So, what is the price of tail risk investing? Using the CBOE Eurekahedge Tail Risk Index since 2008 as a benchmark shows the cost. The index of leading tail hedge managers would have generated an annual drain of 2.65 percent per year. It is not clear whether this is high or low until you consider the impact on an equity portfolio.
We compared the SPY returns versus a simple 95/5 allocation between SPY and the Tail Risk Index for the entire history of Tail Risk Index from the end of 2007 through August 2020. The results show that there is no increase in terminal wealth from holding the index as a hedge. There is a slight decrease in annualized return and volatility with the Sharpe ratio only increasing .01. The "insurance" helped during crisis periods, but then the drag continued. Unfortunately, the support was limited given a 5 percent allocation.
We then compared the stock index and stock/Tail risk portfolio against a 95/5 allocation between SPY and AGG the Barclay Aggregate Index ETF. In this case, the return drag was significantly less than the SPY/Tail Risk combination. The volatility was higher than the SPY/Tail risk combination but lower than the 100% SPY portfolio.
The AGG has a zero correlation with the SPY benchmark while the correlation of the Tail Risk index was -.48. The volatility of the AGG was less than a quarter of the Tail Risk index. Holding the Tail Risk index provides better diversification because of the negative correlation but at a significant cost. Tail Risk investing as generated through the managers in the CBOE Eurekahedge index is no free lunch and there may be better ways to attack this problem.
In the case of house insurance, the value is clear; a house destroyed is replaced. It cannot be replaced on its own without the insurance or a new capital infusion. In markets, the stock portfolio will likely increase in value after a recession as long as the firms invested in do not go bankrupt. Needless to say, this is a critical assumption. Insurance is not needed for the long-run but for protecting or smoothing short-term consumption risk. If you have to consume more wealth during a crisis, the hedge adds value. If you are only worried about terminal wealth, the positive impact of a small hedge is limited.
A tail hedge investment has to be considered against a number of factors like the terminal wealth horizon, the size of the hedge, any return or yield drag, and the diversification alternatives.