Risk Composite recorded the highest negative correlation against the global equity market among the three indices. The Bank of America Merrill Lynch Global Government Bond Index II produced the second highest negative correlation against the global equity market with a correlation coefficient of -0.183. Gold, traditionally seen as a safe haven asset by investors had a positive correlation against the global equity market of 0.0327.

Table 2: Correlation matrix

Source: Eurekahedge

Table 3 provides the returns of the three indices during previous stock market crashes. Key takeaways include:

1. The Eurekahedge Long Volatility/Tail Risk Composite has significantly outperformed Gold and the Bank of America Merrill Lynch Global Government Bond Index II during the COVID-19 stock market crash and the 2008 Global Financial Crisis, the two events that are widely seen as the worst financial crises the world has experienced.
   
   
2. The Eurekahedge Long Volatility/Tail Risk Composite has generated the highest return during five out of the seven previous stock market crashes listed in Table 3. The Escalation of the US-China trade war and the European Sovereign Debt Crisis were the only instances where gold has managed to outperform the other indices.
   
   
3. The Eurekahedge Long Volatility/Tail Risk Composite has managed to produce positive returns during all of the seven events listed in Table 3. On the other hand, gold has only managed to produce positive returns during three of the seven events while the Bank of America Merrill Lynch Global Government Bond Index II fared slightly better than gold, with positive returns in five out of the seven events listed.

Table 3: Performance of the Eurekahedge Long Volatility/Tail Risk Composite Index against other investment vehicles during previous stock market crashes

Source: Eurekahedge

In the following section, we will examine the impact of adding the long volatility/tail risk strategies in a long/short equities portfolio. Equities are the most famous strategies in the hedge fund universe and also the most traded assets in the financial market due to its higher return profile compared to other assets. In addition, equities are also the most vulnerable assets in a period of market distress, hence adding long volatility/tail risk strategies into these portfolios would provide downward protection against market uncertainties. In this section, we will examine the risk-return statistics of the portfolio over the three different periods - since December 2006, over the last five years and over the last three years.

Figures 2a-2b provides the annualised returns and volatilities of a portfolio constructed from the Eurekahedge Long Short Equities Hedge Fund Index and Eurekahedge Long Volatility/Tail Risk Composite at different weights during the period since December 2006. As shown in Figure 2a, allocating a portion of the portfolio into long volatility/tail risk strategies caused a reduction in annualised return and a significant reduction in annualised volatility, resulting in better risk-adjusted returns. In comparison, allocating a portion of the portfolio into gold has a limited impact on its overall volatility while further increasing the allocation to gold decreases the portfolio’s annualised return and increases its annualised volatility.

Tables 4a and 4b provides the portfolio allocation weights and the risk-return statistics of the portfolio shown in the figure above. The allocation of 35% of the portfolio into long volatility/tail risk strategies has resulted into lower volatilities and higher Sharpe ratios compared to the long/short equities on its own. However, the downward protection provided by the long volatility/tail risk strategies has also resulted in a performance drag between 1.44% to 1.15% per annum. On the other hand, in Table 4b, allocation of 14% of the portfolio into gold only reduced the portfolio’s annualised volatilities by 0.34% while increasing its annualised return by 0.13%. Even though gold would act as a hedge in a period of market distress but keeping it on a portfolio for a longer period would minimize its overall downside protection due to its higher volatility and lower annualised return profile.

Figure 3a provides the annualised returns and volatilities of a portfolio constructed from the Eurekahedge Long Short Equities Hedge Fund Index and Eurekahedge Long Volatility/Tail Risk Composite at different weights over the last five years. As shown in the next chart, allocating a portion of the portfolio into long volatility/tail risk strategies significantly reduced the volatility by nearly half, while its annualised return also declines but by a smaller magnitude. On the other hand, allocating a portion of the portfolio into gold have a smaller impact on reducing the risk of the portfolio as seen from its minimum volatility of 7.15% which is only lesser by 0.76% than the long/short equities on its own.

