| Ari Bergmann |
Post-2008 it has become fashionable for institutional investors to allocate some of their hedge fund capital to so-called tail-risk funds. But at least one hedge fund manager says these funds don’t deserve the hype. Tail-risk funds are designed to provide protection when major market shocks, also known as fat-tail events, occur. The funds are designed to hold steady or even lose small amounts of money when the market goes up but provide big gains when it takes an unexpected hit. These funds, which serve as a kind of portfolio insurance, have become enormously popular since 2008, according to a recent Deutsche Bank survey of alternative investors: 34 percent of the investors surveyed are now employing these funds, and another 15 percent intend to over the next 12 to 24 months.
It’s not hard to see why they’re so popular. With macroeconomic uncertainty hanging over the global economy, there is a strong case to be made for some sort of portfolio protection. But Ari Bergmann, founder and managing principal of the New York–based investment and risk management hedge fund firm Penso Advisors, warns that many of the tail-risk funds investors are considering today may not provide the type of protection they want during another market crisis. Bergmann knows of what he speaks: An architect of the credit derivatives market who also worked as a metals and commodities trader at Drexel Burnham Lambert, he started on the U.S. interest rate derivatives desk at Bankers Trust in 1989 and went on to manage that business. He founded Penso in 1997.
The way the most simple fat-tail overlays work is through buying options on single stocks and indexes to protect equity exposure to extreme market events. The problem, Bergmann says, is that as more investors ply this strategy, the prices of the options go up, and more often than not, the insurance does not work the way investors anticipate. The tails themselves become mispriced, creating their own crowded trade. Rather than focus on the fat tails, Bergmann argues, investors should be focusing on the systemic risks that occur when positions get too crowded.
Bergmann also takes issue with the one-size-fits-all approach of traditional tail-risk funds. To Bergmann, who manages money for institutional investors, risk can be customized only to a specific portfolio. “Because we are bespoke, we can actually find the opportunities and the hedge is more beneficial,” says Bergmann. To him, risk management should be its own source of noncorrelated alpha.
Bergmann argues that what he and his firm do is very different from many of the tail-risk funds investors are pouring money into. “For us, the best thing that could happen is the proliferation of fat-tail funds, because it creates the most mispricing in the market,” he says.
He may get his wish: Participants in the Deutsche Bank survey said performance is their No. 1 concern for 2012 — a statistic that will surely lead to even more tail-risk funds.
—Imogen Rose-Smith
