Jeff Speakes

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.