Tail risk hedging: protecting your portfolio in a storm
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The first half of 2025 has underscored the reality of tail risks – those infrequent, high-impact events that can seriously dent portfolio performance in the short term.
This is a theme that we’ve consistently highlighted with our clients over the past year and one that I wrote about last winter.
In this article, I revisit this topic with a specific focus on equity allocations.
Where investors can afford to take a long-term perspective and can tolerate volatility, we continue to recommend incorporating equities as a core component of growth portfolios. In the first half of this article, I review key factors supporting this recommendation and show how remaining calm during equity market downturns has frequently paid off.
However, there are investors that can’t withstand short-term downturns. There are also investors that might look to benefit from short-term market turbulence. With both types of investors we’ve been discussing several options beyond the wholesale removal of equity or growth exposure. In the second half of this article, I introduce three such options: tail-risk diversifiers, private market investments and structured equity solutions.
What are the benefits of equity market exposure?
During market stress and uncertainty, it can be tempting to pull out of equities altogether. Yet history shows that equity risk has typically rewarded investors over the long term, even if downturns test our patience in the moment. The following charts, put this into perspective, illustrating why making snap decisions in times of market stress can often turn out poorly.
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Why is it important to take a long-term view?
Historically, consistent investment has mattered more than perfect timing. We’ve shown in the chart the range of annualised returns for the MSCI World index after an initial 5-year holding period (stretching back to 1970). We’ve based this on investments made on 1 January each year.
Yes, there are a small number of periods giving negative returns, and these primarily relate to having invested immediately prior to market downturns, such as the burst of the dot com bubble (2000), then subsequently experiencing the global financial crisis (2008). However, as of today, investments made during this time period have still delivered positive returns, at around 7% pa.
Downturns are part of the experience of investing in equity markets
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Burst of the .com bubble - 2000
45% market slide -
Global financial crisis – 2008
50% market drop -
Trump tariff – 2025
15% market drop -
MSCI World has delivered returns over the past 35 years
>1000% returns
With a long enough time horizon, you can ride out the short-term volatility shown in the chart. However, if this isn’t an option, we explore ways to limit short-term downturns.
What are the risks of trying to time markets?
Strong equity market returns frequently follow periods of downturns. Trying to time the market, for example by taking wholesale exposure off the table because of uncertainty, and then putting it back on, can have negative consequences.
With the exception of the dot com bubble spanning 2000-2003, since 1990, calendar years of negative returns have been followed by a calendar year delivering returns in excess of 15%.
What can investors with a lower tolerance for equity volatility do?
Some investors that we work with can’t withstand the short-term volatility associated with a long-biased (and unadjusted) equity allocation. These could be institutions with balance sheets that are under public scrutiny, pension schemes targeting short-term insurance transactions, or investors balancing other objectives that require the preservation of assets.
We’ve been discussing a wide range of options with these investors, designed to help them retain risk on the table, whilst limiting the impact of a tail risk event.
These funds provide exposure to various securities that are designed to benefit from stress in equity, credit and other markets.
In early 2024 LCP worked with a specialist investment manager to design and support the launch of a bespoke tail risk solution - encompassing six funds designed to benefit during periods of market downturns. We have no financial stake in this manager or these products – we undertook this exercise to help close a gap in the marketplace that we believed would benefit our clients.
The strategies are actively managed to:
- minimise the cost of protection in more benign market environments - ie performance drag
- create asymmetric return profiles - ie in broad terms the upswings outweigh the downswings, and become more pronounced during the most extreme events
- retain appropriate liquidity and therefore nimbleness during turbulent times
The outcome for our clients that invested in this strategy has been returns aligned with expectations amid the volatility seen in the first half of 2025.
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Tail risk strategy returns over period of good equity return
0% -
Tail risk strategy returns over period of good equity return
10%+ returnwhen equities fell
Valuation methodology means there is typically price stability over short- and medium-time periods, while offering an illiquidity premium that can help enhance returns.
Where clients are seeking balance sheet stability and can lock assets away for an extended period we recommend an allocation to private market assets is considered.
In recent years, we’ve been recommending secondary market funds. In this approach, the fund manager builds a portfolio by purchasing holdings in existing private market funds from other investors, typically at a meaningful discount.
This approach offers a range of benefits, including having sight of the underlying portfolio companies. Historically, this approach has also meaningfully reduced the dispersion of long-term outcomes. The chart below shows the range of returns for a range of private equity asset types covering vintages from 2000 to 2020.
This chart with underlying data sourced from Preqin, covers vintages from 2000 to 2020. Its analysis covers 856 venture capital funds, 687 growth funds, 986 buyout funds and 247 secondaries funds. Please note that past experience is not a direct indicator of future returns.
Where our clients have an existing equity portfolio and are looking to introduce explicit limits on potential losses over a short period, one option is to “shape” the exposure to equity markets using derivative contracts.
There are lots of options, but one solution we help clients implement is a “zero cost” structure where potential upside is sold in return for purchasing downside protection.
The chart below shows a simple structure where upside above (8%) is given up to protect against falls worse than (10%),
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Participate in equity market increases up to
8%Giving up returns above that level -
Protect against market falls worse than
10%While expose to the first 10% of falls
These structures can provide certainty over short-term client-specific events whilst not requiring the sale of physical equities. We generally recommend this approach where there are specific time horizons and desired outcomes at play (eg the potential for a large upcoming cashflow requirement or an upcoming accounting date).
Indicative pricing is based on the S&P 500 for a one-year period, and taken based on the position in late 2024
Conclusion
Meaningful market swings can be concerning, particularly when even well-diversified portfolios are losing value. In general, we don’t view periods of significant volatility as the ideal occasion to make wholesale changes to investment strategy, and our clients have generally been rewarded for remaining patient as equity investors.
However, there are ways to help reduce exposure to tail risk events, to better protect portfolios against market uncertainty, and even capitalise at times when others are fearful. There are a range of options that we’ve been discussing with our clients based on their specific circumstances.
For a deeper conversation about your portfolio
Contact JoelTo hear more listen to our podcast
Your questions answered
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Tail risk hedging protects portfolios from rare but severe market downturns. There are different ways to do this, often involving giving up some possible “upside” in return for protection in the event of market turmoil. What is appropriate for any particular investor will depend on their risk appetite.
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History shows that equities often rebound strongly after downturns. Exiting during market stress risks missing these gains, while long-term investing has typically delivered positive returns despite short-term volatility.
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Options include tail-risk diversifying funds that benefit in crises, private market allocations for price stability, and structured equity derivatives that cap losses while maintaining growth potential.
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