The return of market volatility on the back of the escalating COVID19 outbreak situation around the globe has pushed two particular niche hedge fund strategies back into the spotlight: the CBOE Eurekahedge Long Volatility Hedge Fund Index and the CBOE Eurekahedge Tail Risk Hedge Fund Index returned 10.27% and 12.28% respectively in February 2020. The two strategies which provide crisis alpha and protection for institutional portfolios have long since generated debates among asset owners and academics alike. While these fund managers are capable of generating substantial returns to offset losses during black swan events, these strategies may often act as performance detractors during bull market runs resulting in a drag on portfolio returns. In this report we will take a look at the riskreturn profile of these strategies as opposed to more traditional hedge fund strategies and assess the impact of allocation into long volatility and tail risk strategies in an institutional portfolio of hedge funds.
Figure 1 below compares the performance of the Eurekahedge Long Volatility/Tail Risk Composite and the Eurekahedge 50 against the global equity market as represented by the MSCI ACWI IMI (Local) and gold price in US dollar. The Eurekahedge Long Volatility/Tail Risk Composite is a custom equalweighted index comprising hedge funds utilising long volatility and tail risk strategies. Long volatility fund managers take a net long view on implied volatility with the goal of positive absolute return, while tail risk fund managers specifically aim to generate substantial returns during periods of market distress.
Figure 1: Eurekahedge Long Volatility/Tail Risk Composite performance since the end of 2006
As observed in Figure 1, the Eurekahedge Long Volatility/Tail Risk Composite has managed to generate strong returns during the 2008 global financial crisis and the 2011 Eurozone debt crisis, thereby providing a hedge for institutional portfolios during a black swan event.
Table 1: Performance in numbers  Eurekahedge Long Volatility/Tail Risk Composite
Eurekahedge Long Volatility/ Tail Risk Composite 
Eurekahedge 50 
MSCI ACWI IMI (Local) 
Gold (XAU/USD) 


