Debate Rates Over 'Black Swan' Funds

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 |  Includes: VXX
by: optionMONSTER

By Chris McKhann

I sometimes jokingly compare bears to the proverbial broken clock that's right twice a day. I am allowed as I have a bearish bias myself: Research has shown that traders anchor to the market they start out in, and my professional career began not long before September 2001.

There are so many problems with this analogy, but the big one has played out over the last two weeks. The broken clock is right twice a day -- for exactly one minute, which is just like all other minutes. When the bears are right, however, they are typically right in dramatic fashion. Markets fall much faster than they rise and do so with dramatic increases in volatility, as we have seen.

Anyone who posited the bear case starting as far back as October of last year would have been wrong for most of the last 10 months. But then came month 11, August.

Black SwanThis ties into the conversation that we have been joining sporadically in the last couple of months about "tail-risk hedging." There has been a lot of discussion of the relative worth of such hedging and the "Black Swan funds" that have arisen in the last year or so.

At the end of June, when the SPX was up at 1340, James Montier wrote a widely cited attack on tail-risk protection, suggesting that cash and timing are the best solutions. I respect Montier's work but have trouble with his conclusions here. Tail-risk protection may be "one of many investment fads du jour," as he calls it, but it is one that can save you a lot of money and it therefore worthwhile.

In suggesting that cash may be the best tail-risk hedge, he says: "The hardest element of tail-risk protection is likely to be timing. It is clear that a permanent allocation is likely to do more harm than good in many situations." I agree with the timing issue, but if one can time the move to cash, then one can time other hedges as well -- such as long S&P 500 puts or VIX calls.

I bring up this discussion again because there have been some high-profile examples of tail-risk hedging in recent weeks, and the news channels have been discussing the successes of the so-called Black Swan funds. Universal Investments and others of that ilk are up anywhere from 10 percent to 25 percent this month and therefore this year. (Universal is advised by Nassim Taleb, who wrote "The Black Swan.")

Given their strategies, one would expect excellent returns, as they are usually just long volatility of one form or another. Just one of our recommendations to buy VIX calls in early August was up 550 percent a week later (see chart below), proving that long volatility and good timing will help you make -- or at least save -- money.

VIX

Moving to cash is always an option. But if you can figure out good timing on moving to cash, why not make some money on the downside as well? Bear moves are usually much bigger and quicker than bullish ones, so it only makes sense that one should consider the potential profits.

Tail-risk hedging is a tricky game, as evidenced through the example of just holding a position in the Barclays iPath S&P 500 VIX Short Term Futures (NYSEARCA:VXX) exchange-traded fund, which is down roughly 60 percent from a year ago and below levels even from March. Those who promote such strategies and funds will tell you that they will lose money most of the time. But when they do make money, they tend to do so in dramatic ways.

The arguments over hedging will continue, but it is clear to me that there is money to be made or saved through good use of options. The record option volumes over the last week would support that idea, as would the spikes in the VIX.