Stacking, Diversifiers and Responders

A very kind reader sent me the link to a paper aimed to show the wonders this portfolio:

• 100% ACWI
• 50% trend following
• 100% notional tail risk hedge

The portfolio for the apocalypse 😉 Simple and systematic.

While there isn’t much to say about the portfolio first two component, I will summary here the tail hedging strategy: systematically purchase 10-delta SPX put options with one year to expiration. The design explicitly excludes enhancements such as monetisation and multi-legged structures. No tactical tweaks, no delta-hedging, no premium scaling. Just raw exposure.

The paper behind this setup makes a few generous assumptions:

• Options trade at the mid price (real life, as we know, is never this cheap)
• Funding costs are at 3-month LIBOR/SOFR (pretty friendly)

So, real results would likely look a bit worse.

I will post some of the paper graphs with my comments.

The average portfolio net exposure to risky asset is 103%:

Yes, it’s a leveraged portfolio, but thanks to the overlays, that number drops when the world gets messy.

“Net risky asset exposure falls during episodes of market stress. This is because the overlays become defensive during such periods as trend-following positions turn more short while tail risk hedge becomes increasingly convex with a delta tending towards -1.“

While these results seem great, I can already hear the usual pushback: trend following worked wonders in the earlier part of the back test and not so much in the latter.

But two things stand out:

1. From 2010 onward, stocks crushed it. Yet this portfolio kept up while smoothing out the nastiest drawdowns (COVID, 2022).
2. The returns across different periods? Surprisingly consistent for the apocalypse portfolio: that’s resilience.

This is the power of combining first and second responders: “the tail risk hedging sleeve cushioned sharp market crashes while the embedded trend-following sleeve mitigated losses during extended bear markets.“

Or, if you prefer David Dredge’s metaphor about cars, the tail hedge is like an airbag in a crash and trend following is the brake pedal, to manage your speed during unexpected turns.

All risk metrics get better: lower drawdowns, smoother rides. That’s a buffer against higher costs IRL and a world where hedges don’t work as well as they did in THIS past.

Convexity is the real hero. And this is the most important picture of the paper:

Losses are shallower but gains, especially at the extremes, stay nearly as strong as a pure stock portfolio.

The performance attribution table provides interesting insights:

• Rebalancing: Adds 25bps. Is this luck? Maybe. But when you combine uncorrelated (or inversely correlated) assets, you should expect a boost, little or not so little.
• Trend following: Adds 3.7% (net of trading costs). Benchmarks like KMLM and DBMF delivered more (5.1% and 5.3% respectively), but this looks fair. Or a fair prudence.
• Tail risk hedge: Yes, it drags on returns. No free lunch.

It’s easy to question the value of “brakes” when you’re cruising down a straight highway. But you’ll be grateful for them when the road turns unexpectedly.

This portfolio isn’t about maximizing every last basis point, it’s about surviving whatever the market throws at you. The combination of trend and tail hedging means you get to keep playing the game, even when others crash out. Especially in a world where everyone seems concerned that we are going to experience soon another deflating bubble.

What I am reading now:

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