The black swan hedge funds – A fund in need?

When non-finance people first read through this title, most of them must have recalled the academy award winning performance of Natalie Portman in Black Swan. Even for finance majors, they might be tempted to find linkage between the movie and hedge funds, like I did when I first came across this term in Wall Street Journal. However, in finance, “A black swan is highly improbable event with three principal characteristics: it is unpredictable, it carries a massive index and after the fact, we concoct an explanation that makes it appear less random and more predictable than it was.” (Taleb, 2007). Although unpredictable, at least in terms of when exactly such event may occur, however, there are funds that can offer protection. And you guessed it right, those are the Black Swan Hedge Funds (BSHFs).

Nasim Taleb first popularized the term “Black Swan” in his book The Black Swan – The Impact of a Highly Improbable, which is a NY Times best seller. The author currently works as an advisor to Universa Investments that sells BSHFs. According to Business Insider, a BSHF suggested by Taleb made a billion dollar last week.

The underlying mechanism of such hedge fund is simple. Buy a put option whose value rises high when the market falls. If the market is stable or increasing, one only pays the price of put option, which is analogous to premium paid to insure against risk. For the inflow of money to the investors,the market has to fall. Eg. 2007/08 Financial Crisis, 2010 Flash Crash. These are times when BSHFs come into limelight as word is spread that certain funds have earned millions of dollar while the rest are losing.

They BSHF can be seen as type of insurance policy to hedge against risk. It basically operates using a person’s emotion of fear and greed. And it is a good bet. It’s a win-win situation for both the parties. The firm gets a hefty fee for its service and the customer is insured against the downfall risk. When the firm is bullish, such firm can utilize public’s emotion of fear. Highlighting the past financial crisis and the amount of money that one can lose when the market turns red, these firms can market itself. It’s even easier when the market is bearish. Firms get a lot of publicity as news about so and so firm making so and so amount of money amid such turmoil. As is the case currently, BSHFs are getting ample coverage that has attracted investors who lost money.

So is it a friend in need? At the moment, yes. With the second largest economy taking a hit, emerging markets slowdown, influential CEO of Bridgewater Associates, Ray Dalio, predicting a round of Quantitative easing rather than interest rate hike and a lack of a clear understanding on the Fed’s stand on the interest rate, BSHF seems a viable tool to hold in the short run. However, in the long run, just as the Black Swan events are unpredictable, so is the decision to invest in BSHF. It all depends on one’s personal preference i.e. how much are you willing to pay and till when?