Q1 2022

ir@qvradvisors.com
www.qvradvisors.com

Common Hedging Discussions Part 2:

Tail Hedging Return Myth Debunked
In a prior note from Q3 2020, we made the case for considering tail hedging in a long-term asset allocation
framework. In that original piece, we outlined how a tail hedge can potentially have a net positive impact on the
long-term compound rate of return of an asset pool, despite that hedge line item losing money over time on its
own. We contrast this with popular “defensive equity” approaches that involve option selling, which have
detracted from long-term asset pool returns, because they are highly correlated with equities in market crashes,
while tail hedges are highly inversely correlated.

Many people focus heavily on individual line items and are not used to thinking about portfolio
interactions, finding this extremely counterintuitive.

We cannot count the number of times we’ve heard:

“but hedges lose money over time, so a long-term-focused investor should never hedge.”

In this Common Hedging Discussions Part 2, we seek to debunk the myth associated with long-term, strategic
tail hedging programs being detractors from long-term portfolio performance.
 BENCHMARK ROLLING OPTION HEDGES

Figure 1 illustrates the historical simulated mid-market performance of a variety of simple rolling delta-neutral
put hedges on the S&P 500. For each version, the options are rolled quarterly, targeting new options closest to
the stated delta (20 or 30) and maturity (6 months to 2 years). Cumulative performance is shown as a % of
target notional. The interpretation is (for example) that the simulated 6-month 30-delta rolling put strategy
generated roughly 8% of notional in performance at peak during the 2020 pandemic crash, such that an equity
portfolio protected 100% notionally would have experienced a 26% peak-to-trough drawdown instead of 34%.
Positions are dynamically delta hedged. This is important. The purpose of a tail hedge is to add convexity (large
protective benefit in extreme market moves), not to reduce asset allocation targets for equity. Buying outright put
options against an equity portfolio has the effect of lowering the effective equity allocation. A target 60% equity
/40% fixed income portfolio where the equity exposure is notionally hedged with outright 30-delta puts will only
have a 60% * (1 – 30%) = 42% equity exposure on rebalance dates. In contrast, a delta-neutral hedge overlay
does not change average equity exposure. If an asset owner desires less equity exposure on average, they
can just cut their equity target weights. The purpose of tail hedges is to allow asset owners to maintain
equity exposure while reducing left tail risk and potentially improving long-term compound returns.

Figure 1. Performance of various benchmark rolling option hedges,

Importantly, note that all these
with delta hedging
simple rolling hedges lose
money on average over the
sample period, despite three
large crises (the 2002 tech
bust, the 2008 credit crisis,
and the 2020 pandemic)
along with a variety of
moderate ones. This is
expected. The purpose of the
prior note was to remind the
reader that the stand-alone
returns of one component
of a portfolio does not
provide enough information
to judge the contribution of
that component to the
overall portfolio. In our
experience, most people know
this to be true conceptually,
but significantly underestimate
its importance in practice, and
Notes: Rolled quarterly, targeting new options closest to stated delta and maturity, skew do not have good analytics for
delta neutral, rehedged daily. Targeting a constant gross dollar notional size. evaluating it.
Performance shown as a % of target notional. Pricing at mid-market (no transaction
costs) for illustration. Past performance is not a guarantee of future results.
1In particular, positions are hedged skew delta neutral (or “floating strike delta neutral”). Given that the S&P 500 implied volatility
surface is always downward sloping as a function of strike within the relevant range, this means a smaller amount of delta bought 2
against a put, as compared to Black-Scholes. Delta-neutral put options hedged on a Black-Scholes delta would have a higher
positive drift than Figure 1 and would experience smaller gains in market selloffs.
ASSET ALLOCATION PERFORMANCE WITH
ROLLING OPTION HEDGES
Figure 2. Simplified asset allocation framework, 60/40, various Now we apply the various
benchmark rolling hedges benchmark rolling hedges above
to a standard asset allocation
exercise. This works as follows.
We take a standard 60% equity
(Russell 3000 Index) / 40% fixed
income (Lehman Brothers
Aggregate Bond Index) asset
allocation. For the hedge overlay,
we set the notional size target to
100% of equity exposure, and
fund option premium at the risk-
free rate (rather than reducing
other exposures). This is slightly
different from the analysis in our
2020 note, which targeted option
premium, because with a constant
notional target it is easier to
ensure comparability between a
wide variety of different option
hedge structures with different
moneyness and tenor. We
implement quarterly rebalancing
of the asset allocation back to
target weights. We do so on six
different schedules spaced out by
two weeks to mitigate rebalance
timing luck.

