After the financial crisis there was a rush to buy “tail risk” funds designed to protect against a crash by providing outsize returns when markets fall. They mostly worked well this year as the spread of the coronavirus hammered stock prices.
But now investors have the opposite problem: They want to hold nice safe assets but have a deep fear of missing out—FOMO—if the markets resume their rebound, interrupted this week. One solution: a FOMO fund.
So far as I can tell, there is only one FOMO fund, and it is private with only one external institutional investor. It is run as a sideline to the main tail risk business of California-based LongTail Alpha LLC, and according to a letter shown to The Wall Street Journal by its investor, by the start of this month the fund had gained 93.9% from when it put money in at the end of March.
The idea is to use options to gain heavier exposure to jumps in the market while limiting losses to the premium paid to own those options. That frees the investor to be more cautious with the rest of the portfolio—the exact opposite of the standard tail risk fund.
Call options, which give the right but not the obligation to buy at a predetermined price in the future, are standard fare for investors making active decisions. But systematically using them to gain exposure to any rise in the markets has been a money-losing strategy in the past. Call options expire worthless if the market goes sideways or down. They make most money when the market suddenly jumps, which it has done in the past far less often than suddenly falling.
Vineer Bhansali, chief investment officer at LongTail, said he couldn’t discuss the fund itself because it is private. But he said times had changed.
“Meltups are just as likely as meltdowns in this environment of central bank money printing,” he said.
If the Federal Reserve gives you a free “put” option to protect against losses—because we know policy makers will step in and help if the market plunges—then it makes sense to sell a put, collecting the premium and profiting as long as the market doesn’t fall more than a predefined amount. But selling puts is far too dangerous a strategy for most. It brings with it potentially huge losses if markets crash before central banks get their act together, because the seller of a put has to buy stocks at the predefined price, even if the shares are trading much lower. A better way to make a similar bet on the Fed is to buy a call, where the potential loss is limited to the premium paid.
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Mr. Bhansali’s fund just caught a record meltup in the S&P 500, which rose 39.6% in 50 days (the S&P’s narrower predecessor index rose even more in the false start of 1932). The twin questions for investors wanting to use options are whether we will see more meltups, and whether the market is mispricing the meltup likelihood. If the answers are “yes” and “yes,” a FOMO fund makes perfect sense. If we return to the norms of history, then the answers are “no” and “no,” and it will bleed money for long periods when markets go sideways or rise slowly.
However, there is a deeper question about investor psychology.
Investors tend to take profits too early and hold losing positions too long, a well-known mistake documented by behavioral finance and dubbed the disposition effect. Traditional tail-risk funds help to counter that. They give an investor the confidence to hold on to their risky assets when markets are rising, since they have some protection if the worst happens and markets fall sharply.
Call options also help to overcome the disposition effect: The predetermined expiration date makes it easy to let your winners run until then. One could cash in any gains early by selling the option, but the psychology of having committed up front helps to counter this. On top of that, the losses are defined as the entire premium, which allows an investor to run the rest of her portfolio in the knowledge of exactly what potential losses this upside bet brings. Unfortunately the options market is complex and for most people too hard to trade directly.
Traders on the first day of in-person trading at the New York Stock Exchange after its closure during the coronavirus pandemic.
Photo: brendan mcdermid/ReutersOrdinary investors can try other tricks to overcome the disposition effect. Setting targets in advance for the size of loss or gain that will prompt you to sell helps. In broker lingo, using stop-loss trades that trigger automatically at a predetermined level, is one way. Writing down the reasons for the targets at the time helps too, as we all tend to justify changing our past targets as prices change, inventing justifications along the way.
What about right now? If everyone fears missing out, FOMO will push the market up more than it otherwise should. Those who sat out the rally buy back in at a higher price because they feel silly watching stocks go up; greed finally overcomes fear. But FOMO is a fragile sentiment.
I recommended taking profits on the short bull market at the end of April, which in retrospect looks like it was too early. Maybe stocks can keep going up, propelled by continued easy money and a fast-recovering economy—albeit not in a straight line, as Thursday’s sharp drop should remind the day traders. But the risk that something goes wrong seems to me to be bigger than the market is acknowledging. I’m happy to miss out on fleeting gains. But a FOMO fund would let me access any return to upward momentum for a defined upfront cost. That is better than feeling pressured to put an entire portfolio at risk.
Write to James Mackintosh at James.Mackintosh@wsj.com
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