200219 bondsM

Tail-hedging with market makers

Equities 10 minutes to read
Peter Garnry

Head of Equity Strategy

Summary:  Tail-hedging using put options is expensive and impacts the long-term expected return too much relative to their effect on the portfolio during volatile periods. Put option strategies can be improved if they are actively managed instead of holding options to maturity, but this approach makes things more complicated. Trend-following strategies can be used with some success and are liquid, but they are mostly for the institutional investor. Long volatility through VIX futures is also an option but the curvature of the VIX futures curve creates a sizeable negative carry on the portfolio. We propose instead a novel approach using publicly listed market makers which exhibit tail-hedging capabilities but without the negative carry.

Most retail investors are heavily exposed to equities because of accessibility, it is cheap to trade equities, and it is an asset class most investors understand. Or at least we know the companies and can create simple, and sometimes powerful, heuristics about these companies based on the changes in society we observe or products we engage with (think green transformation or your iPhone device).

But occasionally the equity market experience a drawdown from peak to bottom of somewhere between 30-50% depending on the nature of the recession (2000-2001), financial crisis (2008), or exogenous shocks (the 2020 pandemic). Most retail investors are not designing fancy portfolios using correlation structures and portfolio optimization. Position concentration is often high and specific themes have a high exposure. This often leads to larger drawdowns than the equity market also called high beta (the portfolio falls and rises more than the market) leading to severe tail-risk losses (often defined as the portfolio’s average return in the 5% worst trading days). Like insurance on your house in case of a fire, would it not be smart to limit the losses of a financial fire?

Trend-following, complex option strategies, and long VIX futures

Smart investors have written many papers on this subject. As AQR notes in their Tail-Hedging Strategies paper from Q4 2012, the typical hedging method is buying put options on the equity market which gives the investor the right to sell an equity index or a stock at a predefined price (called the strike price), which means that if the equity market falls you can then sell the instrument at the higher agreed price and make a profit which will offset some of the losses in your main long position (a portfolio of equities). This option is like a typical insurance on your house and cost a premium. This premium is often high and constantly buying insurance against losses in your equity portfolio leads to a negative expected return (also called a negative carry). AQR argues in their paper that a constant buying of put options is inefficient and investors end up with an inferior return stream. They propose that investors hedge portfolio by engaging in trend-following strategies which is essentially buying assets that are going up or have recently broken higher beyond a recent high price.

Ari Bergmann says in this Institutional Investor article from July 2020 that many in the tail-hedging industry are their own worst enemy because they set up strategies with a negative expected return and a few times deliver a big return. These return streams are difficult for pension funds to accept and ironically the California Public Employees’ Retirement System liquidated its tail-hedging position with Universa Investments in January 2020 just before the position would have netted a $1bn during the market crash in February and March 2020 due to the unfolding pandemic.

In a research paper, Corey Hoffstein CIO at Newfound Research argues that options strategies for hedging the tail-risk in portfolio can work if they are managed more actively instead of the option positions being held to maturity. Another way to tail-hedging the portfolio is the one used in our CIO Steen Jakobsen’s 100-year portfolio where the hedging is done being long VIX futures a bit out on the VIX futures curve. It sound complicated but essentially it means that if equities plunge then the VIX (an index measuring the implied volatility on the S&P 500 based on underlying options prices) goes up and the investor profits on the long VIX position; in other words the investor is long volatility because the position benefits from volatility increasing and equities falling. But this strategy has a negative expected return as with buying put options causing it to be a drag portfolio returns.

Market makers are naturally tail-hedging with positive drift

There is a completely different option to investors. In recent years two pure market makers have been listed; Virtu Financial in the US and Flow Traders in the Netherlands. Virtu and Flow Traders are among the largest market makers in their respective markets and thus offer a broad-based exposure to many asset classes and thus volatility profiles. A market maker is a financial technology firm that quotes a bid-offer spread on any instrument and thus providing liquidity to investors. In terms of financial stress bid-offer spreads widen dramatically increasing profits for astute market makers. Virtu made $1.38bn in operating income in 2020 up from $121mn in 2019 showing the upside potential for market makers when markets become very volatile. Market makers are thus benefitting when volatility goes cross-asset making it a good “insurance asset” to consider tail-hedging the portfolio.

As the performance table shows adding market makers as tail-hedging, in this case 10% and 20% of the portfolio, improves the annualized Sharpe ratio. Adding 10% exposure to market makers improve the Sharpe ratio from 0.79 to 0.98 which is an improvement of 24%, and it also increases the annualized return from 5.9% to 6.8% while reducing the worst monthly return from -7.9% to -5.3%. Adding 20% exposure to market maker reduces the Sharpe ratio a bit but improves the annualized return to 7.8% and the worst monthly return to only -3.7%. We also looked at hedging a market equity portfolio consisting of the MSCI World. Here a 20% exposure to market makers improves the Sharpe ratio from 1.01 to 1.18, a 17% improvement in risk-adjusted returns, and reduces the worst monthly return from -13.2% to -6.9% while maintaining the annualized return.


The return stream from a 50/50 portfolio of Virtu Financial and Flow Traders has a -0.18 correlation with the MSCI World and even more negative correlation during the worst return days for equities creating significant improvement in terms of hedging compared to bonds. Virtu and Flow Traders have had annualized total return of 9% and 8% during the period May 2016 to July 2021 underscoring the underlying positive carry. We have not seen any research or academic papers discussing market makers as a tail-hedging strategy that eliminates the negative carry from typical portfolio insurance strategies. We hope our idea can spark other market participants to look into this tail-hedging strategy.

Our analysis starts in May 2016 because that was when we launched our BlackRock portfolios in our SaxoSelect offering which is automated portfolio strategies based on your risk profile. The short period of course limits the scope of our analysis and it would be good to have data during the financial crisis and the euro crisis. In this analysis we have also only looked at a static approach with a fixed exposure profile. Another approach could be to estimate the 5% worst daily returns in the portfolio or the MSCI World using some lookback window and estimate would the market maker exposure should to neutralize the left-tail, or minimize the left-tail of returns subject to some minimum expected return. The biggest drawdown of using market makers as tail-hedging is that we cannot be certain that publicly available market makers will exist in the future as they could go out of business or get acquired.

The beauty of using market makers as tail-hedging strategy is that the overall volume in financial markets increases over time and thus the underlying basis income during normal volatility levels go up for the entire market making industry. Assuming that Virtu and Flow Traders are not losing market share in the industry the expectation must naturally be that their underlying operating profit goes up over time and deliver a positive expected return for their shareholders. The feature eliminates the negative carry embedded in the normally used options and VIX strategies and thus improves the risk-adjusted metrics without negatively impacting the expected return of the portfolio.

Using market makers as tail-hedging is not without risks. The companies could lose market share over time and they could mishandle risk during stressful market events causing losses. The dramatic blowup of Knight Capital in 2012 is a stark reminder that sophisticated market makers can lose it all if their computer systems go wrong. Regulation could lower long-term profitability of market makers such as the potential revamp of the payment for order flow (PFOF) which is being debated in the US Congress.


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