Tables 5a and 5b provide the portfolio allocation weights and the risk-return statistics of the portfolio shown in the figure above. The allocation of 24% of the portfolio into long volatility/tail risk strategies significantly improved the risk-adjusted returns of the long/short equities portfolio as seen on its higher Sharpe ratio. In the same vein, the allocation of 37% of the portfolio into volatility/tail risk strategies would reduce the overall volatility by nearly 50%. On the other hand, the allocation of 23% of the portfolio into gold only reduced its volatility from 7.91% to 7.15% while its return also declined by 0.60% per annum. Although allocation to long volatility/tail risk has a higher reduction on its return compared to gold, the decrease in its volatilities outweigh the impact resulting in a significant improvement on its risk-adjusted return.

Figure 4a provides the annualised returns and volatilities of a portfolio constructed from the Eurekahedge Long Short Equities Hedge Fund Index and Eurekahedge Long Volatility/Tail Risk Composite at different weights over the last three years. In the past 36 months, the market volatility has reached an extreme level which parallels the 2008 global financial crisis. From the tightening of the Federal Reserve to conflict between the US and China, and the COVID-19 pandemic which forced the global economy to shut down. Therefore, exposure to safe-haven assets has been very important to investors to safeguard from huge losses against these uncertain events. As shown in Figure 4a, allocating a portion of its portfolio into long volatility/tail risk strategies would reduce its volatilities by half, thanks to the negative correlation of these strategies against the performance of the equity market, particularly in February to March 2020 when the MSCI ACWI lost 20.73%, while the long volatility/tail risk strategies gained 33.40%. On the other hand, allocating a portion of its portfolio into gold both improved its portfolio return and volatilities by a small margin.

Tables 6a and 6b provide the portfolio allocation weights and the risk-return statistics of the portfolio shown in the figures above. Table 6a shows that allocating 37% of the portfolio into long volatility/tail risk strategies would achieve the lowest possible volatilities from 9.93% of total exposure to long/short equities down to 4.85%, while only reducing its return per annum by 1.69% which brings its Sharpe ratio from 0.82 to 1.34. On the other hand, allocating a small portion of the portfolio into gold increases its overall annualised return, thanks to the recent strong movement of the precious metals in the recent period. However, exposure to gold has only led to smaller changes in its overall volatility as seen in Table 6b, in which 33% allocation of the portfolio into gold would reduce its annualised volatility by 1.37%.

In the following section, we will examine the impact of adding the long volatility/tail risk strategies into a much more diversified portfolio which is the Eurekahedge 50. Compared to long/short equities, the Eurekahedge 50 represents the top 50 hedge funds in the Eurekahedge database which utilises several types of strategies that broadened their exposure to a different asset class. In this section, we will examine the risk-return statistics of the portfolio over the three different periods which are since December 2006, over the last five years, and three years.

Figure 5a provides the annualised returns and volatilities of a portfolio constructed from the Eurekahedge 50 and Eurekahedge Long Volatility/Tail Risk Composite at different weights since December 2006. As expected, allocating a portion of the portfolio into long volatility/tail risk strategies would significantly reduce its overall risk as seen in the large decrease in its annualised volatility in Figure 5a. In the same vein, as Eurekahedge 50 has a lesser correlation to long volatility/tail risk strategies compared to long/short equities as their exposure is not focused on equities, hence the drag on its performance was limited resulting in a significant improvement in its risk-adjusted return. On the other hand, allocating a portion of the portfolio into gold has resulted in higher annualised volatility and annualised return as seen in the upward sloping curve in Figure 5b.

Tables 7a and 7b provide the portfolio allocation weights and the risk-return statistics of the portfolio shown in the figure above. The allocation of 31% - 36% of the portfolio into long volatility/tail risk strategies has resulted in lower volatilities and higher Sharpe ratios compared to the Eurekahedge 50 on its own. However, the downward protection provided by the long volatility/tail risk strategies has also resulted in a performance drag between 0.54% to 0.65% per annum. On the other hand, allocating 7% of the portfolio into gold decreased the volatilities by only 0.15%, while increasing its return by 0.19% per annum.

