Universa’s capital risk in the “high risk” part of its portfolio is only 2 to 3 percent of its overall capital – i.e., the part it dedicates to put options to benefit off the occasional market routs.
It earned at least $3 billion from the market decline with about only $100 million in total derivatives exposure.
The payoff from the safe assets essentially fund the derivatives exposure.
Universa makes it straightforward to its clients that it doesn’t expect to generate anything in sub-average to great market environments for equities. But it expects to make a lot when the market crashes because of its highly convex exposure to big market drops.
Given most investment funds have equity beta (i.e., are long a lot of equities) and have other types of equity risk in addition (e.g., real estate, private equity, early-stage companies), adding a portion of their portfolio to a tail-risk hedging strategy could be a judicious use of capital.
It’s something unique and can provide an offset when the bulk of its portfolio doesn’t do well.
Universa is an example that received a lot of PR attention after the Covid-19 pandemic, but they are not the only ones who make use of such tail risk strategies.
Barbell portfolios – and portfolios that use barbell strategy concepts – are out there in one form or another. But they are not popular because their risk allocation is so low.
For institutional funds in particular, without a consistent low-double digit percentage return each year – or at least something that beats passive index tracking within acceptable risk parameters – it’s hard for them to scale.
The structure of a barbell portfolio
Traders who take the barbell portfolio approach structure the portfolio in a way where there’s a dichotomy between “high risk” and “low risk” and little, if anything, in between:
You see some combination of:
i) a small allocation toward nonlinear, high convexity bets on one end that don’t lose much if they don’t pan out but can make a lot if they do, and
ii) a larger allocation toward assets that have less volatility and lower yields that provide low, stable returns
Because the types of bets are so different from each other from a risk and potential return perspective – virtually on opposite ends of a spectrum – this gives rise to the name barbell portfolio.
You have allocations on each side of the risk/return spectrum, giving it a dichotomous weighting.
As an example of what could be considered on each end of the barbell:
While Universa uses put options as part of its “high risk” basket, it doesn’t have to be puts.
It can be virtually anything that gives high return potential but a high likelihood of either not panning out or simply having a lot of risk or price volatility.
This can mean things like:
– Highly speculative stocks
– Very early-stage ventures, perhaps even pre-revenue companies
– Any type of derivative structure with a low likelihood of winning
If traders risk 2 to 3 percent of their portfolios per year on the highly convex, asymmetric payout bets and return that 2 to 3 percent on the “safe bets” then in an otherwise normal year the portfolio will remain steady.
The returns on the safe bets effectively pay for the losses on the long-shot bets.
It’s not going to be the most exciting portfolio most of the time and you won’t see much growth.
But every now and then, maybe every 10 years, this type of portfolio can see great returns of three-digit or even four-digit percentage gains in one year.
Many institutional investors that look for something different from what they have can benefit if they deem that it helps them manage risk or enhance returns more effectively.
Barbell concepts for non-barbell traders
Hedging tail risk prudently is important for every trader.
Ideally hedging should be done in a way where the benefits outweigh the costs.
Because of the volatility risk premium where options are structurally expensive (similar to standard insurance policies issued by private insurance businesses so they have a profit and a sustainable business), perpetual hedging is a long-run drag on performance.
When hedging tail risk with a focus on value, preparing for an economic and market bruising makes sense when justified. Namely, when volatility is cheap such that it makes sense when making the bet.
How do we know when volatility is cheap?
An easy way is to look at the historic realized volatility of whatever you’re trading and compare that to the implied volatility going forward.
Almost all brokers have an implied volatility calculator within an options chain, often shown as ‘IV’ followed by an annual percentage.
For example, the historical volatility of the S&P 500 is about 15 to 16 percent annualized. In the example below, implied volatility is about 22 percent, making it more expensive than normal.
(Source: Interactive Brokers)
Some brokers even show implied volatility across all strike prices of a certain maturity.
Implied volatility is not static across all strikes.
With respect to stocks, traders have more demand for downside protection to protect against losses, making puts generally more expensive than calls. This reflects in a volatility skew, where put option IVs tend to be higher than call option IVs.
(Source: Interactive Brokers ‘Implied Volatility Viewer’)
At the same time, while historic volatility can be a good guide of how an asset is likely to act, the future is not always like the past.
Because of this lower volatility in interest rates of both the short- and long-term variety, this also cuts down on currency volatility as well.
Price dynamics of barbell portfolios
Barbell portfolios are designed to help get ahead during downturns and mostly tread water during good periods.
Many traders and institutions believe that a portfolio should be fully invested all the time. Universa’s approach is that only a slight part of the portfolio is invested in the convex bets with the remainder in the safer lower-yield assets.
For most investors that type of approach doesn’t work as they’re likely to face years or a decade or more of no capital appreciation.
But barbell portfolios fulfill a niche in the market. Every investment manager looking to take on outside clients has to differentiate in some way.
Being fully invested is generally good for investment firms in order to generate fees, but it isn’t necessarily the best for clients.
With the barbell portfolio, the main consideration isn’t necessarily between earning very little to nothing in cash or cash-like securities and earning something a bit better in standard bond and stock investments.
This is the standard trade-off made in conventional portfolios.
Instead of “opposing extremes” asset allocation is viewed on a continuum in terms of how much to allocate to cash, bonds, and stocks, examining the reward and risk of each in both absolute terms and relative to each other.
Instead, for a barbell portfolio strategy, it’s about the optionality of the cash.
