macrocephalopod

Simple Example: Start with $1 billion of equities and suffer a 20% drawdown, the equity exposure falls to $800 million. If equities turn around and rally 20%, the portfolio will make only $160 million, not the full $200 million you lost.

This is the negative impact of volatility and drawdowns on the compound growth of a portfolio.

Now, another popular argument: “Tail hedging involves buying option-based insurance against market drawdowns. Because markets generally charge a risk premium for insurance, the expected returns of a tail hedging strategy over long periods of time are negative..."

"...As a result, along-term-oriented asset owner should not allocate to hedging strategies, as they will detract from long-term compound returns.” Like many popular arguments, this is only partly correct.

Over the long term, you should expect negative returns from tail hedging strategies. The market would be wildly inefficient otherwise. Individual long convexity trades at certain points in time may be mispriced...

...and smart, dynamic hedging strategies might be able to reduce the cost of carry over time, but it is unrealistically optimistic to think that tail risk hedges can make money systematically over time.

But what this argument is missing is the portfolio effect. Tail risk hedges are inversely correlated with the performance of risk assets and produce outsized returns during times of crisis.

As a result, if tail risk hedges are added to a long-term, regularly rebalanced portfolio, they can cushion drawdowns and mitigate the mechanical reduction of risk asset exposure during times of stress.