Figure 6a provides the annualised returns and volatilities of a portfolio constructed from the Eurekahedge 50 and Eurekahedge Long Volatility/Tail Risk Composite at different weights over the last five years. As shown in the next chart, allocating a portion of the portfolio into long volatility/tail risk strategies significantly reduced the volatility by more than half, while its annualised return also declines but by a smaller magnitude. On the other hand, allocating a portion of the portfolio into gold have a smaller impact on reducing the risk of the portfolio but increases its annualised return. The recent observed volatility of precious metals particularly gold, supported by the weaker US dollar and heightened market volatility have reduced the diversification benefits provided by these assets on investors’ portfolios.

Tables 8a and 8b provide the portfolio allocation weights and the risk-return statistics of the portfolio shown in the figure above. The allocation of 31% of the portfolio into long volatility/tail risk strategies would sharply reduce its volatilities, while it also lowers its annualised return but by a smaller margin resulting in a higher Sharpe ratio compared to Eurekahedge 50 on its own. On the other hand, allocating to gold has a very limited impact in reducing the volatilities of the portfolio, as shown on the chart where an allocation of 14% into gold will only reduce the volatilities of the portfolio by 0.34%. However, the strong performance of gold in the recent period also boosted the overall performance of the portfolio as shown on its higher annualised return compared to Eurekahedge 50 on its own.

Over the last 36 months, the Eurekahedge 50 experienced several periods of heavy losses such as in Q1 2020 and Q4 2018 due to the COVID-19 outbreak and trade conflict between the US and China. In Figure 7a, allocating a portion of the portfolio into long volatility/tail risk strategies significantly improved the overall performance of the portfolio, increasing its annualised return and decreasing its volatilities by more than half. The strong downward protection provided by the long volatility/tail risk strategies has managed to offset the losses generated by the other asset within the portfolio as in Table 3 where the Eurekahedge Long Volatility/Tail Risk Composite gained 33.40%, while the global equity market declined by 20.73%. On the other hand, allocating a portion of the portfolio into gold also resulted in lower volatilities and higher annualised return as seen on the upward sloping curve in Figure 7b.

Tables 9a and 9b provide the portfolio allocation weights and the risk-return statistics of the portfolio shown in the figures above. Table 9a shows that allocating 31% of the portfolio into long volatility/tail risk strategies would reduce the volatilities by more than half from 7.62% of Eurekahedge 50 on its own down to 2.95%. In the same vein, the overall return of the portfolio also increases by 0.36% per annum, which nearly tripled its Sharpe ratio from 0.32 to 0.95. On the other hand, supported by the strong performance of precious metals in the recent period driven by the weaker US dollar, allocating 20% of the portfolio into gold would increase the annualised return by 1.37%, while reducing its volatilities by 0.66%. In terms of risk-adjusted returns, allocation to long volatility/tail risk strategies has resulted in a higher Sharpe ratio compared to allocation into gold as seen in the tables below.

In conclusion, by making a small allocation into long volatility/tail risk strategies, hedge fund managers can provide significant downside protection for their portfolios during periods of extreme market distress and generate better risk-adjusted returns. Even though gold is also widely seen as a good alternative hedging instrument, our analysis has shown that adding long volatility/tail risk strategies into a hedge fund portfolio would result in a larger decrease in portfolio volatility and a larger increase in portfolio Sharpe ratio. Despite the performance drag imposed on portfolios by long volatility and tail risk hedge fund strategies over the long run, the benefit of significant downside protection during black swan events outweighs the cost of allocating a portion of a portfolio into long volatility and tail risk strategies. Given the emergence of new variants of COVID-19 and the resulting uncertainty regarding the effects of a prolonged pandemic and economic disruption, hedge fund managers would benefit by allocating a portion of their portfolio to long volatility and tail risk strategies to ensure that their portfolios remain resilient in the face of unpredictable negative events in the future.

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