New Investment Strategy: Preparing for End Times
Investment professionals have a new pitch: The sky could soon be falling.
While Greece took a step back from the brink on Wednesday, the possibility of a default remains a fear. Europe’s debt crisis, as well as natural disasters and political uprisings, are prompting investors both big and small to seek out investments that promise to protect their portfolios in the event of economic Armageddon.
Worried that Greece could go belly up? So-called black swan funds — named for rare and unexpected events — offer a way to profit in the event of a market collapse. Think a slowdown in the United States or China could set off a global economic crisis? New exchange-traded funds are popping up to help pad investor confidence.
Since the financial crisis, many investors have prospered from a rebound in the markets. But recent events have led some to brace for the worst.
“Clients are suddenly realizing the world isn’t as rosy as it’s been,” said Ahmed Fattouh, a hedge fund executive. “It makes a lot of sense to have these tail protections on.”
That is, protections against what Wall Street calls “tail risk” — a disaster that is estimated to have less than half a percent chance of happening.
Investors learned about tail risk the hard way. For decades, diversification — spreading holdings across stocks, bonds and other investments — was promoted as the way to protect investments from market crashes. But the financial crisis proved that seemingly unrelated assets could fall in unison. As a result, an increasing number of investors now want protection for financial end times.
These funds and offerings, usually costly and complicated, can be likened to insurance. Investors lose money on them during normal times, but they stand to gain if catastrophe strikes. Tens of billions of dollars are in such investments, representing a small but growing fraction of the investment world, particularly for a strategy that many investors would have scoffed at five years ago as expensive and unnecessary.
“In the last decade, we saw two stock market crashes, which wiped out any gains for investors over the decade and meant disaster for those who had to take their money out to meet big expenses at market lows,” said Zvi Bodie, a professor of finance at Boston University School of Management. That, he said, “has just made the current generation of investors more aware that it is risky even over a decade or more.”
Wall Street lawyers say money manager clients have approached them in recent months about forming new funds aimed at providing protection. Banks like Goldman Sachs are marketing tools engineered to bulletproof investors. Products linked to an index known as the market’s “fear gauge” total nearly $2.5 billion. And in the last year, the amount of money managed in dedicated tail-risk accounts by the bond giant Pimco has doubled to $23 billion.
Boaz Weinstein, a former trader at Deutsche Bank who lost more than $1 billion of the bank’s money during the financial crisis, began raising money for his own Armageddon fund late last year. It has since grown to $400 million of mostly institutional money, part of the $3.3 billion he has raised for his hedge funds.
"Some investors after nursing those losses say, ‘I’d be much happier in return for not having that kind of downside to reinvest 1 percent of my portfolio in tail hedging,’ ” he said.
Investors include big public pensions. Joelle Mevi, the chief investment officer of New Mexico’s public employee pension fund, recently presented some tail risk options to her board. “While I wouldn’t tend to put a very large allocation there, I believe in having that type of insurance for the funds,” she said.
But protection does not come cheap and occasionally fails to work. Some say such funds are merely the latest Wall Street fad and may be ineffective because they are designed to protect against the last catastrophe, not the crisis to come.
“I kind of believe that the best way to reduce risk is to take things out of the portfolio, not add them,” said Ken Grant, president and founder of Risk Resources.
Although the names tail risk funds and black swan funds are often used interchangeably, they are distinct. Tail risk events are situations that, while conceivable, are highly unlikely based on mathematical modeling. By contrast, a black swan — a concept popularized by Nassim N. Taleb’s 2007 book “The Black Swan” — is an event that models fail to predict.
So how do such Armageddon funds work? Take a situation like the collapse of China’s economy, an event considered highly unlikely. While most American investors do not own Chinese stocks, real estate or currency, the fear is that a shock to China would spread to the rest of the world. As the stock markets fell, a tail risk or black swan fund would profit because it owned the options to sell shares in the Standard & Poor’s 500-stock index at far higher levels. The more the index dropped, the more valuable those options would become.
At Universa Investments, Mark Spitznagel, a former partner of Mr. Taleb’s, has raised more than $6 billion for a fund that is awaiting a market calamity. In the meantime, he acknowledges, it is losing money nearly every day. Part of the reason is that he buys options to sell a given stock in the future for a price below where it is currently trading. If the stock doesn’t move, or rises, the option is worthless, and he loses money. But if the share price tanks, he can make substantial profits.
Mr. Spitznagel, one of the more experienced doomsday managers, derides those who have jumped into the game recently. It takes a special kind of person to manage these kinds of investments, he says — people capable of slowly taking losses, without losing their composure.
“It takes someone that’s a little bit nuts,” he said. “I’ll do a trade, then say, ‘This is the best trade I’ve ever done in my career, but I’m quite sure I’m going to lose money on it.’ ”
“I understand my payoff and I understand these are very small losses relative to what I know I’m going to make eventually.”
Others are raising money to bet against the world. Capula Investment Management has raised some $2 billion, while 36 South Capital Advisors, a London-based fund that returned more than 200 percent during the 2008 crisis, is at $300 million and counting.
Not all investors are sold.
“Tail risk is out there, we all know it’s out there, but if you have 20 some hedge funds, you’re really looking for strategies that work in the total picture,” said Craig Slaughter, who oversees roughly $12 billion as the head of the West Virginia Investment Management Board. “Focusing on tail risk strategies — I’m just a little suspicious. It’s a little bit of a sales technique.”