Leveraging defence into offence: enhancing absolute and risk-adjusted equity returns with tail risk management overlays

Abstract

ABSTRACT Research has shown that tail risk hedging using explicit option purchases and trend-following effectively mitigate equity tail risk. This paper demonstrates that these defensive qualities can be leveraged into offence: overlaying a two-pronged tail risk management strategy that employs both option-based tail risk hedging and trend-following has empirically enhanced absolute and risk-adjusted returns relative to a buy-and-hold equity portfolio. Option-based tail risk hedging has empirically mitigated equity risk best during market crashes, while trend-following has notably supported equity during slower bear markets. In combination, and when overlayed onto equity, the resulting portfolio reliably outperformed equity during the most significant drawdown episodes suffered over the period under investigation and broadly maintained this advantage during equity bull markets.