For funds that thrive on crisis, the volatility jolt that wiped out over $4 trillion of global stock value in February was merely a tremor. A full-blown financial earthquake looms.
They’re known as tail funds, for whom the traditional objective of producing annual returns is replaced by the contrarian task of preparing for events that are more than three standard deviations from the norm, or those that have a 0.3% chance of coming to pass.
Those mandated to hedge such maelstroms — like Richard “Jerry” Haworth, whose 36 South Capital Advisors LLP profited handsomely from the 2008 crisis — say conditions are now ripe for the next big one.
“The financial system is a lot more fragile than it was in 2007,” said Haworth in an interview in his Mayfair office in London. “Leverage is up on every single metric, in just about every category, and debt has increased. The more you indebt someone, the more fragile they become, especially with variable interest rates.”
Tail-fund investors are predisposed to warning against the next blow-up. Haworth admits that he’s called “10 of the last two recessions.” To steel themselves against financial armaggedon, the funds typically scoop up long-dated out-of-the-money options on multiple asset classes — and wait.
Assets in tail-risk funds have grown to $4.9 billion from $3.2 billion in 2011, according to Eurekahedge Pte Ltd. In 2011, the year of the Greek crisis, tail-risk funds boasted the top-performing strategy, but as markets rallied in the six following years they suffered the steepest losses of any hedge-fund style tracked by Eurekahedge. This year, they’re up 0.54 percent, according to the data provider.
It’s getting easier to make the case that the probability of outsize losses is rising thanks to an increasingly complex market landscape late in the U.S. business cycle.
Risky securities and investing strategies that have flourished during the decade of easy-money policies — from autocallable structured products to risk-parity funds — could accelerate a downturn, Haworth says. The boom in passive investing may intensify the looming deleveraging wave as exchange-traded funds rush to sell the same securities in unison, he added.
Haworth, who co-founded 36 South in 2001, declined to say how much he manages in his tail-risk funds, which hedge extreme scenarios in both bull and bear markets. After returning 204% during the global financial crisis in 2008, his Black Swan Fund closed the next year and returned money to investors.