More financial pain in the months ahead.
After a decade-long bear market and two years of turmoil that saw the stock market plunge by 57%, investors are betting on still more financial pain in the months ahead.
Bond yields are near record lows. Gold continues to soar. And stocks are whipsawing as traders try to predict the direction of an economy that remains, in the words of Federal Reserve Chairman Ben Bernanke, “unusually uncertain.”
But not every investor is trembling with anxiety over the next financial blowup. Some are embracing the market’s volatilityâ€”and constructing portfolios to profit from it.
A growing number of money managers and financial firms are rolling out investment products designed to exploit big declines known as “black swan” events. Most of the products are geared toward institutional investors such as pension funds, endowments and high-net-worth familiesâ€”but black-swan strategies are trickling down to Main Street as well.
The term black swan was popularized in a 2007 best-selling book by author and investor Nassim Nicholas Taleb. It derives from the ancient belief, once widespread in the West, that all swans are whiteâ€”a notion that was proven false when European explorers discovered black swans in Australia.
The gist: Anything is possible. In fact, big surprises are more common than people think.
In financial terms, a black swan usually results in drastic moves in the marketâ€”events such as the 1990 Iraqi invasion of Kuwait, the Sept. 11, 2001, terrorist attacks and the recent financial crisis. Statisticians call these events “fat tails” (because they occur on the fringes, or tails, of a bell curve), while professional investors try to manage their “tail risk.”
The basic idea behind Mr. Taleb’s black-swan strategy is to keep most of your money ultrasafe, and to bet a small portionâ€”say 10%â€”on options contracts or other speculative bets whose prices will soar during a market panic.
The collapse of Lehman was a boon to black-swan investing. Funds run by Universa Investments LP, a Santa Monica, Calif., hedge fund managed by Mr. Taleb’s longtime collaborator Mark Spitznagel, gained more than 100% in 2008. Mr. Taleb has been an adviser to Universa since it launched in 2007; its assets have swelled during that time to about $6 billion from $300 million.
Today, there are as many as 20 hedge funds specializing in tail-risk strategies, most of which have formed in the past 18 months, according to Hedge Fund Research Inc. Capula Investment Management LLP of London and Pine River Capital Management LP of Minnetonka, Minn., are among the firms that have started tail-risk hedge funds this year.
Some of these specialized funds aim to profit when markets tank. Others are designed to protect against a market plunge but still profit when markets rise. Investors don’t typically put all of their money into these fundsâ€”but they are putting in more these days.
Retail investors are getting more access to black-swan-oriented strategies, too. Bond-fund giant Pacific Investment Management Co., or Pimco, has recently begun using tail-risk strategies in its Pimco Global Multi-Asset Fund, which launched in October 2008; in its RealRetirement target-date funds; and in its new equity funds launched this year. The firm also has filed a registration statement with regulators to offer exclusive “private placement” investments to well-heeled investors using tail-risk hedging strategies.
Some individual investors even are considering setting up black-swan portfolios of their own. “The 2008 downturn got me thinking that black swans can happen and will happen,” says Justin McCurry of Raleigh, N.C. The 30-year-old transportation engineer says he is thinking of putting a small portion of his portfolio into options as a way to “limit downside or to pick up some extra money if things went crazy.”
Black Swan (blak-‘swan)
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.An unforeseen event that can wreak havoc on the financial markets.
1987 Stock-Market Crash
(10/16/87 â€“ 12/4/87)
Iraqi Invasion of Kuwait
(8/2/90 â€“ 2/28/91)
Sept. 11 Attacks
(9/10/01 â€“ 9/21/01)
Implosion of Long-Term Capital Management
(7/17/98 â€“ 8/31/98)
Collapse of Lehman Bros.
(9/12/08 â€“ 3/9/09)
.Spreading Your Bets
The old cure for extreme events was simple diversification: spreading your bets among a broad array of asset classes. But the financial crisis showed that asset allocation isn’t always reliable when markets tumble in unison.
Diversification “works most of the time, but when it doesn’t work, those times really kill you,” says John Liu, who heads up Citi Portfolio Solutions, a newly formed unit at Citigroup Inc. dedicated to developing and managing tail-risk hedging strategies for institutional investors.
But black-swan investing has its risks, too. The biggest: When markets are behaving normally, the strategy can miss out on a rising stock marketâ€”even as costs add up.
That is because the strategy typically involves buying lots of out-of-the-money “put” options on everything from stock indexes and interest rates to currencies. Put options confer the right to sell the underlying instrument if the price falls to a certain level. Because they offer protection, their values soar during market panics, producing big profits for the holders. But if the market doesn’t plunge, the options expire worthless, and the investor must buy new options to replace the old ones.
If markets hold steady or rise for long periods, those costs can add up. During the stretch from late 1990 to early 2000 there wasn’t a single bear market, commonly defined as a 20% or greater fall from the peak. An investor using a pure black-swan strategy would have missed out on one of the greatest bull markets in history.
Another risk: Because black-swan events are so unpredictable, the markets’ reactions to them can be equally unpredictable. Just because an approach worked last time doesn’t mean it will work in the future. Some of the new products launched in the past two years might not perform well under duress.
And Wall Street is always happy to cater to investors’ bullish or bearish whims, so long as it can charge fees. “Whenever an investment company tells you that they’ve come up with a product that can protect you from black swans, you should hold onto your wallet,” says William Bernstein of Efficient Frontier Advisors.
Despite the risks, a growing number of professional investors are diving in, whether to protect against a plunging market or to profit from one. Brett Barth, a partner of BBR Partners LLC, a multifamily office in New York, in June started investing client money in Pine River Capital’s Nisswa Tail Hedge Fund. “For what we expect to lose on the premium we’re spending, we expect to get a big payoff in a tail-risk event,” Mr. Barth says.
Similarly, Brinton Eaton, a wealth-management firm in Madison, N.J., earlier this year began using a structured product from Deutsche Bank AG called “Emerald” to reduce its black-swan risk. The instrument, which uses derivatives tied to an index such as the Standard & Poor’s 500-stock index, typically does better in periods of higher volatility. It is designed to post small returns in most markets, says Jerry Miccolis, Brinton’s principal and chief investment officer. “But in very dramatic times, that bet gets amplified.”
Ordinary investors are seeking out black-swan investing opportunities as well. Pimco’s Global Multi-Asset Fund, launched in 2008, has attracted $2.3 billion in assets so far despite its hefty fees for retail investors, including a 1.91% levy for its Class A shares.
Kent Smetters, a risk-management professor at the University of Pennsylvania’s Wharton School and president of Veritat Advisors, a Philadelphia-based online financial-planning firm, is working with financial advisers to bring tail-risk strategies to retail investors in a lower-cost mutual-fund vehicle by early next year. “Turbulent markets also provide lots of opportunities,” Mr. Smetters says.
Investors wary of paying fees to mutual-fund managers can implement their own tail-risk strategies. In “The Black Swan,” Mr. Taleb recommends a “barbell” strategy in which investors put 85% to 90% of their portfolios in extremely safe instruments, like Treasury bills, and the remaining 10% to 15% in highly speculative bets such as options.
That strategy is designed to lose a little bit during ……
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