As market volatility widens the appeal of tail-risk hedging beyond pension funds and endowments, Behrouz Fatemi explains how systematic strategies are bringing down the cost of protection.
“What can go wrong?” That’s the first question asked by investors to Berouz Fatemi, partner at Investcorp Tages, each month. A volatile market environment, prone to significant peaks and troughs, has crystallised the importance of downside protection across portfolios. Investcorp Tages has established itself a significant appeal to investors through tail-risk hedging, where derivatives or uncorrelated assets act as financial insurance during market slumps. Fatemi has been at the centre of managing tail-hedge portfolios for institutional investors for close to a decade. He defines the mechanism as “giving investors the confidence to remain invested.”
Quantitative easing in the 2010s created the possibility of a market realignment in the future, where interest rates rose, and investors who had accrued heavy exposure to credit and equities would require tools to hedge within their portfolio. Fatemi capitalised on this shift to develop systematic strategies for investors, with a properly diversified portfolio across several asset classes and regions. For investors interpreting the changing dynamic, their investment objectives were very much bifurcated – defensive, with hedging strategies built around consolidation, or building portfolios that try to capture alternative sources of yield. Tamizhmarai Rajendran, Executive Director at Nomura, notes that the investment universe around hedging is continuously expanding: “Investors are increasingly considering asset classes and strategies outside traditional equity hedging strategies, such as volatility in interest rates as a hedge, private credit, liquid credit.”
One of the central pillars of hedging strategies is the absence of discretion, which helps reduce the cost of carry across strategies, as Fatemi outlines: “Buying options can cost 7-9% a year; we can bring the cost down to roughly flat using systematic strategies. A 2-3% decline in a sell-off usually results in a market recovery, but larger events hurt investors, and they want to use hedges.”
The strategies that Investcorp Tages offers carry a UBS certificate structure, allowing daily buying and selling, and are available on JP Morgan’s platform, where investors can select which strategies to trade within a total-return swap structure. This kind of accessible, liquid wrapper reflects a broader shift in who is actually using tail-risk hedging.
The investor base for tail-risk hedging was traditionally dominated by large pension funds and endowments. Now, products like these are drawing significant interest from family offices, private banks, and smaller investors with equity exposure who are looking to manage downside risk. “This investor profile is looking at a much wider range of assets, including private equity, private credit, and illiquids. They manage big portfolios and understand that when the market’s down, people want to know what you’re going to do about it. We see ourselves as outsourcing portfolio insurance,” explains Fatemi.
The importance of tail-risk strategies within a portfolio was demonstrated by a recent paper published by Fatemi, which outlined the structural re-rating of US equities. In this dynamic, tail-risk strategies have an important role to play. Investors are monitoring a myriad of diverging forces: wanting exposure to the AI buildout, questioning exuberant company valuations when viewed against company fundamentals, and the overbearing influence of huge passive funds distorting the market.
Across their portfolio, hedge funds want to hold positions over varying time frames, so they can benefit from potential upside, while adding downside protection elsewhere. Fatemi explains how Investcorp Tages’ strategies support managers in this scenario: “Managers don’t need to sell 10-15% of their portfolio to buy tail-risk protection. By using a swap structure like ours, it will only cost them 2-3% to hedge some of their beta.” The firm also outsources the function to external hedge funds, who see the cost-benefit return better from partnering with Investcorp Tages, over hiring a new portfolio manager.
Whilst tail-risk strategies can protect existing positions, managers also diversify across markets to negate potential concentration risks. However, for funds looking to expand their investment universe, illiquidity has traditionally been a stumbling block and limits the breadth of capital, meaning that managing downside risk is less of a concern as positions are far smaller. These markets can also operate at very high levels of volatility – in the case of South Korea, close to 70% – so to build a risk framework with options is incredibly expensive. “These are liquid listed options that we can use. But we try and guide investors towards using the index closest to their market, as correlations converge in major indices during a crisis, so broader liquid proxies become a more efficient tail hedge.”