In other words, how much it can earn you if assets become cheap enough versus the potential cost of holding them at more expensive levels.
But having a lot of cash and cash-like assets is not popular among investment managers because it’s not good for business.
People don’t want to pay management fees just to have their cash lay around not being used.
People are naturally impatient. While most sophisticated clients – e.g., pension funds, sovereign wealth funds, endowments – have healthy expectations, they still want to see results to stay onboard.
It’s not an easy argument to make that they should sit out present gains for the prospect of future gains that may not transpire. It’s the standard conundrum of the value investor who prefers to mostly sit out expensive markets only to see them zoom higher most of the time.
Most investment managers can’t have a barbell portfolio strategy – in the sense of a heavy concentration in very safe assets – and expect their business to thrive.
Universa is unique, but it also doesn’t have a lot of money allocated to it – at least pre-Covid – for a reason. Few clients are willing to see no gains year after year.
One’s fiduciary duty is to nonetheless do what’s best for clients, even if that does lead to a smaller client base.
Those that are willing to allocate to a tail risk hedging fund will likely only do so in a small quantity to help balance out their equity risk.
Other types of barbell portfolios
Barbell strategies often refer to fixed income portfolios.
Part of the portfolio might be in longer duration securities (e.g., longer than 10 years) that give higher yields while the other part might be in shorter duration securities (e.g., less than five years) that are more stable in price.
But the barbell can mean many different approaches.
It could be as basic as a stocks and bonds dichotomy, such as a 60/40 or 50/50 portfolio.
The weightings can also move around as necessary to help accomplish certain objectives.
The barbell portfolio attempts to provide diversification in such a way to get access to both safe yields and riskier assets (that can provide higher yields) at the same time.
Many portfolios do this, but don’t have a distinct dichotomy between the two.
In a fixed income context, the short-term yields can take advantage of current interest rates while also holding longer duration securities that pay higher yields.
If interest rates were to rise, the shorter duration bonds won’t have as much price risk and can be rolled into new bonds that offer the higher yields.
The barbell strategy is a more active form of trading, whether it be due to the shorter duration nature of some securities and the rolling over process, monitoring the riskier part of a portfolio, or otherwise.
As in Universa’s case, the barbell strategy enables a portfolio to earn returns safely to help effectively fund a riskier part of the portfolio.
It uses cash and bonds to fund the put option part of the portfolio. The liquidity associated with cash and bonds also provide flexibility if one wants to more actively manage a portfolio.
A barbell manager might have the goal to at least return the rate of inflation to avoid losing purchasing power over time.
To do this, the portfolio might invest in inflation-protected bonds and a mix of other securities to get to the inflation rate plus any additional return required to fund the higher risk portion of a portfolio (e.g., OTM options).
Risks of the barbell portfolio strategy
Interest rate risk
The traditional barbell portfolio of long duration bonds and short duration bonds has interest rate risk.
When interest rates rise, bond prices fall, and more so for long duration bonds. A trader may end up getting stuck with 10+ year duration securities that yield less than safer shorter term instruments had they been purchased when yields were lower.
Either the trader might sell the bond and realize a loss or bank on the bonds performing better going forward.
Portfolios with a lot of nominal rate bonds face risks of inflation.
Most bonds are fixed-rate in nature. If a bond yields one percent and inflation is three percent, the trader has a real yield of minus-two percent.
Missing out on ‘stuff in the middle’
A barbell portfolio will invest in a mix of low-risk and high-risk assets with little to no allocation toward middle-of-the-road assets like safe stocks, moderate-quality bonds, and so on.
There is a time when these types of assets will outperform in absolute and relative terms. Diversifying broadly and not just on each end of the spectrum can help improve risk-adjusted returns.
A portfolio that invests heavily or exclusively in mid-duration or moderate risk assets is called a bullet portfolio.
Reinvestment risk occurs when bonds are maturing and the yields of new debt are lower than the ones that just returned their principal.
In a low interest rate world, this is a reality for many investors. Before the financial crisis, they may have gotten 5 percent yields in safe government debt. Now they look across the yield curve and see yields of one percent or even negative nominal yields.
That leaves a lack of viable replacement securities to choose from. That means traders must look into riskier securities that have more credit risk or longer duration, or pursue riskier strategies to generate they yield they’d like.
The Barbell Portfolio Strategy in a Low Interest Rate World
The Black-Scholes model predicts that put options are less expensive when interest rates are high.
This makes sense given any drop in earnings that can cause stocks to fall can normally be “caught” by cutting interest rates.
In a low interest rate world, that process no longer normally works as designed. Put options become more expensive with less ability to offset drops in earnings with lower interest rates. That puts a premium on put protection.
Moreover, when interest rates are high, this enables barbell strategies to function well for those who rely on investing in cash and bonds to bankroll the riskier part of the portfolio.
When interest rates fall, this squeezes the barbell portfolio strategy’s potential margins on both sides.
The safe part of the portfolio returns less and the risky part of the portfolio either becomes more expensive (e.g., put options) and/or riskier. Speculative stocks are even more expensive than normal because they’re discounted at lower interest rates and more people pile into them without much yield in other securities.
Accordingly, one might expect the barbell strategy practitioners to adapt during these periods. The safe part of the portfolio might have to become riskier. Or else accept mild losses most years.
It may have to include bonds and other securities of lower creditworthiness or longer duration. These have more price risk and volatility. The investment manager might also have a lower allocation to the riskier side of the portfolio.