Volatility in financial markets has jumped sharply in recent weeks, thanks to the U.S. debt ceiling debate and ongoing financial crisis in Europe. For most investors this has been a period of great consternation. But for some “Black Swan” investors, it has been a period of extraordinarily positive return. A Bloomberg article1 notes that some Black Swan funds have enjoyed massive returns so far in August.

The idea of the “Black Swan” was popularized by author Naseem Taleb in his 2007 book by the same name. The basic idea is that extreme events occur more frequently than either our training or intuition lead us to expect. In particular, the normal distribution, or bell-shaped curve, does not capture the probability distribution of asset prices. Since most people are taught to think in terms of the bell shaped curve, they tend to underestimate the likelihood of an extreme outcome. This is sometimes called “tail risk”.

The basic idea of the Black Swan fund is to take advantage of this cognitive defect by buying out-of-the-money options on stocks or bonds or commodities or currencies. If the market prices options according to the normal distribution, and yet actual outcomes follow distributions with greater tail risk, the Black Swan fund will periodically perform extremely well.

This is just what has occurred of late. Spikes in volatility in stock and bond markets have generated enormous gains for investors who bet on rising volatility, which is just what Black Swan investors do. The Universa Fund (which is loosely affiliated with Taleb), claims a ten-fold increase in capital value for the year through August 8. The top bond management company in the world, Pacific Investment Management Company (PIMCO), also has a tail risk fund that did very well recently.

The problem with Black Swan funds is that they will have mediocre or poor performance in most periods, when markets are relatively stable, and will only shine in the occasional periods of extreme volatility. Their managers and supporters claim that the massive out-performance in the brief periods of market dislocation offset the more frequent periods of under-performance.

Should you try this at home?

This strategy is not for everyone. Buying out of the money options will pay off dramatically every once in a while. The problem is that the market is pretty smart and probably will incorporate into the fat tail risk into options prices. Investing in tail risk strategies should be based on informed estimates of the likely volatility of asset prices compared with the implied volatility (as implied by observed prices of options). It is not easy to come by such informed estimates. Since it is safe to assume that the other side of the trade does have the benefit of such information, non-experts should leave this field to the experts.

Still, in managing an investment position, it is attractive to attempt to minimize the “worst case” loss. One way to do this is to diversify by making as many independent, or close to independent, bets as possible. Also, in the same Bloomberg article, strategist James Montier suggests that keeping a greater portion of your portfolio in cash may be the most efficient way to protect against extreme events.

1Universa, Pimco Posted Gains on Black-Swan Funds as Market Fell. August, 10, 2011.

“After nearly two years of global economic and financial upheaval, shockwaves are still being felt, as we have seen with recent developments in Europe and the resulting financial market volatility,” Naoyuki Shinohara, the IMF’s deputy managing director, said in Singapore on Wednesday. “The global outlook remains unusually uncertain and downside risks have risen significantly.”

They are right in that uncertainty and risk are high.  I don’t think they’ve changed much, though, in recent weeks.   What has changed has been people’s perception of the risk.

For some reason, unfathomable to me, people started getting giddy about our economic prospects last August or so.  There were some good data points, but you had to look at them only in a cursory manner, and you had to ignore other discouraging data to believe we were headed for a robust recovery.

A more in-depth analysis and a broad look at the data gave no reason for a giddy attack.  The gains were mostly transitory, driven by temporary government programs.  Consumers, businesses, and governments were still over-leveraged.  The financial sector was still weak.

Still, it became consensus that our economic challenges were behind us.  The stock markets soared, and this was taken as another sign of economic prosperity just around the corner.

Now, the stock markets are down again, and some economists are talking about new risk.  I’d say the risks were there all along, and our forecast reflected those risks.

Today, things seem to be much better. Some economists have declared the recession over. Policy makers and talking heads seem to have adopted a complacent attitude. They are confident the worst is over. Sentiment surveys aren’t quite so sanguine. Maybe this time the political class is wrong.

I reviewed the 3-month TED spreads (Libor-Treasury—usually interpreted as a short-term risk premium), and sure enough they are down a bunch from a year ago. However, a 50 basis point spread is quite different when the 3-month Treasury is 18 basis points versus when it is 200 basis points. So, we normalized the TED spread by the Treasury rate to provide a measure that is consistent across interest rates. This tells us a very different story. That spread in July, the most recent month for which we have data, was higher, on average, than even in September 2008.

Combine the normalized TED spread with data on bank lending, consumer and business borrowing and bank charge offs, you might start thinking that things are not looking all that good.