Notes: asset allocation with 60% weight on Russell 3000 Index
and 40% weight on Lehman Brothers Aggregate Bond Index.
Tail hedge overlays use the strategy indices described in Figure
2, with target notional equal to 100% of target equity exposure,
and long option premium is financed at the risk-free rate.
Quarterly rebalancing of the asset allocation back to target
weights on six different two-week intervals (results averaged
across rebalance schedules to mitigate rebalance timing luck).
Pricing at mid-market (no transaction costs) for illustration. Past
performance is not a guarantee of future results.
2This does have some substantive implications; in particular, it means less
Figure 2 shows the results in terms of simulated
growth of the NAV of the asset pool over time. Note
how hedges sharply cut losses in 2008 and 2020,
experiencing modest decay relative to unhedged
60/40 during long periods of quiet. As described in
our Q3 2020 note, five out of the six simple
benchmark hedges result in a higher simulated
total portfolio return over the period, despite the
hedges losing money on a stand-alone basis.

implicit “hedge timing” coming from larger notional positions when implied 3
volatility is low.
Table 1 summarizes these results. In terms of risk, clearly the hedged versions of the asset allocation are more
stable, experiencing mid-9% annualized realized volatility versus 11% unhedged, and around 30% max
drawdown versus almost 40% unhedged. This is not surprising and is the part that most hedging discussions
focus on.

The more interesting thing is the differences in compound rate of return. The ICCRR (incremental contribution to
compound rate of return) in the second column is the impact of each simple benchmark hedge on portfolio CRR.
Five out of six ICCRR’s are positive, ranging from +0.11% basis points to +0.50%; only the 6-month 30-delta put is
negative, at –0.14%. By adding a negative-performing line item to a rebalanced asset allocation, in these cases we are
seeing higher simulated long-term rates of return from the overall asset allocation over the 2002-22, because that line
item tends to be up big at the same time the core portfolio is down big.

The impact of tail hedges on an

Table 1. Summary results for asset allocation framework, 60/40, asset pool’s long-term
various benchmark rolling hedges compound rate of return
depends on the weight of equity
and equity-like risk assets in the
portfolio. In the last few years,
the forward-looking returns on
fixed income exposures fell with
low or negative real yields,
rising inflation and prospective
interest rate hikes. In response,
many asset owners are cutting
fixed income allocations in
Notes: same as Figure 2. favor of larger private equity
Table 2. Simplified asset allocation framework, 90/10, various benchmark and venture capital exposures.
rolling hedges Many large institutional
portfolios are nowhere close to
60/40 anymore. The more
equity-oriented an asset
allocation is, the more powerful
the portfolio benefits of hedges.

Table 2 illustrates the summary

statistics for a more aggressive
Notes: identical to that described in Figure 1 except with 90% target asset allocation 90% equity, 10% fixed income
weight on Russell 3000 Index and 10% on Lehman Aggregate Bond Index. asset allocation. Note that the
unhedged compound rate of return for 90/10 is only modestly higher than 60/40 (6.85% vs 6.22%) with much larger
max drawdowns (-55.4% versus -38.9%). The same dynamics are at work here; fixed income’s diversification benefits
during crisis were quite strong over the past two decades.

Our six benchmark rolling hedges have significantly higher ICCRR for the 90/10 portfolio as compared to 60/40. Five out
of the six have positive ICCRR, with the 6-month 30-delta put still negative but -0.04% versus -0.11% for 60/40, and the
others ranging from +0.35% to +0.93%. The hedge benefits in most cases are roughly twice as large.

