TAIL's Underperformance Explained

Summary

• TAIL is a tail risk ETF, meant to be a hedge against market declines.
• The fund is down YTD, even as equity markets tumble, underperforming relative to expectations.
• An explanation as to why follows.
• This idea was discussed in more depth with members of my private investing community, CEF/ETF Income Laboratory. Learn More »

mikkelwilliam/E+ via Getty Images

Close to a year ago I wrote about the Cambria Tail Risk ETF (BATS:TAIL), a tail risk ETF investing in S&P 500 put option and treasuries. TAIL is meant to perform as a portfolio hedge during market declines, outperforming during these. Markets are down YTD, with most equity indexes posting double-digit losses, including the S&P 500, the Nasdaq-100, and the Dow Jones index. TAIL is meant to post significant gains during periods such as this, but it has not, and is down by 5.6% instead. TAIL has underperformed relative to management and my own expectations, so thought an article explaining why this has been the case was in order.

TAIL's S&P 500 put options have performed as expected, posting significant gains as equity markets tumble. TAIL's treasury holdings have not, posting significant losses as inflation sends rates skyrocketing upwards. The fund's strategy and holdings are simply ineffective during market downturns coinciding with increased inflation, so expect further underperformance if inflation remains elevated. These issues were always apparent, but seemed minor before, as inflation had been kept under control for decades before today.

TAIL - Overview

TAIL is an ETF meant to perform as a portfolio hedge during market declines. The fund does so through investments in treasuries and S&P 500 put option. Fund holdings are as follows.

TAIL Corporate Website

TAIL's put options are a small portion of the fund's holdings, accounting for 10-15% of the same, but a significant portion of the fund's exposure / expected returns due to their (implicit) leverage. TAIL's put options give the fund the right to sell shares on the S&P 500 index for predetermined strike prices, ranging from 4400 to 4000. These options can be profitably exercised and increase in value as the S&P 500 goes down in price, as has been the case YTD. These same options increase in value as volatility increases, as heightened volatility increases the probability of further losses / price declines. Due to a combination how options are priced, market expectations, and investment choices, TAIL is able to buy many put options at comparatively low prices, meaning potential gains are quite high even though the fund only invests a small portion of its portfolio in these securities. TAIL's options have performed as expected during the recent downturn, increasing in value as equity prices tumble.

TAIL also invests quite heavily in treasuries, with these accounting for over 80% of the fund's holdings. TAIL's treasury holdings lack the (implicit) leverage of its put options, so their exposure / expected returns are lower than said 80%. Treasuries are relatively simple assets, with clear characteristics. Treasuries are issued by the U.S. Federal Government, the most credit-worthy institution in the world, and so are the safest financial asset in the world, and one with effectively zero credit risk. Treasuries are generally effective equity market hedges, as investors tend to flee towards high-quality, low-risk assets during downturns, to protect their portfolios. Government policy also matters, as the Federal Reserve tends to buy treasuries during downturns, boosting their price, lowering their interest rate, as part of its toolkit to combat recessions and depressions.

Due to the above, treasuries tend to perform exceedingly well during downturns and recessions. This was the case during 1Q2020, the onset of the coronavirus pandemic, and the most recent recession. Treasuries outperformed during said quarter, as did TAIL, as expected.

Data by YCharts

Treasuries also outperformed during 2008, during the financial crisis / housing bubble. TAIL did not exist back then so we can't analyse its performance during said time period, but considering treasury performance, and based on my knowledge and understanding of S&P 500 put options and index performance, I'm quite confident that the fund would have significantly outperformed during the crisis as well.

Data by YCharts

Treasuries tend to outperform during downturns and recessions, but there are exceptions. As mentioned previously, treasury outperformance is dependent on a flight-to-quality effect, combined with Federal Reserve policy. Treasuries might not outperform if investors refuse to buy treasuries during a downturn, or if Federal Reserve policy turns hawkish. The latter is a catalyst for the former. Hawkish Fed policy means higher interest rates. Investors tend to sell older, lower-yielding treasuries and bonds when rates rise, and use the cash proceeds to invest in newer, higher-yielding instruments.

Federal Reserve policy is currently quite hawkish, as the Fed hikes rates to combat surging inflation. Federal Reserve policy, and expectations thereof, have led to a significant bond selloff, ultimately resulting in declining bond asset prices. Treasuries have been hit particularly hard, suffering losses of about 9% YTD.

Data by YCharts

Equities have also seen declining asset prices YTD, due to bearish market sentiment, frothy valuations, surging rates, and deteriorating economic conditions. All major equity indexes are down double-digits, and counting.

Data by YCharts

As previously mentioned, in most cases when equities are down, investors buy treasuries, boosting their price. Right now, both equities and treasuries are facing significant selling pressure, due to heightened inflation rates and increased interest rates, ultimately resulting in declining prices for both asset classes.

Data by YCharts

TAIL invests in both treasuries and S&P 500 put options. The fund's treasury holdings are down, while the fund's put options are up (as equities are down). Under these conditions, the fund should be more or less flat.

TAIL is currently down by 5.6%, as treasury losses have outweighed put option gains. Still, the fund is down by only a bit, roughly consistent with the above.

Data by YCharts

From the above, it seems that TAIL's treasury holdings resulted in losses of 7.5% for the fund and its shareholders. Treasuries are down 8.8%, treasuries account for roughly 85% of the fund's holdings, so the fund's treasury holdings accounted for 8.8% * 85% = 7.5% losses. TAIL was only down 5.6%, with the difference of 5.7% being accounted for put option profits.

In any case, TAIL's treasury holdings have performed quite poorly during the recent downturn, as skyrocketing inflation causes rates to rise and bond prices to fall. TAIL's strategy is not particularly effective during inflationary downturns, an important fact for investors to consider.

As an aside, I (briefly) mentioned these issues on my previous article on TAIL. Although they didn't seem all that significant at the time, the risks were there, and readily apparent.

Conclusion

TAIL is a tail risk ETF, meant to act as a portfolio hedge during market downturns. Although the fund has its merits, it is ineffective during inflationary downturns, making it a subpar investment under current market conditions.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.