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Do You Need a "Black Swan" Fund?

Our lives are filled with any number of elemental truths -- those things that are so self-evident that even the notion of debating them is ludicrous. The sun rises in the east and sets in the west; the earth is round; mothers-in-law love to share parenting tips.

I was reminded of another truth recently upon reading an article in The Economist: Wall Street is always eager to sell you an investment that would have performed incredibly well in the market conditions just passed.

The article described the growing interest in investments that hedge "tail risk," which presumably protect portfolios against black swan-type extreme events. The term black swan entered Wall Street's lexicon in 2007 with the publication of Nassim Taleb's book of the same name.
In the book, Taleb argued that exceedingly rare and improbable events occur with much more frequency than we might expect, and that it's dangerous to assume that past experiences limit what the future might hold. As an example, Taleb cited the old European belief that all swans were white, which was grounded in the simple fact that the inhabitants of that continent had never encountered a swan of any other color. The subsequent discovery of black swans in Australia demonstrated the folly of extrapolating what you can directly observe too broadly.

Given that Wall Street has been rocked by its share of black swans over the past decade -- Doug Kass recently quantified the staggering list -- it's hardly surprising that there's a growing interest in developing investments that will provide some protection when the next black swan hits.

There's no denying that these investments have a certain amount of sex appeal. The idea of allocating a portion of one's portfolio to an investment that will zig when everything else is zagging is intriguing, but there's reason for skepticism. First, these investments tend to be costly. PIMCO's Global Multi-Asset Strategy fund, for instance, carries a 1.66 percent expense ratio, plus a 5.5 percent load for the fund's A-class shares. Implementing many of these strategies carry similarly hefty price tags, in addition to heavy trading costs -- expenses which present a significant drag on long-term performance.

Second, there's a strong possibility that funds that engage in tail-risk hedging will undergo long fallow periods. The Economist article noted that funds that invest in assets expected rise in bad economic times "tend to lose around 15 percent each year when the market is normal but can return 50-100 percent when the market dives."

Hmmm. Let's do a little math here. If your investment loses 15 percent annually for five years, you'd need a return of 125 percent in year six just to break even. That doesn't sound like a particularly compelling proposition to me.

Which gets me to my next concern. As much as I'm sure that investors currently interested in such funds are convinced that they'll be a wonderful addition to their portfolio, I have a suspicion that after a few years of fat stock market returns, those same investors might be eyeing that corner of their portfolio that's been losing ground and decide that money could be put to more productive use -- likely just in time to catch the market's next slide.

Finally, isn't the belief that one can reliably construct a way to profit from future black swans go against the very definition of a black swan? Sure, Wall Street today can build a fund that would have done exceedingly well during the past crisis, which is great as long as tomorrow's crisis resembles yesterday's. But black swans by definition are crises that are unlike anything we've ever seen, and thus it's impossible to predict how these tail-risk hedging strategies will fare when the next black swan hits.

Investors interested in protecting themselves from the worst the stock market can throw at them might do well to consider an old-fashioned form of black swan-hedging -- broad diversification. Take Vanguard's Balanced Index fund, for instance. With a 60/40 stock/bond mix, the fund provides exposure to the entire U.S. stock and bond markets. True, it lost 22.2 percent in 2008 -- a far cry from the 50-100 percent returns that black swan funds are supposed to return -- but that loss was recouped within two years, and an investor who bought and held is now back in positive territory.

While it's true that such a method of hedging tail risk won't captivate anyone at your next cocktail party, there's little doubt that this simplistic strategy is a great way of hedging another risk: buyer's remorse.

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