China eyes the Black Swan Protection Protocol

By Felix Salmon
August 24, 2010
Jenny Strasburg misses the point of the Black Swan Protection Protocol:

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Jenny Strasburg misses the point of the Black Swan Protection Protocol:

Clients don’t hand over their entire account for the firm directly to manage. Instead, clients designate a certain pool of assets, a notional value, that they seek to hedge, or protect against extreme losses.

For example, a client with a $100 million account with Universa would pay the firm a flat annual fee of 1.5% on that amount, or $1.5 million. The client would transfer to Universa typically less than 10% to fund its account in the strategy…

The goal is for the value of the puts to pay off 60% if the market drops by 20% or more in a month…

“The biggest home run would be if we went into ’70s-style or worse inflation,” Mr. Spitznagel said. “If I had a gun to my head, right now I’d fall on the deflation side, but that’s going to flip at some point.”

The Black Swan inflation strategy has less than $1 billion in client assets. Clients might have to tolerate steady losses in order to reach a hoped-for bonanza.

In fact, it’s the other way around: clients hope for steady losses on their protection protocol (down 2% this year, down 4% last year), because that means that they’re living in Mediocristan and the rest of their investments are happily and steadily performing more or less as they’re meant to.

If the clients reap a bonanza on their protection protocol, that means that the global economy has gone in a very nasty direction, people are losing jobs and wealth all over the world (including the clients themselves, quite possibly), and we’re entering another era of unpredictability and chaos. I’d hardly characterize any of that as “hoped-for”.

Note that even the fund manager, Mark Spitznagel, reckons that deflation is more likely than the inflation that the protection protocol is hedging. The point isn’t that inflation is hoped-for, or even that it’s likely. But the bet can still make sense as an insurance policy on the rest of the portfolio blowing up. And it can even make sense on its own, if the payoff is large enough: the most successful fund managers, just like the most successful gamblers, tend to be the ones who intuitively understand that it often makes sense to bet on something with a relatively low probability of happening, just so long as your return is high enough in the event that it happens.

The thesis of the Black Swan Protection Protocol is that the risk of chaotic inflation is underpriced, so it makes sense to hedge that risk now, when doing so is cheap. That doesn’t mean that anybody is hoping for chaotic inflation. It just means that clients — who might soon include China’s sovereign wealth fund — sensibly want to be able to protect their portfolios across a wide range of possible outcomes, even if none of them rises to the level of being a probable outcome. And even if — especially if — many of those outcomes are things you devoutly hope will never happen.

It’s possible to quibble about probabilities here. Nassim Taleb and Mark Spitznagel reckon that the probability is actually pretty high, given the complexity of the global financial system, that there will be some kind of blowup sooner rather than later. Does that mean they think that the probability is higher than 50%? The question is silly: it presumes some kind of mathematical model of the world, with various calculable probabilities applicable to various specifiable outcomes. And even if the world does blow up, can one be sure that it will do so in such a way that the BSPP will make lots of money for its clients? Of course not. But at least the BSPP is trying its best to profit from the characteristics of Extremistan. If, and when, they manifest themselves.


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