Black swan funds have their day in the sun
According to Bloomberg’s Mike Weiss, so-called black swan funds have been doing wonderfully well of late:
Universa, a hedge fund founded and owned by Mark Spitznagel that consults with New York University professor Nassim Taleb, had a 10-fold return this year through Aug. 8 on the capital in its black-swan accounts, said a person familiar with the firm who asked not to be identified because the information is private. Black-swan clients of Pimco, manager of the world’s biggest mutual fund, saw gains this month of as much as 5.5 times the premiums they paid, according to Vineer Bhansali, a Pimco portfolio manager.
Does this mean that I was wrong to be skeptical about such funds back in July? I guess that depends on whether you consider the market volatility of late to be a black swan; I don’t. Maybe what’s really going on here is that I just fundamentally misunderstood the purpose of these funds and what they’re designed to do.
The internal returns being quoted by Weiss are certainly impressive — it’s not easy to set up a fund which can keep its head relatively close to the waterline during quiet months and which can still end up providing 1,000% returns when things get volatile.
That said, the net effect of all this hedging is smaller than you might think:
At funds such as the $4.9 billion Pimco Global Multi-Asset, the insurance program has added 3 percentage points to 5 percentage points of performance this year, according to Bhansali, the chief architect of the firm’s tail-risk management program. The global multi-asset fund, co-managed by Bhansali and Mohamed El-Erian, Pimco’s chief executive officer, is down about 1.1 percent so far this year.
Being down 1.1% this year is a good performance, on a relative basis. But on an absolute-return basis, it’s still negative, in a world where some major hedge funds have posted impressive figures: Och-Ziff’s flagship OZ Master Fund is up 1.2% this year, while Citadel’s two biggest funds are both up around 14%.
The point here is that you get surprisingly little information by looking at the performance of black swan funds in a vacuum, without looking at the broader performance of the people who are making use of them. Most sophisticated investors employ hedging strategies; if they’re invested with Universa, then they’re certain to do less hedging elsewhere in their portfolio. So the real question isn’t what happened to their Universa assets, it’s what happened to their portfolio as a whole, compared to what would have happened had they simply hedged their portfolios internally. And that’s a much harder question to answer.
And we still don’t have any data on what might happen to these funds in the event of a real black swan — something genuinely unexpected, as opposed to a simple bout of market volatility. In many ways, what we’re seeing now is the absolute best-case scenario for these funds: markets bouncing around a lot, with an associated massive rise in options prices, without any real panic surrounding counterparty risk or the future of entire asset classes. For all its volatility, the market has been orderly and liquid throughout, with high volumes, low bid-offer spreads, and none of the crazy quotes we saw during, say, the flash crash.
The black swan funds, then, have done well when faced with what you might call a gray swan — market activity at the extreme end of normal. Does that mean they’d do even better in the event of a real black swan — the kind of tail risk which can wipe out entire portfolios? That’s far from clear: these strategies don’t necessarily scale as you might expect them to. RG Niederhoffer’s tiny $22 million Negative Correlation Fund might be up 5.3% this year, but that doesn’t mean it couldn’t blow up if things got significantly worse.