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‘Black swans’ are unpredictable, outlier events that have sweeping, often catastrophic consequences. According to author Nassim Taleb, who popularized the term, surprising events can either be anticipated, or are so implausible that they’re not on anyone’s radar.
Events in the first category, like the Brexit vote or the US election, have binary outcomes which make them possible to prepare for. A black swan would be more like the September 11th terrorist attacks or the 2011 Japan tsunami: unforeseen and universally shocking.
Taleb recommends investors build more robustness into their portfolios and decision-making processes, so that they can better brace for such events before they take place. This means diversifying sources of risk and holding hedging instruments, in addition to other measures discussed below. On the other hand, funds and instruments which position specifically for black swan events tend to produce negative returns on most days, and the costs of insurance add up over time.
For most people, it makes sense to stay invested most of the time, which means taking reasonable risks while being mindful of potential market shocks. It's impossible to completely avoid drawdowns when investing, but thoughtful portfolio construction and contingency planning can still reduce the impact of large sell-offs.
Lessons learned from black swans such as the 2008 Lehman crisis
- Expect the unexpected. History has shown that highly improbable events happen more often than expected, so investors should look closely at tail risks which could seriously damage their portfolios. For instance, there are ongoing concerns that a large country could leave the Eurozone, which could sound the death knell for the euro. This amplified the market sell-off in May 2018 during the Italian elections. Although the election was in the diary, the subsequent flight to safety among global investors showed fears of further disunity among Eurozone nations. Investors try to assess what could go wrong, quantify how likely the event is, and think about the possible implications if it happens.
- Quantitative models are unlikely to identify black swan risks. Models are inevitably based on some form of historical data, while black swan events by definition have no precedent. The event’s drivers will be unknown and correlations will be unexpected. We only know that the next crisis will be different from any other. Therefore, portfolio managers try to simulate market reactions to unprecedented events, and analyse qualitative factors to spot broader, less measurable trends or imbalances.
- Diversification isn’t what it used to be. Markets are increasingly interlinked and different types of assets may suddenly become highly correlated. In response, portfolio managers try to include a greater variety of assets with different drivers to minimize correlations within a portfolio. They also need to monitor changing correlations and asset class dynamics as market conditions change.
Managing and monitoring risk exposures
After understanding a market’s key drivers and how they change over time, investors can model how portfolios would react to a real adverse, high-impact event. For example, investors in the stock of French bank BNP Paribas are not only affected by developments within the company itself, but also by any factors correlated with the company such as the euro, the wider banking industry, French government bonds, the yield curve, and so on.
Before the Brexit vote, like many investors, our base case was for the UK to vote to remain in the EU. We ran scenario analyses to evaluate our exposure to Europe and how metrics such as volatility, profit and loss, and value-at-risk looked under different outcomes. Although the outcome of the vote was surprising, our simulations helped to ensure that we were not overexposed. Uncertainty remains as to what form the actual event will take, so the scenario planning continues.
In addition to statistical measures based on forward projections of risk, qualitative factors may affect returns. For example, North Korea has threatened military action against South Korea for six decades, but usually these threats fade. As with the boy who cried wolf, markets have grown numb and skeptical to the threat, so a sudden attack without warning would be surprising and highly impactful. Experience suggests that Korean equities would sell off aggressively, as would other emerging market assets in Asia, while the dollar and treasuries would rally. By simulating this market reaction, it’s possible to plan a response ahead of time.
Markets tend to become less liquid during times of high uncertainty and tail risk events, raising counterparty and liquidity risks. The operational and financial stability of all potential counterparties needs to be assessed and this exercise is repeated as market events unfold. Analyzing the liquidity of holdings and portfolios under stress-test scenarios can help investors anticipate and minimize issues when redeeming the assets.
Mitigating the impact of large sell-offs
It’s impossible to position for every event in advance, and the cost of hedging or insurance adds up over time, eroding portfolio returns. There are also opportunity costs. For example, the impact of Brexit could be very different depending on whether the outcome (not yet decided at the time of writing) is ‘hard’, ‘soft’ or somewhere in between, so positioning portfolios for a specific outcome may not make sense . Instead, it’s better to plan ahead for a range of possible market moves, and then respond as the situation evolves. There are often warning signs ahead of large moves in markets; the key, of course, is deciding when and how to react to these signals.
Not having all your eggs in one basket is also a big part of mitigating tail risks. Increasingly, it’s important to identify assets that have a negative correlation with other holdings as well as being attractively valued. For example, onshore Chinese government bonds have provided diversification benefits as correlations increased between bonds and equities in other regions. They were also one of the few asset classes that behaved defensively during the February 2018 correction.
Finally, investors may use instruments that are neutral in terms of performance costs, but protect the portfolio during periods of sudden market volatility. A short position in Italian Government Bond (BTP) futures has been a useful hedge against Italy’s political risk and relatively weak fundamentals as the bond yields jumped in May 2018.
Source: Bloomberg, August 2018
Shorting the VIX
In recent years, one of the most popular trades has been retail investors taking short exposure to the VIX using exchange-traded products, which has kept downward pressure on volatility. Investors perceived the low volatility as supportive of equity markets, which ultimately fed a positive feedback loop. Our portfolio managers were concerned that the feedback loop could easily reverse, although it was not clear what the catalyst would be.
At the beginning of 2018, the portfolio managers took profits on some of the better-performing markets in multi-asset portfolios as US equities hit record highs. The team wasn’t expecting a bear market, but thought that volatility was unusually low and could normalise in a random shock event. This event occurred in February, when higher wage inflation data caused the VIX index to spike. That triggered a negative chain reaction in stocks, as the short VIX vehicles had to sell US equity futures to rebalance their portfolios. By positioning more defensively ahead of this crowded trade unwinding, our portfolio managers reduced the impact on returns.
From market falls come opportunities
Fundamentals drive long-run market returns but are not always reflected in market prices. Some of the best opportunities arise in the aftermath of a large market sell-off.
In the second half of 2015, falling oil prices weighed on the outlook for the US energy sector, especially high yield. Then China unexpectedly devalued the renminbi in August 2015, which caused global markets to sell off in lockstep. At that point, high yield bonds priced in a big global slowdown and presented a buying opportunity, especially relative to equities. Around the same time, emerging market local-currency bond funds were beaten down after years of significant outflows. When China devalued its currency, emerging market currencies weakened and bond valuations fell to very attractive levels. They priced in a worse outcome than fundamentals suggested, providing a good entry point with a margin of safety.
Through detailed research, thoughtful portfolio construction and a range of monitoring tools, investors can be better prepared for changes in market dynamics and high-impact, tail risk events.
Investors should combine quantitative models with market practitioners’ experience and insights to stress test portfolios for events that have never occurred. They should also account for the changing nature of correlations between asset classes to diversify and manage the risk of contagion. Hedging instruments often erode returns and should be used sparingly, with an understanding of the cost and the risks. Investors should also assess risks adjacent to the market that could arise during times of stress, such as counterparty and liquidity risks.
By considering potential black swans, investors can better understand their vulnerabilities and incorporate mitigation measures or plan responses. What are the extreme scenarios no one expects? A good question to bear in mind.