2007 
4.25% 
11.35% 
4.93% 
30.90% 
2008 
102.94% 
(21.58%) 
(41.12%) 
5.59% 
2009 
(2.60%) 
29.35% 
28.10% 
24.54% 
2010 
3.25% 
13.12% 
9.99% 
29.67% 
2011 
11.67% 
(0.17%) 
(9.02%) 
10.05% 
2012 
(10.68%) 
11.10% 
13.56% 
7.07% 
2013 
(6.80%) 
11.69% 
23.80% 
(28.02%) 
2014 
(0.61%) 
3.04% 
6.82% 
(1.79%) 
2015 
(1.60%) 
(0.01%) 
(0.52%) 
(10.36%) 
2016 
(3.70%) 
4.27% 
7.33% 
8.53% 
2017 
(10.23%) 
6.96% 
17.51% 
13.08% 
2018 
0.15% 
(1.50%) 
(10.10%) 
(1.51%) 
2019 
(8.97%) 
7.14% 
23.49% 
18.28% 
2020 yeartodate 
7.99% 
(1.85%) 
(8.64%) 
4.54% 
3year annualised return 
(3.43%) 
2.79% 
4.57% 
8.30% 
3year annualised volatility 
6.32% 
3.37% 
11.77% 
9.99% 
3year Sharpe ratio (RFR = 2%) 
(0.86) 
0.23 
0.22 
0.63 
5year annualised return 
(3.34%) 
2.65% 
3.91% 
5.51% 
5year annualised volatility 
5.76% 
3.19% 
11.38% 
12.95% 
5year Sharpe ratio (RFR = 2%) 
(0.93) 
0.21 
0.17 
0.27 
10year annualised return 
(2.04%) 
5.14% 
6.92% 
3.57% 
10year annualised volatility 
7.44% 
3.69% 
11.72% 
15.98% 
10year Sharpe ratio (RFR = 2%) 
(0.54) 
0.85 
0.42 
0.10 
Source: Eurekahedge
Table 1 provides the detailed risk return statistics of the four indices shown in the figure above. Key takeaways include:
 The Eurekahedge Long Volatility/Tail Risk Composite was up 7.99% over the first two months of 2020, as concerns over the COVID19 outbreak’s impact on the global economic growth resulted in elevated market volatility in February. The Eurekahedge 50 and the MSCI ACWI IMI (Local) were down 1.85% and 8.64% respectively over the same period.
 Fund managers utilising long volatility and tail risk strategies returned 102.94% in 2008 and 11.67% in 2011, in contrast to how the Eurekahedge 50 slumped 21.58% in 2008 and ended 2011 mostly flat. On the other hand, the Eurekahedge Long Volatility/Tail Risk Composite has recorded annualised returns of 3.43% over the last three years, 3.34% over the last five years, and 2.04% over the last ten years, exemplifying the cost investors must pay in exchange for the tail risk protection afforded by these funds.
Table 2 provides the correlation values between the Eurekahedge Long Volatility/Tail Risk Composite, the Eurekahedge 50, the global equity market, as well as gold since the end of 2006. As observed in the table below, long volatility and tail risk strategies are very negatively correlated against the global equity market and the Eurekahedge 50 which represents 50 large hedge funds with strong track record of performance. The Eurekahedge 50 returns are weakly but positively correlated against gold, with a correlation coefficient of 0.15.
Source: Eurekahedge
Figure 3 provides the performance distribution of all long volatility and tail risk hedge funds in the Eurekahedge database. The year 2008 saw substantial performance dispersion among the fund managers in this category, with the top 10% returning no less than 44.82% for the year. The distress caused by the COVID19 outbreak, which have since evolved into a pandemic as of March has pushed global equities into the negative territory, resulting in another chance for long volatility and tail risk strategies to excel. The top 10% of the Eurekahedge Long Volatility/Tail Risk Composite constituent funds have returned at least 15.79% as of February 2020 yeartodate, and given the volatile market situation throughout the first half of March, they are on track to continue their strong performance.
Figure 2: Performance distribution of long volatility and tail risk hedge funds
The following section of the report focuses on the construction of a portfolio comprising the Eurekahedge 50 and the Eurekahedge Long Volatility/Tail Risk Composite to illustrate how a tail risk protection component would affect the volatility and riskadjusted performance of a hedge fund portfolio.
Figure 3 provides the annualised returns and volatilities of portfolios constructed from the Eurekahedge 50 and the Eurekahedge Long Volatility/Tail Risk Composite at various different weights during the period starting December 2006. As shown in the figure, allocating a portion of the portfolio into long volatility/tail risk strategies resulted in lower volatilities, owing to the negative correlation between the returns of the two indices.
Figure 3: Long volatility/tail risk portfolio optimisation (since December 2006)
Table 3 provides the portfolio allocation weights and the riskreturn statistics of the portfolios shown in the figure above. The allocation of 22% to 24% of the portfolio into long volatility/tail risk strategies have resulted in higher Sharpe ratios and lower volatilities compared to the Eurekahedge 50 on its own. On the other hand, the tail risk protection strategies have resulted in a performance drag between 0.24% and 0.25% per annum.
Table 3: Long volatility/tail risk portfolio optimisation (since December 2006)
Eurekahedge 50 
Eurekahedge Long Volatility/ Tail Risk Composite 
Portfolio Annualised Return 
Portfolio Annualised Volatility 
Portfolio Sharpe Ratio (RFR = 2%) 
Remark 

1.00 
0.00 
4.93% 
5.49% 
0.53 

0.80 
0.20 
4.71% 
3.33% 
0.82 

0.78 
0.22 
4.69% 
3.27% 
0.82 
Max Sharpe Portfolio 
0.76 
0.24 
4.68% 
3.26% 
0.82 
Min Volatility Portfolio 
0.60 
0.40 
4.50% 
4.47% 
0.56 

0.40 
0.60 
4.29% 
7.54% 
0.30 

0.20 
0.80 
4.07% 
11.03% 
0.19 

0.00 
1.00 
3.86% 
14.64% 
0.13 
Source: Eurekahedge
Figure 4 provides the annualised returns and volatilities of portfolios constructed from the Eurekahedge 50 and the Eurekahedge Long Volatility/Tail Risk Composite at various different weights within the last 10 years. It is worth noting that the financial market has not witnessed a black swan event of a similar magnitude to the 2008 global financial crisis within the last 10 years, diminishing the value of a tail risk protection strategy for the period. As shown in the figure below, the addition of Eurekahedge Long Volatility/Tail Risk Composite does not improve the portfolio Sharpe ratio, but still reduces the portfolio volatility by virtue of its negatively correlated returns against the Eurekahedge 50.
Figure 4: Long volatility/tail risk portfolio optimisation (last 10 years)
Table 4 provides the portfolio allocation weights and the riskreturn statistics of the portfolios shown in the figure above. A 29% allocation into long volatility/tail risk strategies resulted in the minimum volatility portfolio over the last 10 years.
Table 4: Long Volatility/Tail Risk portfolio optimisation (last 10 years)
Eurekahedge 50 
Eurekahedge Long Volatility/ Tail Risk Composite 
Portfolio Annualised Return 
Portfolio Annualised Volatility 
Portfolio Sharpe Ratio (RFR = 2%) 
Remark 

