“You guys better figure out how, while hedging tail risk, you’re not letting liquidity risk sneak in the back door … you don’t know how to get out and we’ve just had a liquidity event not so long ago,” one investor told a panel of hedge fund managers managers.
Tail funds, also known as black swan strategies are supposed to hedge against rare but dangerous events, such as the market sell-off following Lehman Brothers’ demise.
“You guys should figure out the difference between volatility and tail risk, which you tend to put together.”
GAIM 2012 hedge fund conference this week in Monaco revealed widespread doubts about whether such funds can perform as they are expected to.
Hedge fund investors have voiced their concerns about complex funds designed to protect against major market meltdowns, just as fears of a break-up of the euro zone have spurred huge interest in these products.
Tail risk is defined as the probability of rare events.
Confusion of Complex Mathematics
Dozens of different strategies can carry the tail-risk tag, many of them using complex mathematics which leave investors puzzled about how they work.
In their most simple form, the funds buy “put” options – contracts which give them the right to sell an underlying stock or security on expectations of a drop in price.
Under the terms of the contract, the seller of the put – such as an investment bank – is obliged to buy the asset from the fund at a pre- determined price, earning the fund a profit if prices have slumped below that level.
Other funds, however, bundle these traditional tail-risk hedges with bets on indexes that track volatility rather than protection from falling prices
Another worried investor at the conference said managers were getting confused in their terminology and execution, increasing their exposure to risk instead of minimizing it.
“You can have a market falling very slowly by 1 percent a week for 36 weeks, then up 1 percent a week for another 36 weeks, and you will have a tail event but you’ll lose money like hell being long volatility on a variance swap,” he said.
Read More: Reuters