Saba’s Boaz Weinstein, Ambrus’ Kris Sidial Discuss Their Unusual Tail Risk Strategies

Traditionally, investors were advised to place 60% of their portfolio into stocks and 40% into bonds, but things have changed dramatically since those days. In a recent interview, Boaz Weinstein, founder and chief investment officer of Saba Capital, a $4.6 billion fund, noted that 40% used to be considered tail risk protection because Treasuries were supposed to rise when stocks fell.

However, the strange market environment we’re in right now has seen stocks and bonds fall together, leaving investors with no place to hide. As a result, Weinstein advises investors to take some of that 40% part of the portfolio and invest it into tail risk funds.

Strange times cause the death of traditional tail hedges

“Black swan” or “tail” events are those that could never have been predicted and have a catastrophic impact on the economy and markets. Historically, black swan events have been rare, but more recently, the number of black swan events has grown dramatically, with the last few years churning out multiple such events. Thus, it should come as no surprise that tail risk funds have increased in popularity.

Some recent examples of tail events include the COVID-19 pandemic and Russia’s invasion of Ukraine. Other examples from history include the 9/11 terror attacks, the Great Financial Crisis in 2008, the dotcom bubble in 2001, and the 1998 collapse of Long-Term Capital Management, a hedge fund run by some Nobel Prize winners that had been hugely successful until its sudden collapse.

With the 60/40 portfolio essentially dead and the rate of black swan occurrences increasing, the need for alternative tail risk protection may be greater than ever before. Most tail risk hedge funds utilize similar strategies, but Boaz Weinstein and Kris Sidial of newcomer Ambrus Group say their strategies differ from the norm.

A time for fear

Although investors have many things to worry about now, like soaring inflation, Weinstein pointed out that the tail events that have struck the markets down were “bolts from the blue,” or things no one saw coming. However, black swan events notwithstanding, he added that there is a great deal of fear in the market right now.

“I don’t remember another time when the market was closer to its highs than the median despite there being so much fear,” Boaz opines. “Stocks are down this year, but there has been a huge bull market since 2020 and before that, since 2009. Yet, you hear Jamie Dimon say, ‘Brace for a hurricane,’ and every bank CEO talks about de-risking, which goes to show that tail protection is very topical today, but how to implement effective hedges is not well understood.”

He also drew attention to the current “tech stock debacle,” which has tech stocks off more than 20% year to date as measured by the Nasdaq Composite.

Due to all these issues gripping the market right now, Weinstein has seen robust demand for tail risk funds this year.

Common tail risk strategies

Common tail risk strategies involve buying puts on the S&P 500 that are way out of the money. Others may involve buying calls on the VIX that are way out of the money. Sidial explained that there are different ways to implement these kinds of tail risk strategies, although not all managers who claim to be tail risk managers actually are.

“I’ve even heard some say they’re a tail risk fund, and they’re shorting futures,” he said in a recent interview. “That’s not a real tail risk fund, so there are different ways to implement different convex structures… “The important thing is how they are able to add uncorrelated alpha to minimize the portfolio’s bleed while maintaining that convexity that can pay out big during a crash.”

Kris sees no real value add in tail risk funds that merely buy puts beyond execution. Even in the event of outstanding execution with efficiently cheap puts, he would still expect the fund to bleed 20% to 30% per year in a typical market environment.

“There’s a fine line between value-add or being a hazard for the client because if the fund depreciates too much, they’re losing too much on their tail risk,” Sidial explains. “We’re not bleeding out that large amount, and yet, we’re still able to give you that type of a payoff when these crashes happen.”

Gauging a tail risk fund’s bleed

He added that judging a tail risk fund involves looking at the expected annual bleed during a normal market environment and dividing it by the expected return in a crash. Sidial categorizes a crash as the S&P 500 being down 20% in a month or the VIX being above 70. However, he emphasized that investors must understand this ratio.

According to Sidial, a tail risk fund that only generates 10% in a crash but doesn’t bleed during a typical market environment isn’t efficient because it won’t provide enough coverage in a tail event. On the other hand, a fund that returns 500% in a crash but bleeds 70% a year during a normal environment isn’t good either.

Sidial adds that the key is finding a tail risk fund that generates a large enough return to offset a crash in the rest of the portfolio without bleeding significantly during typical market environments. This is why he believes running a successful tail risk fund is more than buying puts on the S&P 500 or calls on the VIX.

Dealing with volatility

Like Sidial, Weinstein notes that most tail managers are doing very similar things, although he emphasized that this was not a pejorative statement against other fund managers. In addition to the strategies Kris discussed, many managers use derivatives on implied volatility or realized volatility or other professional products, many of which can be expensive.

In the current bull market phase, volatility is elevated, so it costs much more to buy downside protection than it did before the pandemic. An excellent way to understand this is to look at the VIX. Between 2014 and 2019, a VIX of 10 to 12 wasn’t uncommon.

However, the VIX began this year at 23, which led to a much higher price for downside protection. Although volatility got expensive, Weinstein doesn’t buy these expensive options, and his fund’s returns show that what he’s doing is working.

Sources familiar with Saba’s Tail Fund say it is designed to perform during periods of market stress and dislocation. They add that it has outperformed the CBOE Eurekahedge Tail Risk Hedge Fund Index by 76% since inception. The sources added that this year, Saba’s Tail Fund is already up more than 24%—returning more than the Eurekahedge index.

