The bear market on Wall Street is not a “black swan.” This is important is for semantic clarity, if nothing else. The term “black swan” has been thrown around with such abandon in recent months that it’s in danger of losing all meaning.
There’s a more important reason not call this bear market a black swan: it creates unrealistic expectations about what can be achieved with black-swan protection strategies. Those strategies hedge against certain rare events, but not everything bad that can happen in the stock market.
The black swan theory has a long history in philosophy and mathematics, but its use in the investment arena traces to the work of Nassim Nicholas Taleb, a professor of risk engineering at New York University. Taleb wrote a book in 2007 entitled “Black Swan: The Impact of the Highly Improbable,” in which he defines a black swan as an extremely rare and sudden event that has very severe consequences.
A key aspect of black-swan events, Taleb argued, is that they are unpredictable. This unpredictability means that, in order to protect yourself, you must always hedge your portfolio against the worst. That hedge will detract from your return in most years, but pay off in a big way in the event of a black swan.
A good analogy is to fire insurance on your house. House fires are extremely rare, but you still buy insurance against the possibility and are more than willing to pay your insurance premium.
Black-swan insurance in the investment arena pursues two general approaches. The first is to be as conservative as possible with almost all of your portfolio and extremely aggressive with the small remainder. The second is to couple your normal equity portfolio with an aggressive hedge — such as with deep out-of-the-money puts.
Neither of these strategies has offered complete protection against the current bear market, as you can see in the chart below. The three strategies listed in the chart are:
- Swan Hedged Equity U.S. Large Cap ETF HEGD, -0.18%, which invests more than 90% of its portfolio in large-cap stocks and hedges with put options.
- Amplify BlackSwan Growth &Treasury Core ETF SWAN, -0.55%, which invests 90% in U.S. Treasurys and 10% in S&P long-dated call options.
- S&P 500 SPX, -0.27% fund (96.67%) plus long-dated out-of-the money puts (3.33%). This specific strategy was derived by Michael Edesess, an adjunct professor at the Hong Kong University of Science and Technology, in an attempt to replicate the reported returns of a hedge fund (whose strategy is proprietary) with which Taleb is associated.
Clearly, all three approaches’ year-to-date losses are in the double-digits, with the Amplify BlackSwan ETF actually losing more than the S&P 500 itself.
These otherwise disappointing returns are not necessarily a criticism. If this year’s bear market is not a black swan event, then it doesn’t seem fair to criticize these offerings for failing to protect investors. For example, during the waterfall decline that accompanied the economic lockdowns at the beginning of the COVID-19 pandemic, which is more appropriately classified as a black swan event, a portfolio that allocated 96.67% to the S&P 500 and 3.33% to deep out-of-the-money puts would have held its own or posted a small gain.
Hedging against more than black swans
Your comeback might be to suggest constructing portfolio hedges that insure against more than just black swan-like losses. But the cost of such hedges would be much greater than the insurance premium for protecting against a black swan. That cost could be so high, in fact, that you might decide it’s not worth it.
Consider fixed income annuities (FIAs), which allow you to participate in the stock market’s upside while guaranteeing that you never lose money. The “premium” you must pay for this insurance is that your participation rate — the share of the price-only gains that you earn — is often well-below 100%. Currently, for example, according to Adam Hyers of Hyers and Associates, a retirement-planning firm, an FIA benchmarked to the S&P 500 has a 30% participation rate — in effect setting its insurance premium to be 70% of the index’s gains in those years in which the stock market rises.
Would you be willing to forfeit 70% of the S&P 500’s price-only gains in years the stock market rises, along with all dividend income, in order to avoid losses in those years in which the market falls? There’s no right or wrong answer. But you need to be aware of the magnitude of the insurance premium.
The chart above plots the calendar-year price-only returns of the S&P 500 since 1928. The red line shows what your return would have been since then — 3.7% annualized — if you were flat in years in which the index fell, and earned 30% of the index’s increase when it rose. That 3.7% annualized return is a lot less than the 10.0% annualized total return the stock market has produced over the past nine-plus decades.
I’m not suggesting that FIAs are never appropriate in certain circumstances. In an interview, Hyers told me that there are many different FIAs to choose, and some that are benchmarked to indexes other than the S&P 500 have higher participation rates than 30%. Indeed, he added in an email, “many of the [FIAs benchmarked to] proprietary indexes have… participation rates above 100%, so those are where larger gains are locked in.”
My point in discussing FIAs is instead to remind you that there is no free lunch. The more you want to insure against losses, the more upside potential you forfeit in the process. While it is possible to insure against a black swan event, such insurance won’t protect you from all losses.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks invest/ment newsletters that pay a flat fee to be audited. He can be reached at firstname.lastname@example.org
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