The return of market volatility driven by the combination of the restrictive monetary policies of global central banks to tame multi-decade high inflation rates and the geopolitical conflict in Eastern Europe has pushed a particular hedge fund strategy back into the spotlight: the CBOE Eurekahedge Tail Risk Hedge Fund Index which returned 6.82% over the first five months of 2022. The tail risk strategy provides crisis alpha and protection for institutional portfolios and 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 hedge fund strategies and assess the impact of allocation into tail risk strategies in an institutional portfolio of hedge funds.
Figure 1: May 2022 year-to-date return of hedge fund strategies and other asset class
Figure 1 shows the May 2022 year-to-date return of hedge fund strategies and other asset classes. With the exception of CTA/managed futures hedge funds that benefitted immensely from rising commodity prices, tail risk hedge funds outperformed their strategic peers and other major asset classes during the year. Gold; which is seen as the traditional safe haven asset was only up by 0.45% over the same period, while government bonds were down by 7.86%. As the rising inflation rate was the primary driver of market uncertainties that has forced central banks to raise rates resulting in higher yields, government bonds were less effective as safe-haven assets over the past few months. Equities, as represented by the S&P 500 fared the worst and was down 13.30% as the combination of the COVID-19 pandemic, Russia-Ukraine conflict and resulting skyrocketing inflation led to aggressive monetary policy tightening by the Federal Reserve in a bid to curb inflation, negatively impacting risk sentiment as investors became increasingly concerned that the aggressive moves might unintentionally tip the economy into recession.
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