If you had left on the day of the US election at the market close and come back the next morning, you would look at your market screens and see that the equity markets, at least, had done barely anything.
This would have completely hidden the amazing turn of events in US, and indeed, in global politics, and shown no sign of the limit down move in the S&P E-mini futures before they (and other risk markets) rebounded back to be essentially unchanged from close to close.
If you had any tail hedges, like we did, and if you did not do anything with them during the night, you would have realized no gains from them, and possibly even a loss, as implied volatility fell and another day passed.
On our end, we were up most of the night of the election and managing our portfolio of tail hedges – readjusting, rebalancing and optimizing. The fact that the major macro futures markets trade electronically almost 24 hours allowed our team to make sure that the fleeting value added from the financial market carnage in the overnight session was captured in our portfolios.
As we have described before in our writings and discussions, we use four major levers to manage a highly convex portfolio of hedges.
First, and what we use sparingly, is monetization, i.e. conversion of increased hedge value into cash that can be used to re-invest in the markets at a cheaper level. Taking hedges completely off is very dangerous, since it is impossible to know when the tail event is over.
Second, we can convert certain types of strategies into other types that allow for better risk-reward, i.e. converting puts into put-spreads or vice versa. Good models, of course, are important for this.
Third, we can exchange our hedges in one market that has outperformed into another – our algorithms attempt to scan every market that we can trade and evaluate the relevant relative value tradeoffs.
Because markets do not process information efficiently in the short term, these opportunities present themselves frequently. A great example from the election night’s market action was the dramatic fall in yields as a consequence of the fall in equity markets, which allowed us to liquidate and convert our long treasury hedges into other hedges. Fundamentally, the knee jerk reaction of falling bond yields made no sense in the context of a Trump policy that would increase deficits and bond issuance.
Fourth, and finally, we can exchange non-linear instruments for linear instruments and vice versa depending on what has happened to volatility.
Our process and the liquidity in the markets allowed us to execute three of the four major levers. As we have discussed in the past, tail management cannot be passive since the value added arises from perceptions of risk changing and perceptions change very quickly; and election night’s price action showed the importance of active tail management.
The US election outcome was a classic tail event. The market and poll probabilities of candidates’ chances were too extremely skewed and one-sided on the morning before the election results started to come in. And the severity of the outcomes was even harder to pin down. Compound this with the ability of investors to trade continuously in real-time as news comes out and you have created an environment that requires a disciplined process to manage a portfolio of hedges.
It was a sleepless night at our firm, but one that was fruitful and indeed required for managing our hedge portfolios.
We believe that many such events are on the horizon on both the “left” and the “right” sides, and investors who can analyze such events rapidly, and act upon them by using the evolution in investment technology, are likely to be able to extract the value from tails.
Vineer Bhansali, Ph.D. is the Founder and Chief Investment Officer of LongTail Alpha, LLC, a California-registered investment adviser and a CFTC-registered CTA and CPO. Any opinions or views expressed by Dr. Bhansali are solely those of Dr. Bhansali and do not necessarily reflect the opinions or views of LongTail Alpha, LLC or any of its affiliates (collectively, “LongTail Alpha”), or any other associated persons of LongTail Alpha. You should not treat any opinion expressed by Dr. Bhansali as investment advice or as a recommendation to make an investment in any particular investment strategy or investment product. Dr. Bhansali’s opinions and commentaries are based upon information he considers credible, but which may not constitute research by LongTail Alpha. Dr. Bhansali does not warrant the completeness or accuracy of the information upon which his opinions or commentaries are based.