Thread by @bennpeifert

One popular argument goes as follows:

“We are long-term investors. Volatility doesn’t matter to our portfolio.”

This is an appealing idea.

(thread)

However, volatility itself reduces the long-term compound rate of growth of a portfolio, via a phenomenon called variance drag. Let’s consider two return streams, both with average annual returns of 10%, but with annualized volatility of 10% and 20% respectively.

The long-term compound growth rates of the
two portfolios will be 9.5% and 8.0%!

The adjustment factor is equal to half of the variance (or squared volatility). A reduction in volatility from 20% to 10% for the same average annual return increases the long-term compound rate of growth by 150 basis points.

For sufficiently high volatility levels, a return stream with 10% average annual returns actually compounds at a
negative long-term growth rate!

Simple Example: Start with $1 billion of equities and suffer a 20% drawdown, the equity exposure falls to
$800 million. If equities turn around and rally 20%, the portfolio will make only $160 million, not the full
$200 million you lost.

This is the negative impact of volatility and drawdowns on the compound growth of a portfolio.

Now, another popular argument:

“Tail hedging involves buying option-based insurance against market drawdowns. Because markets generally charge a risk premium for insurance, the expected returns of a tail hedging strategy over long periods of time are negative..."

"...As a result, along-term-oriented asset owner should not allocate to hedging strategies, as they will detract from long-term compound returns.”

Like many popular arguments, this is only partly correct.

Over the long term, you should expect negative
returns from tail hedging strategies. The market would be wildly inefficient otherwise. Individual long convexity
trades at certain points in time may be mispriced...

...and smart, dynamic hedging strategies might
be able to reduce the cost of carry over time, but it is unrealistically optimistic to think that tail risk hedges
can make money systematically over time.

But what this argument is missing is the portfolio effect. Tail risk hedges are inversely correlated with the performance of risk assets and produce outsized returns during times of crisis.

As a result, if tail risk hedges are added to a long-term, regularly rebalanced portfolio, they can cushion
drawdowns and mitigate the mechanical reduction of risk asset exposure during times of stress.

In doing so, they can enhance the long-term compound rate of return of the overall investment program, **despite the hedges themselves losing money over long periods of time on a stand-alone basis**.

@BigDawgSaluki @PNL_Wizard @TheStalwart yeah if you're really super into managing it, some deep out of the money 1-month puts could be good against a COVID style crash

longer, slow bear markets are harder to hedge