4
COMPARISON TO “DEFENSIVE EQUITY’ OPTION
SELLING APPROACHES
Some common views among asset consultants is:
“Option selling as equity replacement is a preferable alternative to hedging. Option selling is
more efficient since call write and put write strategies have positive expected return over time
but are less volatile than ordinary equity exposure.”

Or restated as:
“Options are systematically overpriced, instead of buying tail hedges, we prefer to replace
equity exposure with cash-secured puts or overwrite calls in order to buffer downside risk and
generate income.”

Below we consider four common Cboe benchmark indices for option selling as equity replacement:
 BXM: call overwriting
 BXMD: out of the money call overwriting
 PUT: cash-secured put selling
 CNDR: iron condor (put spread and call spread) selling

The first two, BXM and BXMD, are long equity exposures with option selling overlays. BXM is the most popular
S&P 500 call overwriting benchmark. BXMD is a variation on BXM where the options sold are out of the money
30-delta calls instead of near the money calls. PUT is a cash-secured put selling benchmark. CNDR is an iron
condor selling strategy that sells call spreads and put spreads and is the only one of the four which is delta
neutral on option roll dates, relying only on volatility risk premium and not on equity exposure to generate
returns over time.
Figure 3. Simplified asset allocation framework, 60/40, with and Figure 3/Table 3 illustrates how performance
without option selling partially substituting for equity exposure for the 60/40 asset allocation compares to
versions which substitute a third (20
percentage points) of their ordinary equity
exposure for option selling. Long-term returns
are lower across the board. Risk metrics are
lower, as the proponents of these strategies
suggest, with max drawdowns down from 39%

Notes: benchmark (blue line) is asset allocation with 60%

weight on Russell 3000 Index and 40% weight on
Lehman Brothers Aggregate Bond Index. Then we
individually recalculate the performance of the asset
allocation substituting 20 percentage points of equity
exposure for option selling programs represented by the
Cboe BXM, BXMD, PUT and CNDR indexes. Quarterly
rebalancing of the asset allocation back to target weights.
Pricing at mid-market (no transaction costs) for
illustration. Past performance is not a guarantee of future
results.
to the 27-35% range. Particularly during 2008 these benefits were evident as option selling performed relatively
well during the protracted drawdown and steady recovery. However, the long-term CRRs are materially lower
than the benchmark 60/40, ranging from –0.32% to –0.68% for versions including call and put write to –1.24%
for the version including iron condor selling.

These results are as expected and the asset consultants who promote defensive equity strategies would say that
the lower returns are an intentional tradeoff against risk reduction. However, volatility selling strategies as
equity replacement offer some path diversification, but not outright risk reduction in all types of paths.
An option selling strategy is not inherently risk-reducing: a cash-secured put selling strategy has the
same exposure as outright equities in a sharp market selloff. Option selling strategies are short convexity
(loses money at a faster rate the worse things get), not long convexity like a tail hedge. As a result, while they
may make money over time on a standalone basis, they are potentially less additive from an overall portfolio
perspective to an already equity-heavy asset allocation.

Table 3. Summary results for asset allocation framework, 60/40 There are market environments
with and without option selling partially substituting for equity exposure in which option selling
strategies have historically
generated equity-like returns or
better with lower volatility and
downside capture. When
option flows from end users are
skewed to buy and risk
premiums are high, such as
2001-05 and 2009-12, this is
Notes: For illustrative purposes only. Past performance is not a guarantee of future results. apparent.
As shown in Table 4, during 2013-20 when option selling strategies were very popular, and markets tended to
crash quickly on high volatility and bounce back quickly, returns in option selling strategies fell dramatically
relative to simple equity exposure. The potential risk reduction benefits from option selling strategies as equity
replacement come in a slower selloff where elevated risk premium captured over time helps to materially offset
losses on exposure. We discuss this and a lot more in our 2021 paper, Common VRP Discussions.

