Six sigma is part of the jargon of industrial quality assurance – reducing the number of faulty parts in manufacturing processes to achieve 99.9997% perfection. For market participants, it has a more ominous meaning – when equities undergo a move of six standard deviations. It’s supposed to be a rare move, but it’s happened twice in the past decade.
These “black swan” events have obviously bolstered risk management practices. But they are also giving rise to new investment strategies, the Wall Street Journal reports.
“Today, there are as many as 20 hedge funds specializing in tail-risk strategies, most of which have formed in the past 18 months, according to Hedge Fund Research Inc. Capula Investment Management LLP of London and Pine River Capital Management LP of Minnetonka, Minn., are among the firms that have started tail-risk hedge funds this year.”
“Some of these specialized funds aim to profit when markets tank. Others are designed to protect against a market plunge but still profit when markets rise. Investors don’t typically put all of their money into these funds—but they are putting in more these days.”
“Retail investors are getting more access to black-swan-oriented strategies, too. Bond-fund giant Pacific Investment Management Co., or Pimco, has recently begun using tail-risk strategies in its Pimco Global Multi-Asset Fund, which launched in October 2008; in its RealRetirement target-date funds; and in its new equity funds launched this year. The firm also has filed a registration statement with regulators to offer exclusive “private placement” investments to well-heeled investors using tail-risk hedging strategies.”
Still, black-swan investing isn’t a slam dunk.
“But black-swan investing has its risks, too. The biggest: When markets are behaving normally, the strategy can miss out on a rising stock market—even as costs add up.”
“That is because the strategy typically involves buying lots of out-of-the-money ‘put’ options on everything from stock indexes and interest rates to currencies. Put options confer the right to sell the underlying instrument if the price falls to a certain level. Because they offer protection, their values soar during market panics, producing big profits for the holders. But if the market doesn’t plunge, the options expire worthless, and the investor must buy new options to replace the old ones.”
“If markets hold steady or rise for long periods, those costs can add up. During the stretch from late 1990 to early 2000 there wasn’t a single bear market, commonly defined as a 20% or greater fall from the peak. An investor using a pure black-swan strategy would have missed out on one of the greatest bull markets in history.”
Former money manager Eric Falkenstein, who blogs at Seeking Alpha, is skeptical about black swan investing:
“In my book Finding Alpha, I argue that people tend to pay for hope, and nothing offers hope better than the lottery-like returns available in potential Black Swans. Hope is a good thing, and motivates a lot of hard work and creativity. But it would be foolish to think that the more improbable, the more speculative, the more derided by economists, the better the risk-adjusted return merely because of this. This tendency to buy into lottery ticket leads to all sorts of really bad investments:
- Higher volatility stocks have lower return than low volatility stocks
- Higher beta stocks have lower returns than low beta stocks
- out-of-the-money options have lower returns–and higher betas–than in-the-money-options
- higher leveraged firms have lower returns than lower leveraged firms
- firms in greater financial distress have lower returns than firms with low financial distress
- Junk bond mutual fund returns are lower than investment grade mutual fund return over the past 22 years
- sports longshots such as 50-1 odds horses, have lower returns than favorites
- lotteries with the highest payouts have the lowest expected returns
- IPOs have lower-than-average stock returns”
To paraphrase Oscar Wilde, the only thing worse then banking on the expected is banking on the expected.