Long time readers know that I am fantastic with coming up with great ideas but less so at monetizing them. Anyways, here is an obvious idea (Barclay’s/PIMCO are you listening?):
Start a suite of three public mutual funds or ETFs that focus on fat tail hedging including equity, credit, and inflation(deflation) protected funds. One could also design them against other factors but these seem simplest. All they do is buy out of the money options on those asset classes. This is a perfect example of a strategy you should only be paying 50 bps for (Universa and Landmark charge hedge fund style fees). Really, all they are doing at the end of the day is buying out of the money options so why charge alpha fees? (Note: This is not the same thing as 3X inverse funds – rather, this focuses on the optionality of using derivatives so it works almost like insurance.)
PIMCO does this within their Global Multi Asset Fund (PGMAX) but I am talking about someone that breaks it out separately.
Should be tons of demand for a product (ie insurance) like this. Over/under until we see something? I definitely think < one year.
That's an interesting idea, but I read that book two years ago. Something about a black swan
Meb-
I like the idea, but unfortunately it's a tough sell. I think people associate investing with making money and not paying out insurance. It's probably a behavioral finance topic. At the end of the day, buying out of the money options to hedge tail risk involves paying an insurance premium to protect against infrequent disasters(although seemingly less infrequent these days). So while it's a losing proposition over time, it's there when you need it most to prevent serious negative compounding of equity. The real benefit of such a strategy is that it reduces negative skewness in a portfolio composed of the usual asset classes. But most people don't spend much time considering the higher order moments of their return distributions.
Of course Taleb wrote TBS and ran Empirica and runs Universa. I think it is a 50 bps product not a 2% and 20% one.
What's your point?
I think it is mostly an advisor product.
Issues in a public vehicle that I see:
*The vehicle that should be worthless when the insurance turns out not to be needed (i.e. if you're protecting against the downside, but only upside happens over that period).
* Making sure investors get that the vehicle is only insurance and not a stand alone fund
* What do you do with the gains when the options move in-the-money? Are they redistributed to the holders of the fund annually? If so, there could be major timing issues (i.e. right when the fund is needed, you need to liquidate). If not, then how often are they redeployed which is also timing issue with how much protection the buyer believes they are purchasing?
has a fund/etf come out yet that trades like your paper?
Why can't it be a stand alone fund that targets losing 10% a year during stable, appreciating markets? Structuring the fund as an ETN gets around the tax issues.
Not publicly.
So lets assume it returns 200% in systemic crashes and loses 10% in stable periods (there are private vehicle offerings in this space). Then the most important thing to do in the first place is sizing (how much to buy) and then a regular basis is re-sizing.
The question would be whether retail investors are sophisticated enough to re-size every 3-6-12 months. After a “normal” year, the investor would need to buy 10% more to maintain whatever exposure they had all else equal. The issue is nothing is ever all else equal. In that environment, their other assets probably gained in value, thus they need to buy more than 10%.
The difficulty is ampligied when the investor needs to resize the other direction (i.e. the markets crash and it doubles in value), which leaves the investor over-hedged.
Ask any sophisticated investor / institution about hedging. The hard part isn't getting the mapping right. It's when to hold on.
Why would you need need insurance when the world is full of great FAs that work for Edward Jones and have no experience managing a kool aid stand let along other peoples money. If you're a good enough sales person, you can sell water to a fish.
Mebane, love your stuff. This opposite of this is being done in bondland by Pimco. They have been doing it for over 20 years, constantly selling out of the money volatility, which helps to account for the high long term yields they have produced. Here's my summary:
http://alephblog.com/2007/06/13/pimco-in-theory...
As for a fund that buys such options on a rolling basis, when interest rates were higher, there were funds that bought options with the interest from t-bills. Some had a lockup, and were able to buy longer with more proceeds, immunizing the principal with a zero coupon bond. Then there are EIAs (Equity indexed annuities) — that's the strategy that they pursue.
Just a few thoughts.
Mebane, would any of the Volatility ETFs not do much the same? Thing is any of the advisors client portfolios, will have different factor exposure, so it would properly be better for him to customize hedging strategies through derivatives.
Hi Meb,
I would be concerned about implementation of this product. How would we know that it works before a black swan actually appears? For example, when the VIX options first came out a lot of folks purchased that new insurance policy. Only later did they find out that the further dated options did not track the volatility of the day. Even the near dated options tracked poorly when they still had some time to expiration. I think whoever puts out this product (and if it works as advertised, yes, it would be a great idea) needs to have a pretty strong reputation in the field and have some pretty convincing backtests with hedging instruments that existed at the time of the backtest.
On the equity side, PIMCO has Stock Plus funds for long or short the SP500. They hold short bonds, then buy long options to bet on the SP500 rising or falling. Exp ratios 64bps to 105 bps.
You are right, perfect for mgmt fee based vehicle, but I'll definitely take the over (if you take me up on that, I'll assume you have some info I don't have
. Would be nice as a structured product from a bank, but haven't even found it in that format. I don't think 10% implies enough convexity to make it a really juicy hedge, though, it would be much more interesting to see 20-50% bleed per year and you would just re-up to your desired allocation every 6-12 months. Agree we're even less likely to see an ETN like that, but seems to me a more efficient hedge that way.
You are right, perfect for mgmt fee based vehicle, but I'll definitely take the over (if you take me up on that, I'll assume you have some info I don't have
. Would be nice as a structured product from a bank, but haven't even found it in that format. I don't think 10% implies enough convexity to make it a really juicy hedge, though, it would be much more interesting to see 20-50% bleed per year and you would just re-up to your desired allocation every 6-12 months. Agree we're even less likely to see an ETN like that, but seems to me a more efficient hedge that way.