Universa pitch

The returns versus risk battle is the front line of investing.

We all want higher returns with lower risk, but of course the two are seen as a trade‑off. Traditional asset allocation deals with this by striking a balance between risky and less risky assets, typically between stocks and bonds.

Think of your portfolio as a pie. We can slice it into different pieces by these different allocations, the size of each piece representing its relative size in your portfolio. An allocation of 60% to stocks and 40% to bonds is a pretty standard, simple pie in the investment world.

The idea behind this typical weighting, as you can see here, is that these two slices—stocks and bonds—balance each other in terms of their risks, as they typically go up and down in opposite directions, or at least don’t often collapse together.

So over long periods of time and over many environments, this combination should do pretty well—hopefully better than average. Some take this balancing act even further, adding more slices for credit spreads, real estate, emerging markets, and so on. Many smart people with all kinds of complicated formulas and forecasts, and a lot of capital, work to fine‑tune this intricate balance. But simple or complex, the point here is the same. The problem is that all this fine‑tuning doesn’t always work out so well. All of these slices at times can get distorted and manipulated into bubbles as central banks compress interest rates and lure investors into ever‑riskier assets.

There’s immense pressure to add to the slices with the highest yield and best performance, and we find ourselves chasing the most immediately gratifying as well as the most expensive and riskiest assets, ultimately succumbing to these serial bubbles. We even find ourselves here today where not owning enough high‑returning assets like stocks feels foolish—like missing an opportunity, though a very, very risky one.

So what do you do? There must be a better way than this to allocate capital and manage this presumed trade‑off between returns and risk.

Well, there is. What if you could take a tiny sliver of a slice of your portfolio pie and invest in something that does even better when the bigger slice—stocks—goes down? Notice how profits in this tiny slice essentially cancel out the losses in the stock slice. This loss cancellation allows you to actually take more risk in stocks. And of course, being such a tiny slice, it couldn’t hurt you much when stocks rise, especially compared to what you gain with your larger stock position, no matter how far that sliver goes down. This sliver thus acts very much like an insurance hedge—hence the name tail insurance or tail hedge.

By allocating, say, just one percent of your portfolio to the tail‑hedge sliver, as Universa does by owning put options, you could go from a 60/40 stocks‑bonds mix to a much greater stock allocation, and yet your portfolio’s total risk would go down. The key here is the tininess of that sliver relative to how much you can make when stocks go down, or in financial parlance, the asymmetry of that position. This means that when stocks go up, it only costs a very small amount on its own relative to what it can make when stocks go down. This asymmetry is challenging to conventional asset allocators, as it just doesn’t fit in with their conventional models. It even creates what looks like a paradox: how can higher returns possibly come from lower risk?

Whatever happened to the trade‑off? The real challenge here, as well as the real opportunity, lies in a misperception. When looked at in isolation like this, this tiny slice will look like a disadvantage when stock markets rally. However, as we saw, when looked at holistically within the context of an entire portfolio, it becomes clear what a huge advantage and transformation it can create.

The tail hedge allows for a bigger slice of stocks in the investment pie than the 60/40 portfolio because the stocks are protected in a steep sell‑off. The tail‑hedge portfolio thus indirectly and counterintuitively beats the 60/40 portfolio, as well as most alternative investments and other supposed low‑risk things. And as you can see here, it beats them when stock markets rise and when they fall. And importantly, after the fall, when everyone else is selling their stocks, notice how the tail hedge has created all this cash or liquidity to use to invest in more cheapened stocks. This is cash you would otherwise have only if you had started with a much smaller stock allocation.

So you can see how that tiny sliver of a hedge, in its own indirect, roundabout way, in up and down markets, can be the driver of consistently higher returns for the entire portfolio.

Investing this way is what I’ve been doing my whole career and is precisely what Universa did for clients in the 2008 crash and in the rally that followed. Moving from a traditional stock‑bond balanced portfolio to a tail‑hedge portfolio requires viewing asset allocation and risk in a different way—holistically rather than reductively.

But when looked at in this way, there is no trade‑off, there is no paradox, and higher returns really can come with lower risk.