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For as long as I can remember, I have had a particular fascination with correlation or, more accurately, identifying investment strategies that are reliably non-correlated or, in some cases, negatively correlated to traditional asset classes.  

It is my experience that correlation is often over-looked in favour of focusing on volatility. I think this is a mistake: if low volatility at the portfolio level is an ambition (and for many it will be), then the best way to achieve this is by combining a number of strategies that are non-corelated to each other. When this is done, portfolio volatility looks after itself.  This strikes me as a far better solution than combining a range of low volatility strategies that are all correlated to each other. 

The problem, some argue, is that everything correlates towards 1 in a crisis but in my experience, whilst ‘low’ or ‘medium’ correlated strategies will often exhibit much higher correlation in times of market stress, strategies that have no correlation do not.  

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Tail Protection

Negatively correlated strategies are a different beast and whilst mathematically it is entirely possible for two strategies to make money whilst being negatively correlated to each other, this is rarer in real life.  

To my mind well-managed tail protection strategies bring to the investor three considerable benefits, above-and-beyond the obvious one of providing portfolio protection when most needed:

  • Before a crisis: with protection in place, the investor can stay more fully invested than would otherwise be the case. Given financial crises often come after extended bull runs, this has significant value to the investor that is not captured in the returns of the portfolio insurance strategy. 

  • During a crisis: the protection buys the investor time to think, rather than panic. If the fundamental principal of investing is to buy low and sell high, then being forced to capitulate when markets are crashing, must be counter to this ideal. This is neatly summarised in Warren Buffet's famous quote: "be fearful when others are greedy, and greedy when others are fearful". Not having to panic out in a crisis, provides investors with real value that is not captured in the raw returns of the tail protection strategy.

  • After a crisis: owning tail protection enables investors to do the opposite of panic out; they can average in. This is possible because an attractive feature of tail protection, is that liquidity in the positions they own generally increases in a crisis as market participants scramble to cover their short vol positioning. As gains are locked in, these returns can be redistributed to investors, providing them with valuable cashflow that can be invested just when markets are 'on sale' and when the most interesting, stressed opportunities exist. The gains made from these additional allocations, often compounding over many years, and which would not have been possible without owning the tail protection, are, once again, never encapsulated in the raw returns of the tail protection strategy.

Unfortunately, because these benefits are mostly invisible and, therefore, almost impossible to evaluate, they end up being significantly under-appreciated by investors, who wrongly conclude that tail protection has a negative value.

As an aside, even if tail protection did have a negative expected value – which, in any event, would depend on how often substantial drawdowns occurred – I would still make the argument to own it, in the same way I would advocate owning home insurance, car insurance and health insurance, all of which have negative expected values. 

I have written about these points and others concerning tail protection in more detail. You can download a copy of that report here. 

I am reminded of an excellent article by Matthew Syed in the Times after the 2018 Football World Cup when he commented on how certain players never appear in the stats because they defy the data. The focus of his article was N’Golo Kante, France’s wonderful defensive midfielder who, in Syed’s words, ‘knows he has done a good job if he is absent from the highlights montage’. As Syed goes on to say, you can only ‘begin to fathom his efficiency, if you watch him for a full 90 minutes (or, better still, an entire season).  I think this analysis holds true for tail protection strategies; if you judge them just on their numbers, you significantly undervalue their true utility, over the investment cycle.

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