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Hedge Funds Pile Into Doomsday Trade

The idea of hedging against catastrophe, otherwise known as tail risk, has become the latest rage among hedge funds, according to money managers and traders.

Three years after Nassim Nicholas Taleb popularized the idea of guarding against so-called black swan events—extremely rare but disastrous market circumstances—a small but growing number of hedge funds have opened dedicated tail-risk hedging vehicles to provide wary investors with additional insurance against calamity. (The fund Taleb advises, the Santa Monica, Calif. based Universa Investments, has been dedicated wholly to tail-risk hedging since 2007.)

Tail-risk funds buy products like credit default swaps and equity put options as down payments that will reap returns if certain markets decline far more than they would on an average day.

Capula Investment Management, the London fixed-income fund company with $8 billion under management, in March opened a tail-risk fund that now has $1.5 million in assets.

Several months later Pine River Capital, the Minnetonka, Minn. hedge-fund, opened a similar dedicated fund as an extension of its existent hedging activities. Pine River’s tail-risk fund, which began in June with about $200 million in assets, now has north of $300 million, according to people familiar with the matter.

Pimco, the large bond fund company, has reportedly been marketing what it describes in regulatory filings as a “private fund” to do tail-risk hedging since at least June. (A spokesman declined to elaborate on the details of the fund.) Saba Capital, the $2 billion hedge fund, opened a tail-risk fund with about $150 million in assets last month, says someone familiar with the matter.

Because the purchase of insurance policies always costs money, tail-risk funds are actually designed to lose money in an average month or year.

For that reason, most investors pour only a small fraction of their assets into tail hedging, say traders and money managers. But as the global economy remains choppy and bears continue to worry about another significant leg down in the U.S., tail-risk hedging has become a popular trend, they add—often the subject of discussion at hedge-fund conferences and other gatherings.

This post was updated on December 9, 2010.

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