Table 4. Comparison of S&P total returns to Cboe BXM and PUT, pre and post 2012/13

Notes: 1990 to March 11th 2022. For illustrative purposes only. Past performance is not a guarantee of future results.

6
 REBALANCING AND MONETIZATION

All the results above depend importantly on regular rebalancing as part of asset allocation and portfolio
construction. That means regularly replenishing hedge budgets during normal market conditions and then
steadily monetizing hedges during periods of extreme market stress.
There are various approaches to this. The simple assumptions used for our analysis are purely calendar driven,
with quarterly rebalancing of the entire asset allocation back to target weights. This raises the quantitatively
important issue of rebalance timing luck, especially given the possibility of rapid crises and recoveries like
March 2020. One rebalancing calendar might miss most of a large market drawdown and a volatility spike and
only rebalance after the rebound; another might rebalance right at the bottom. Figure 4 illustrates the impact of
rebalance timing luck over a long horizon, with quarterly rebalancing on six different cycles offset by two-week
increments. Our results shown above average across these cycles, effectively assuming small partial rebalances
regularly. This may not be practical for a large asset owner across their whole portfolio but can be
approximately implemented via overlays.
Figure 4. Rebalance timing impact: comparison for 1-year 20-delta rolling put hedge For tail hedges
specifically, it may
make sense to have
explicit rebalancing or
monetization triggers
based on market
moves and not just the
passage of time. The
key here is in striking
the right balance
between the desire to
capture gains and the
need to deliver
outsized performance
in times of crisis. Tail
hedges are by nature
highly convex,
providing much more
incremental benefit
when equities fall to –
30% below the highs
from –20% below
versus when they fall
Notes: For illustrative purposes only. Past performance is not a guarantee of future results.
the first 10% from the
highs. And the contribution of tail hedges to long-term portfolio performance comes from delivering outsized
gains when core portfolios are getting wrecked. So, selling those hedges too early is self-defeating.

3See Hoffstein et al (2020) https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3673910 7

 Figure 5 illustrates this by plotting the cumulative performance of a rolling 3-month variance swap position on
the S&P 500 through 1H 2020 along with various exit triggers that might have been struck based on historical
performance during previous market stress events.

Figure 5. Beware the temptation to monetize too early

We often relate the story of the
(reproduced from QVR Q1 2020 letter)
largest participant in the VIX
options complex, an asset
manager that volatility traders
termed 50 Cent because of its
hedging strategy of buying front-
month VIX calls targeting the
contracts with a price around
$0.50. That asset manager had
experienced several smaller stress
events like February 2018 where
its VIX calls performed very well
briefly but retraced all its gains.
During late February and early
March 2020, they aggressively
liquidated their hedge portfolio for
a decent gain, with the front
month futures (the underlying for
their call options) trading in the 25-30 range. Two weeks later those futures hit 80+. The hedging program
made a small fraction of what it could have at peak. Meanwhile, the scale of the selling pressure was pushing
the underlying March 2020 VIX futures below theoretical arbitrage boundaries with respect to the S&P 500
volatility surface.
Three points here:
1) Market-conditions-based monetization strategies should be incremental based on a ladder of triggers, rather than
binary. There is no set of data points that are reliably predictive of the scale of a selloff or how much further it
could go that gives an asset owner high confidence in what is to come. Avoid over-fitting mental models to
inherently small samples of historical crises.
2) Monetization strategies should be simple enough to track easily but also price dependent. There are scenarios in
which markets are very stressed, but option prices have not risen enough to be very expensive relative to extreme
realized volatility. In such cases, simply buying synthetic equity exposure against tail hedges may be the best
decision. Keep in mind the story of 50 Cent; know if the thing that you own and are trying to sell is extraordinarily
cheap (possibly because you’re trying to sell so much of it into a dislocated market!). In other cases, option prices
may have risen very excessively relative to the equity market selloff, and it is better to sell the core hedge
positions. 2011-12 was a great example of this with the extreme bid for long-term equity index volatility.
3) Ideally, monetization strategies should be framed in advance to coordinate expectations and mitigate behavioral
biases. That does not mean they have to be mechanical – every crisis is different, and a large asset owner may
find themselves putting on large opportunistic trades in very dislocated markets and wanting to keep more of their
hedges than the otherwise would. But managers and clients should be on the same page about the expected
approach to monetization and triggers set out in advance should raise decision points. Otherwise, it is too easy to
act like a deer gazing into headlights.
8
 STRATEGIC OWNERSHIP

