Last week, Bloomberg reported on a hedge fund that achieved a 3,600% return in March. The fund — advised by statistician Nassim Taleb — used unorthodox hedging strategies to profit off the unprecedented stock slide. Known as the Universa Tail Fund, it flew under the radar for years because of the unprecedentedly long bull market we had been in.
Now, however, it’s getting renewed interest. With the uncertainty surrounding COVID-19, investors are looking for ways to stay safe in uncertain times. Hedge funds seem like one way to achieve that. By hedging against market downturns, they provide a convenient way to minimize losses in bear markets. As Universa’s results showed, they can even generate profits during crashes.
The question is, can small-time investors replicate this? Hedge funds are notoriously hard to access, requiring would-be investors to have “accredited investor” status before buying. Unless you have a few million dollars lying around, you’re not buying into the Universa Tail Fund any time soon. However, as you’re about to see, there are more moderate “hedging” strategies you can employ as a small-time investor. I’ll explore those in just a minute. First, let’s take a look at how the Universa Tail Fund achieved its widely reported 3,600% return.
How Universa achieved the feat
The Universa Tail Fund is based on the concept of “tail risk hedging” — hedging to mitigate against unprecedented events. “Tail risk” is the extreme risk that presents itself in unlikely scenarios. By making hedges against such extreme events, you can profit off bear markets.
Universa hasn’t commented on its specific plays in detail. However, it’s been widely speculated in investing forums that manager Mark Spitznagel has been buying puts against stocks. With puts, you earn a payoff if a stock or index falls below a certain value (the “strike price”). By buying, say, S&P 500 puts, you can realize a positive gain when the S&P 500 goes down.
Could a regular investor achieve the same?
As mentioned previously, regular investors can’t invest in hedge funds. You need accredited investor status, which usually means millions of dollars and professional experience.
You may, however, be able to “hedge” more modestly in your own portfolio. Depending on what brokerage you have, you could buy puts or short shares yourself. This is a highly technical strategy that’s not recommended for amateur investors, but it is a possibility.
Perhaps a more realistic strategy is to simply minimize risk through diversification. Diversification takes the unsystematic risk out of a portfolio, reducing overall risk. To diversify against the risks in stocks, you could put a chunk of your money in a bond ETF like the BMO Mid-Term U.S. IG Corporate Bond Index ETF (ZIC).
ZIC is a bond fund that invests in U.S. corporate debt. All of the bonds it holds are investment grade, so it doesn’t have too much risk. It has a 2.95% yield, which means significant income potential. The fund did lose value in the March stock market crash. However, it only lost 14.5% from top to bottom. The TSX by contrast fell 37%.
By diversifying into bonds, you protect against some of the risk in stocks. That’s not a hedge per se, but it is a decent form of risk mitigation.
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.
Fool contributor Andrew Button has no position in any of the stocks mentioned.