If there was a way to protect your portfolio from periodic blowups like the one earlier this year, would you want it? Of course you would, but so would everybody else. And because there is such a strong desire for this type of insurance, the eventual payoff might not be worth it if the premiums that you pay along the way are too expensive.
AQR took a closer look at tail risk hedging strategies and showed that:
Over the 35 years or so where we have good index option data, OTM put prices were set at a high enough level to give negative returns each decade – despite big market events like 1987 (the biggest daily crash in history), 1998 (Russia/LTCM crisis), 2001 (9/11), 2008 (Lehman), 2020 (Covid), as well as a recession roughly every decade and two bear markets where the market lost roughly half of its value.
The chart below shows how these strategies work, at least the plain vanilla ones. Bleed, bleed, bleed, boom!
There is a ton of nuance here. These strategies are neither good nor bad and like everything else, it depends how you use them in concert with the rest of your portfolio, how much they cost, and what you’re trying to accomplish.
If you’re interested in learning more, check out the whole paper, and definitely listen to Corey Hoffstein’s fascinating discussion with Benn Eifert, who is an expert in the options market.