In 2020, Saba Capital reportedly delivered returns of 73% for its flagship fund and 63% for its tail fund. Those full-year numbers include not only the steep drawdown in February and March but also the raging bull market rally during the rest of the year.

How Boaz Weinstein covers tail risk

Weinstein touts Saba Capital’s reputation of coming up with creative ideas, adding that they look toward credit spreads instead of equity derivatives, a strategy that he said has worked “super well.” Weinstein came up with his idea when studying the booming SPAC market more than a year ago.

“SPACs were trading at a premium to their net asset value until Q1 2021 because people were, at the time, overly excited about innovation technologies,” he said. “But when SPACs started to trade significantly below net asset value by Q3 2021, the yield on them became very high, and to us, they turned from an equity investment into a safe, bond-like investment.”

Breaking down his SPAC strategy

Weinstein explains that buying SPAC shares for $9.70 each when you’ll get $10 back a year later has an additional built-in yield of 3%. He added that the 3.5% yield was in addition to the yield from the T-bills, which today are higher because the Federal Reserve has been hiking interest rates.

Special acquisition companies are blank-check companies created and taken public for the sole purpose of merging with an operational company. When investors buy shares in a SPAC’s IPO, those shares must be held in a trust and invested in Treasuries while management looks for an attractive acquisition target.

Thus, investing in a SPAC’s IPO is like a backdoor to buying Treasuries, especially when those SPAC shares are trading at a discount to the standard $10 a share price that’s typical of SPAC valuations. Then when a 3.5% yield is added to the rising yields of the Treasuries, Weinstein sees opportunities.

Upon that realization, he looked at where else he could find similar yields and came across B-rated junk bonds, which are surely much riskier than a SPAC. Some investors find SPACs to be more exciting because of the wide array of potential acquisition targets ranging from Lucid Group, which makes high-end electric vehicles, to former President Donald Trump’s Truth Social network.

Shorting credit for tail protection

Additionally, if the SPAC share rises above $10, it offers additional gain to the holders, which Boaz describes as a “free equity option.”

“Using SPACs to offset the cost of credit default swaps was a way to look the investor in the eye and tell them that they could have tail protection without an onerous way of having to pay for it,” he said. “Shorting credit via derivatives is very liquid because all of the largest banks and hedge funds are active users. In fact the volumes on derivatives referencing the top 100 junk bonds are larger than the volumes on all junk bonds combined.”

Weinstein often shorts the credit names he likes and then pays for those positions using AAA-rated SPACs or highly rated corporates like Verizon, IBMIBM
and WalmartWMT
. He noted that SPACs haven’t been down at all this year, and the money his tail fund received from the yield was used to buy credit protection, fulfilling Weinstein’s goal for tail protection.

Coming into 2021, he owned less than $100 million worth of SPACs, but by the end of June 2022, he owned $6.7 billion worth of SPACs, becoming the world’s largest SPAC owner. Weinstein states that owning SPACs as a way to pay for the negative carry involved in buying portfolio protection is a fresh take on funding tail protection.

Kris Sidial’s tail risk strategy

Sidial also touts his tail risk strategy as unique among tail fund managers, and, like Weinstein, he also developed his strategy during the strange pandemic-era market. Ambrus Group is a new fund, having been founded in 2020.

He got the idea for his tail fund strategy while working at the U.S. exotics desk at BMO. During the sharp selloff in March 2020, the U.S. exotics desk did quite well, so Kris started looking at how he could use such strategies to combat tail risk. Exotics involve trading baskets of equity derivatives that combine into different structures. He explained that his strategy differs from what most other tail fund managers do.

“You often see some other tail risk funds short concave structures to fund the convex structures,” Sidial explains. “You see people selling Treasury volatility and buying S&P 500 volatility. We don’t believe in that mentality: short something convex to fund something concave. In a real tail risk event, you don’t know what can happen, so what you’re doing is compromising the mandate of what you’re trying to do. We saw this a lot during March 2020. A lot of funds that were marketing themselves as a tail fund ended up losing a lot of money.”

For example, he suggested that an investor might want to be long on Treasuries to fund the tail, but then Treasuries start tanking. Sidial notes that the investor would lose more money than they could make on that tail.

“So those sorts of carry trades, we don’t really do,” he clarified. “We focus on what we think we’re good at… We do a lot of intraday order flow trading to offset the bleed of being long these tails. Other funds short volatility or go long volatility, but we are just taking more active intraday order flow to make money through that process to fund the tails.”

How big should a tail risk position be?

When asked how large a tail risk position should be, Weinstein states that it depends on the investor and their strategy. However, Kris advises a tail risk size no bigger than 3% to 5% of the total portfolio.

His tail strategy involves aiming for flat to slightly below returns during typical market environments and sizable returns when the market crashes. Sidial explains that losing 5% on 5% of a portfolio results in less than a percent loss for the overall portfolio.

However, when a crash happens, that same 5% allocation has the potential to generate a more than 300% return, which amounts to a 15% impact on the entire portfolio when the market crashes.

“When the market is crashing, it can be beautiful,” Sidial states. “With this hedge, we’re talking about an investor going from down 20% when the whole world is crashing to being down 5% for their overall portfolio because of their tail risk protection, so you can see why these things are so attractive.”

Michelle Jones contributed to this report.