1.00 
0.00 
5.14% 
3.69% 
0.85 
Max Sharpe Portfolio 
0.80 
0.20 
3.70% 
2.47% 
0.69 

0.71 
0.29 
3.07% 
2.31% 
0.46 
Min Volatility Portfolio 
0.60 
0.40 
2.27% 
2.56% 
0.11 

0.40 
0.60 
0.83% 
3.86% 
(0.30) 

0.20 
0.80 
(0.60%) 
5.58% 
(0.47) 

0.00 
1.00 
(2.04%) 
7.44% 
(0.54) 
Source: Eurekahedge
Figure 5 provides the annualised returns and volatilities of portfolios constructed from the Eurekahedge 50 and the Eurekahedge Long Volatility/Tail Risk Composite at various different weights within the last five years. Further reducing the length of period analysed, we observe a similar outcome: the lack of a period of significant market distressed in the recent years results in the inability of long volatility/tail risk strategies to improve portfolio Sharpe ratio, which is completely expected given the nature of the strategy.
Figure 5: Long volatility/tail risk portfolio optimisation (last 5 years)
Table 5 provides the portfolio allocation weights and the riskreturn statistics of the portfolios shown in the figure above. A 33% allocation into long volatility/tail risk strategies resulted in the minimum volatility portfolio over the last five years. However, given the market development within the first two weeks of March 2020, it may be too early to gauge the extent of the market rout. The magnitude of the impact of the COVID19 pandemic on the global economy over the upcoming months may result in a completely different landscape and tilt the figures in favour of allocating more heavily into tail risk protection strategies.
Table 5: Long volatility/tail risk portfolio optimisation (last 5 years)
Eurekahedge 50 
Eurekahedge Long Volatility/ Tail Risk Composite 
Portfolio Annualised Return 
Portfolio Annualised Volatility 
Portfolio Sharpe Ratio (RFR = 2%) 
Remark 

1.00 
0.00 
2.65% 
3.19% 
0.21 
Max Sharpe Portfolio 
0.80 
0.20 
1.45% 
2.06% 
(0.27) 

0.67 
0.33 
0.70% 
1.79% 
(0.73) 
Min Volatility Portfolio 
0.60 
0.40 
0.26% 
1.89% 
(0.92) 

0.40 
0.60 
(0.94%) 
2.86% 
(1.03) 

0.20 
0.80 
(2.14%) 
4.25% 
(0.98) 

0.00 
1.00 
(3.34%) 
5.76% 
(0.93) 
Source: Eurekahedge
Given the nature of long volatility and tail risk strategies, hedge fund allocators may have concerns surrounding the survivability of hedge funds within this category. Long volatility and tail risk hedge funds are expected to constantly record minor losses during periods of suppressed market volatility, raising the question of whether a fund is capable of surviving through long bull markets until the next market downturn. To address this concern and to emphasise the importance of selecting a hedge fund manager with strong track record, one such fund is selected among the constituents comprising the Eurekahedge Long Volatility/Tail Risk Hedge Fund Composite.
Figure 6 provides the annualised returns and volatilities of portfolios constructed from the Eurekahedge 50 and a single tail risk hedge fund managing over US$1 billion in asset and having a robust track record spanning over more than 10 years. This particular tail risk hedge fund is capable of marginally improving the portfolio Sharpe ratio and reducing portfolio volatility over the last 10 years.
Figure 6: Tail risk hedge fund portfolio optimisation (last 10 years)
Table 6 provides the portfolio allocation weights and the riskreturn statistics of the portfolios shown in the figure above. The maximum portfolio Sharpe ratio was attained by allocating roughly 9% of the portfolio asset into the tail risk hedge fund, while the minimum portfolio volatility was achieved by allocating 34% of the portfolio asset into the same fund. We believe that provided sufficient information to select tail risk hedge fund managers with robust track record and sufficiently big assets under management, a singledigit percentage allocation would be closer to the ideal allocation for maximum riskadjusted return as opposed to the 22% allocation suggested in Table 3.
Table 6: Tail Risk hedge fund portfolio optimisation (last 10 years)
Eurekahedge 50 
Tail Risk Hedge Fund 
Portfolio Annualised Return 
Portfolio Annualised Volatility 
Portfolio Sharpe Ratio (RFR = 2%) 
Remark 

