Two niche exchange-traded funds showed in the recent selloff that they were made for such markets. The problem is, they’re not built for the generally positive markets US stock investors have enjoyed for a long time.
These so-called tail-risk, or black swan ETFs, are designed to rise when rare market catastrophes hit, and the two in question—Alpha Architect Tail Risk ETF CAOS and Cambria Tail Risk TAIL—have done just that. By their very nature, though, they will lag, or even lose money when markets rise.
What Are Tail-Risk ETFs?
Alpha Architect and Cambria’s offerings share a simple objective: profit during periods of maximum panic.
The options contracts these ETFs use are a form of portfolio insurance. The ETF pays regular premiums, just as you would with home or car insurance, to guard against some rare and damaging event. In the home- or car-owner’s case, that might be a fire or traffic accident; for these ETFs, the calamity is a market crash.
Tail-risk ETFs try to profit when an index, usually the S&P 500, falls. They do this by buying out-of-the-money, or OTM), put options on the index. OTM puts are contracts that allow the buyer of the option, in this case, the ETF, to sell the index at a strike price lower than where it currently trades. This is a losing bet in steady markets, but it can pay off big when markets decline.
The strike price determines where the ETF begins to profit from the index’s fall, such as 5 or 10% below its current price. The ETF profits if the index falls sharpy past the strike price, and before the option’s expiration date.
These ETFs purchase several deep OTM puts with staggered expiration dates to profit when the market tanks. If markets continue rising, though, the ETFs are stuck paying the premiums, which erode returns.
Cambria holds US bonds, and Alpha Architect holds other options contracts to offset some of that erosion, but they’re not designed to beat the stock market long term.
Leverage Can Be Costly
Options are a form of leverage, and using leverage can be costly.
The option’s return must exceed the cost of the leverage (premiums paid) for it to be a viable strategy. This is a risky proposition for day traders and option buyers alike, but option buying in this context doesn’t carry the same multiplicative risks associated with speculating on margin—a popular strategy among day traders.
The major risk here is that the put options never pay out, and tail-risk ETF investors sacrifice returns for nothing.
Tail-risk ETFs can be useful insurance during steep market drops, but expect weak results between such crashes. And depending on market conditions, an investor, or the ETF itself, may not be able to afford the strategy’s cost until the insurance pays out. If it pays out all.
Several tail-risk strategies have closed in recent years as their option bets lost money and investors lost interest amid generally strong markets.
Simplify Tail Risk Strategy ETF, which had the colorful ticker symbol CYA, had some good days in 2022, but the fund ultimately lost 99.9% from its late 2021 inception to its March 2024 liquidation. The ETF continued to take in new money until the end, but its demise highlights the high costs of paying for portfolio protection.
ETF Investing Takeaways
Tail-risk ETF investors pay for peace of mind. Earthquake insurance helps property owners sleep better at night, even if the big one never hits. Similarly, tail-risk ETFs can provide investors confidence that at least some of their portfolio will be protected next time markets fall. Until then, though, tail-risk ETF investors are likely foregoing better returns elsewhere while still paying the fund’s annual fee.
They deliver what they promise, but tail-risk investors should be willing to endure long periods of underperformance before any payout.