So-called "tail risk" funds, also known as "black swan" strategies after the popular book by Nassim Nicholas Taleb, are supposed to hedge against rare but dangerous events, such as the market sell-off following Lehman Brothers' demise.

But the GAIM 2012 hedge fund conference this week in Monaco revealed widespread doubts about whether such funds can perform as they are expected to, leaving investors dangerously exposed to a deepening global debt crisis.

"You guys better figure out how, while hedging tail risk, you're not letting liquidity risk sneak in the back door ... you don't know how to get out and we've just had a liquidity event not so long ago," one investor told a panel of managers discussing their funds on Wednesday.

He accused firms who offer the strategies of not knowing how to exit their positions, particularly if markets seize up and liquidity in the derivatives markets these funds trade evaporates.

Tail risk is defined as the probability of rare events.

Pension funds and family offices, still smarting from the huge losses they suffered in the 2008-2009 financial crisis and fearing another blow-up is just around the corner, are handing over billions of dollars to bank and fund providers promising protection - many without really knowing if the funds will pay out when they need them to.

CONFUSION

Dozens of different strategies can carry the tail-risk tag, many of them using complex mathematics which leave investors puzzled about how they work.

In their most simple form, the funds buy "put" options - contracts which give them the right to sell an underlying stock or security on expectations of a drop in price.

Under the terms of the contract, the seller of the put - such as an investment bank - is obliged to buy the asset from the fund at a pre-determined price, earning the fund a profit if prices have slumped below that level.

Other funds, however, bundle these traditional tail-risk hedges with bets on indexes that track volatility rather than protection from falling prices.

Another worried investor at the conference said managers were getting confused in their terminology and execution, increasing their exposure to risk instead of minimizing it.

"You can have a market falling very slowly by 1 percent a week for 36 weeks, then up 1 percent a week for another 36 weeks, and you will have a tail event but you'll lose money like hell being long volatility on a variance swap," he said.

"You guys should figure out the difference between volatility and tail risk, which you tend to put together."

A variance swap is a product that lets the owner hedge the risk of volatility of an underlying security or index.

HIGH PRICE

With so many different strategies on offer, it is difficult to estimate just how much investors have riding on these models.

But JP Morgan Chase & Co's (JPM.N) global asset allocation group estimates assets in tail-risk hedge funds ballooned to about $38 billion in April last year from less than $500 million prior to the Lehman collapse.

As demand for tail-risk type derivatives has soared, so have their prices. Some fund managers said they were now actively betting against these tail-risk trades, believing investors wowed by these products have created a bubble in prices.

Jane Buchan, CEO of fund of funds house PAAMCO, is investing in managers that are selling puts, often on U.S. equities.

"There is tremendous fear and risk aversion in the market right now. It's pushing rates down, it's also pushing the price of puts very, very high. If you are willing to invest for the long term and not just worry about the short-term fear, you can actually make some really good money," she told Reuters.

Roberto Giuffrida, head of global business development at asset manager Permal, also highlighted the cost of such funds.

"We are certainly getting inquiries for tail-risk type strategies ... but we advise clients to combine pure option-based strategies with macro funds so that they can mitigate against the very expensive carry (of tail-risk investments)."

(Editing by Sinead Cruise and David Holmes)

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