Tail hedging programs most commonly fail because an organization is unable to view the asset allocation as a
whole. When an individual portfolio manager is delegated ownership of the hedge line item, and the
organization focuses on the stand-alone performance of the hedge line item as if it is an ordinary fund
investment, this inevitably leads to hedge fatigue and to poor decision making around rebalancing and
monetization. Organizations that are able to effectively deploy tail hedging programs have buy-in at the very
top, and the tail hedging program should be viewed in conjunction with the asset base it is hedging. In
such organizations, the asset allocation and portfolio construction function owns hedging and rebalancing, and
they utilize analytics for attributing the portfolio-level benefits on both a realized basis and a simulated what-if
stress scenario basis, offering deep-dive educational sessions to boards and other people in governance
positions.

TAKEAWAYS

 If an asset owner desires less equity exposure on average, they can just cut their equity target weights. The
purpose of tail hedges is to allow asset owners to maintain equity exposure while reducing left tail risk and
potentially improving long-term compound returns.

 The stand-alone returns of one component of a portfolio does not provide enough information to judge
the contribution of that component to the overall portfolio.

 Typically, we see higher simulated total portfolio return over any given period, despite the hedges losing
money on a stand-alone basis.

 The ICCRR (incremental contribution to compound rate of return) is the impact of each simple benchmark
hedge on portfolio CRR.

 Tail hedging program should be viewed in conjunction with the asset base it is hedging.

9
 APPENDIX

REVISITING WHY LONG-TERM PORTFOLIO RETURNS CAN BENEFIT FROM PROTECTION

Since so many people find this counterintuitive, lets review the mathematical intuition. As discussed in our 2020
note, the key thing is that the long-term growth rate of an asset pool is not in some sense a weighted average of
the individual contributions of its components. There is an important and powerful interaction effect among the
components of a portfolio. If some components tend to perform very well during the time periods when the
overall portfolio is experiencing drawdowns, then their presence in the portfolio results in smaller drawdowns
during times of stress and higher exposures to risk assets during recovery periods when those risk assets
experience high returns.

Take a simple two-asset example, with assets i and j, where the per-period asset returns are given by 𝑟 and 𝑟 ,
and portfolio weights are 𝑤 and 𝑤 . We can write the value of the total portfolio at some future date T as the
following product:

The compound rate of return of the overall portfolio is:

2 CRR = ln(𝑅 /𝑅 )/𝑇 = 1/𝑇 ln 1 + 𝑤 𝑟 + 𝑤 𝑟

Using a second-order Taylor expansion (which is exactly true in the case of normally distributed asset returns),
the mathematical expectation of the compound rate of return is approximately:

𝑣𝑎𝑟 𝑤 𝑟 + 𝑤 𝑟
3 𝐸 𝐶𝑅𝑅 ≅ 𝑤 𝐸 𝑟 +𝑤𝐸 𝑟 −
2 1+𝑤𝐸 𝑟 +𝑤𝐸 𝑟

𝑤 𝑣𝑎𝑟(𝑟 ) + 𝑤 𝑣𝑎𝑟(𝑟 ) + 2𝑤 𝑤 𝑐𝑜𝑣(𝑟 , 𝑟 )

= 𝑤 𝐸[𝑟 ] + 𝑤 𝐸[𝑟 ] −
2(1 + 𝑤 𝐸 𝑟 +𝑤𝐸 𝑟 )

The covariance effect in the numerator of the third term penalizes co-movement between the two assets.
Holding expected returns of each individual asset the same, lower covariance among the assets in a portfolio,
results in smaller drawdowns and higher compound rates of return.