1.00 
0.00 
5.14% 
3.69% 
0.85 

0.91 
0.09 
4.64% 
3.07% 
0.86 
Max Sharpe Portfolio 
0.80 
0.20 
3.99% 
2.41% 
0.82 

0.66 
0.34 
3.19% 
2.06% 
0.58 
Min Volatility Portfolio 
0.60 
0.40 
2.83% 
2.13% 
0.39 

0.40 
0.60 
1.68% 
3.13% 
(0.10) 

0.20 
0.80 
0.53% 
4.64% 
(0.32) 

0.00 
1.00 
(0.62%) 
6.31% 
(0.42) 
Source: Eurekahedge
This section of the report takes a look at the ability of gold, which is typically seen as a safe haven asset to act as a tail risk protection component for a hedge fund portfolio. Figure 7 provides the annualised returns and volatilities of portfolios constructed from the Eurekahedge 50 and goldat various different weights within the last 10 years.
Figure 7: Gold portfolio optimisation (last 10 years)
Table 7 provides the portfolio allocation weights and the riskreturn statistics of the portfolios shown in the figure above. It could be observed from Table 7 that allocation to gold offers negligible improvements to the portfolio Sharpe ratio and volatility. The weak, but still positive correlation between the performance of gold and the Eurekahedge 50 index resulted in minimal diversification benefits over the last 10 years. Referring to Table 1, we can also observe that gold returned 5.59% in 2008, which would not offset much of the 21.58% loss registered by the Eurekahedge 50 without substantial tilt of portfolio allocation towards gold. However, looking at a longer time period starting from the end of 2006, maximum Sharpe ratio would be achieved through 12% portfolio allocation into gold. This difference could be attributed to the strong rally of gold throughout 2007 and 2009, which would not be accounted for in Table 7.
Table 7: Gold portfolio optimisation (last 10 years)
Eurekahedge 50 
Gold 
Portfolio Annualised Return 
Portfolio Annualised Volatility 
Portfolio Sharpe Ratio (RFR = 2%) 
Remark 

1.00 
0.00 
5.14% 
3.69% 
0.85 

0.99 
0.01 
5.12% 
3.66% 
0.85 
Max Sharpe Portfolio 
0.96 
0.04 
5.08% 
3.64% 
0.85 
Min Volatility Portfolio 
0.80 
0.20 
4.83% 
4.50% 
0.63 

0.60 
0.40 
4.51% 
6.91% 
0.36 

0.40 
0.60 
4.20% 
9.80% 
0.22 

0.20 
0.80 
3.89% 
12.86% 
0.15 

0.00 
1.00 
3.57% 
15.98% 
0.10 
Source: Eurekahedge
Based on the figures above, while an argument could be made for the use of gold to enhance portfolio Sharpe ratio and provide diversification benefits, an allocation towards long volatility and tail risk hedge fund strategies would provide better tail risk protection during periods of extreme market distress.
Table 8 below summarises the riskreturn statistics of the optimised maximum Sharpe ratio portfolios over the period starting from the end of 2006 and ending February 2020.
Table 8: Maximum Sharpe portfolios (since December 2006)
Portfolio Allocation 
Portfolio Annualised Return 
Portfolio Annualised Volatility 
Portfolio Sharpe Ratio (RFR = 2%) 

78% Eurekahedge 50 
4.69% 
3.27% 
0.82 
88% Eurekahedge 50 
5.22% 
5.54% 
0.58 
Source: Eurekahedge
In conclusion, despite the performance drag introduced by long volatility and tail risk hedge fund strategies over the long run, institutional portfolios could reap the benefit of downside protection during periods of extreme market distress, and generate better riskadjusted returns by making a small allocation into these strategies. Take note that the double digit allocation into a composite of long volatility/tail risk strategies is likely exaggerated on account of the smoothening of returns on an index level, and a more realistic allocation will likely lie in the lowtohigh single digits as examined in our single fund allocation scenario earlier. The ability of these managers to deliver crisis alpha during periods of heightened market volatility when correlations across asset classes tend to breakdown offers much needed downside protection for institutional investors, if utilised tactically in anticipation of major market corrections the gains here can be even more significant.
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