Black Swan Funds, or tail-risk funds, are funds that seek to structure their portfolios such that they produce great returns in the statistically unlikely event that the markets go haywire, as happened in the financial crisis.
Q. So, these are funds that should do well when the markets go haywire, right?
A. That’s the idea. The name is from Nicholas Taleb, references extremely rare events. Until 1694, everyone thought all swans were white… then a black swan was discovered in Australia. They’re also called tail risk funds, where the “tail” refers to the ends of the bell curve distribution graph… highly unlikely events. But the point is that even unlikely events do in fact occur on occasion.
Q. Right, and the fund that Taleb was advising did incredibly well in the crash, right?
A. Yes. Taleb was beating the drum on the idea that Wall Street’s pricing models simply ignored events out on the extremes of the bell curve. That’s wrong, because, as you just said, those events do occur rarely, but with certainty. So the idea was that you could effectively buy super cheap options that eventually would pay off. And they did.
Q. So how exactly do these things work?
A. Some focus on equities, so might buy puts on the S&P. Some focus on credit, so might buy sovereign credit default swaps… in the most recent turmoil, Boaz Wienstien’s done well with that. Other funds play the VIX, which of course will spike if there’s big trouble. And, of course, you can mix and match these.
Q. Are there ways for normal investors to participate?
A. Definitely there are; aside from lots of hedge funds, there are even ETFs out there now. But generally, I’m not a fan. Black Swan strategies can be very expensive to hold when the world isn’t imploding, because any form of option suffers decay. Many of these funds lose several percentage points a year when there isn’t a catastrophe, on top of the management fees.
Q. So what do you like instead?
A. The poor man’s black swan fund is cash, or maybe TIPs. For every dollar that’s in cash or TIPs, you’re not holding an asset that might crash; and more important, you can pick up the pieces when things fall apart. To me, the most conservative bet is playing the upside that comes after a crash, rather than trying to profit on the crash itself: be ready to buy when the blood is running in the streets.