Of course, in practice there is a tradeoff between expected returns and covariances – hedges should generally
have negative expected return, and in perfectly efficient, perfect-information academic markets, it would all be
priced in. But what we are trying to illustrate here is simply that negative expected returns on a stand-alone basis
does not imply negative contribution to overall portfolio compound rate of return; similarly, positive expected
returns on a stand-alone basis does not imply positive contribution. How efficient a tail hedging strategy might
be in augmenting long-term asset allocation is an empirical question and a question about market pricing and
flows.

10
 APPENDIX

OPTION SELLING FOR “ENTRY AND EXIT”

Above we covered defensive equity and primarily iron condors as the other option selling approaches. We’d like
to revisit option selling for “entry and exit” and also for “income”. Select excerpts from Common VRP
Discussions – Q2 2021 are included here to round out most all topics that would arise in this discussion.

It is very common to see option selling strategies pitched as overlays for implementing entry and exit triggers for
an equity position.

“You would love to buy the stock 10% below where its currently trading, so just sell the 90% put,
it acts like a limit order down 10%.”

“You’d want to sell the stock 5% higher, so why not sell the 105% call?”

This framing is misleading and problematic, leading to clients not understanding what option selling
strategies are and what determines their performance.
Option positions are inherently asymmetric. A long option holder’s gain can potentially be quite large, but
their loss is limited to the premium paid. Conversely, the most an option seller can make is the premium, but
their loss is potentially quite large. See Figure 1 for a simple example of a 3-month 90% put with an implied volatility
of 20%, corresponding to an initial option price of 0.71%.

Figure 1 from note. Payoff, mark to market PNL and equity exposure on a short put option

Notes: example 3-month put option with strike 90% of spot, implied volatility 20%.

The equity exposure of an option (or its “delta”) comes from a probabilistic assessment of how likely it is to end
up in the money at expiration. This is the slope of the blue line in the top pane of Figure 1, which corresponds
to the green line in the bottom pane. Note that, for the hypothetical short put option position, the equity
exposure rises as the equity price falls. This is why you hear things like “selling a put is like planning to buy the
dip”. 11
 APPENDIX

OPTION SELLING FOR “INCOME”

Another very common story we hear especially in pitches to retail investors:

“Covered call selling uses an investor’s equity position to generate income. By selling a call worth 1%
every month, for example, the investor adds a 12% yield.”

This is again highly misleading. It is even too much for Morningstar, which felt to comment on it in 2013 given
the slew of option selling mutual funds hitting the market.

See here: https://www.morningstar.com/articles/612677/option-selling-is-not-income

Common VRP Discussions can be found here: https://www.qvradvisors.com/media

12
QVR IN THE MEDIA – Recent in 2021-2022
January 2022 – Resolve Riffs:
https://www.toptradersunplugged.com/podcast/vol06-finding-true-value-in-the-world-of-volatility-ft-benn-eifert-january-5th-2022/

September 2021 – Resolve Riffs:

https://www.youtube.com/watch?v=amw8-7ygE3o

July 2021 - The BIP Show – S3 E8:

https://play.acast.com/s/the-bip-show/benn-eifert-equity-derivatives

May 2021 – BloombergTV – AMC Becomes the Latest Meme Stock of the Day
https://www.bloomberg.com/news/videos/2021-05-28/amc-becomes-latest-meme-stock-of-the-day-video

March 2021 – BloombergTV – QVR Advisors CIO Says Movement Back to Trading
Commissions ‘Hard to See’: https://www.bloomberg.com/news/videos/2021-03-27/qvr-advisors-cio-on-retail-trading-etfs-vix-video

February 2021 - Bloomberg Odd Lots – How Retail Traders Rocked Markets Like Never
Before: https://www.bloomberg.com/news/audio/2021-02-02/how-retail-traders-rocked-markets-like-never-before-podcast

February 2021 - The Alpha Exchange - Episode 58:

https://alphaexchange.simplecast.com/episodes/benn-eifert-founder-and-cio-qvr-advisors-tomr0enl
13
Disclaimer
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