“A lot of corporate debt now looks better than government”, Henaghan says, adding that an active approach to sovereign debt investing is now warranted. He finds that government paper of emerging market economies can be defensive – “you’ll get your money back” – but says valuations will continue to be volatile, because political risk is as strong a risk factor as the quality and demand for issuance. He says hedge funds have not deserved the beatings they received from the investment industry. “Hedge funds were unfairly blamed for a lot of problems. People talk about excessive leverage in hedge funds: they were threeto- four-times levered, while the investment banks were 20-to-30- times.” The typically opaque funds were easy scapegoats for politicians facing angry electorates. Their primary flaw, from an investment perspective, was their participation in crowded strategies, the most common being long volatility and short financials, Henaghan says.

This worked well – even as markets took a beating – until governments imposed shorting bans on the funds’ favourite targets. Their strategies stalled; investors asked for their money; managers had to unwind crowded trades at deep losses. “They weren’t the cause [of the crisis], but the effect,” Henaghan says. He says a “properly constructed” hedge fund-of-fund (hedge FoF) portfolio, which isn’t exposed to excessive leverage or crowded trades, is a defensive exposure, and should not suffer when periods of turbulence cause investors to shun risk. Gold is often seen by investors as a beacon “if the world loses faith”, but for super funds, it is best accessed through a broad commodity exposure, Henaghan says. “I can understand why people have it in their portfolio, but it does create a real performance drag. It’s there almost as a tail-risk strategy.”

The expensive option There is some irony in using options strategies to mitigate tail risk so soon after a market rout, Henaghan says. “Your house has just burnt down, so you better get some insurance.” If a fund is going to buy options year-in, year-out, to defend against market downturns, it’s best to buy this protection when it’s cheap and positively unwind it when it’s expensive, Henaghan says. “The best time to be thinking about tail risk is when markets are blue sky.” In principle, options strategies make sense. But they are very expensive in volatile markets, and can amount to a significant cost if they are only valuable in rare, unpredictable circumstances. “The next fat tail is going to be something completely different.” Christensen says that even if options strategies are bought opportunistically, “you need to deal with that frustration that you may buy options and they expire worthlessly”.