By Marc Hubert
Strategies that hedge against rare events won’t protect you against everything that can happen to stocks
The Wall Street bear market is not a “black swan”. This is important for semantic clarity, if nothing else. The term “black swan” has been thrown around with such abandon in recent months that it risks losing all meaning.
There is a bigger reason not to call this bear market a black swan: it creates unrealistic expectations about what can be achieved with black swan hedging strategies. These strategies cover some rare events, but not everything that can go wrong in the stock market.
The black swan theory has a long history in philosophy and mathematics, but its use in the field of investing dates back to the work of Nassim Nicholas Taleb, a professor of risk engineering at New York University. Taleb wrote a book in 2007 called “Black Swan: The Impact of the Highly Improbable”, in which he defined a black swan as an extremely rare and sudden event with very serious consequences.
A key aspect of black swan events, according to Taleb, is that they are unpredictable. This unpredictability means that in order to protect yourself, you must always protect your wallet against the worst. This hedge will hurt your yield in most years, but will be very profitable in a black swan.
A good analogy is fire insurance on your home. Home fires are extremely rare, but you always buy insurance against the possibility and are more than willing to pay your insurance premium.
Black swan investment insurance follows two general approaches. The first is to be as conservative as possible with almost your entire portfolio and extremely aggressive with the small remainder. The second is to combine your normal stock portfolio with aggressive hedging, such as out-of-the-money put options.
None of these strategies offered complete protection against the current bear market, as you can see in the chart below. The three strategies listed in the table are:
Clearly, year-to-date losses from all three approaches are in the double digits, with ETF Amplify BlackSwan actually losing more than the S&P 500 itself.
These otherwise disappointing returns are not necessarily a criticism. If this year’s bear market isn’t a black swan, it doesn’t seem fair to criticize these offerings for failing to protect investors. For example, during the cascading fall that accompanied the economic lockdowns at the start of the COVID-19 pandemic, which is more appropriately classified as a black swan event, a portfolio that allocated 96.67% to S&P 500 and 3.33% on the out- puts of-the-money would have held up or posted a small gain.
Protect against more than black swans
Your feedback might suggest building portfolio hedges that insure more than just black swan type losses. But the cost of such hedges would be much higher than the insurance premium to protect against a black swan. This cost could be so high, in fact, that you might decide it’s not worth it.
Consider fixed income annuities (FIAs), which allow you to participate in the rising stock market while guaranteeing you never lose money. The “premium” you have to pay for this insurance is that your participation rate – the share of the prize-only winnings you earn – is often well below 100%. Currently, for example, according to Adam Hyers of Hyers and Associates, a retirement planning firm, an AIF listed on the S&P 500 has a participation rate of 30% – effectively setting its insurance premium at 70% of earnings. of the index in these years when the stock market is rising.
Would you be willing to give up 70% of S&P 500 price gains only in years when the stock market goes up, as well as all dividend income, to avoid losses in years when the market goes down? There is no right or wrong answer. But you should be aware of the magnitude of the insurance premium.
The chart above plots returns for the S&P 500 over the calendar year only since 1928. The red line shows what your return would have been since then – 3.7% annualized – if you were flat in the years the index fell , and got 30% of the increase in the index when it went up. This 3.7% annualized return is well below the 10.0% annualized total return that the stock market has produced in more than nine decades.
I am not saying that AIFs are never appropriate in certain circumstances. In an interview, Hyers told me that there are many different AIFs to choose from, and some that are benchmarked against indices other than the S&P 500 have participation rates above 30%. Indeed, he added in an e-mail, “a lot of [FIAs benchmarked to] proprietary indices have…participation rates above 100%, so that’s where bigger gains are locked in.”
My purpose in discussing AIFs is rather to remind you that there is no free lunch. The more you want to insure against losses, the more upside you lose in the process. Although it is possible to insure against a black swan event, such insurance will not protect you from all losses.
Mark Hulbert is a regular MarketWatch contributor. His Hulbert Ratings tracks investment/ment newsletters that pay a fixed fee to be audited. He can be contacted at [email protected]
More: Don’t be afraid of the bear. It gives you chances to pick winning stocks and beat the market
Also Read: ‘The Stock Market Isn’t Going To Zero’: How This Individual Investor With 70 Years Of Experience Is Trading The Bear Market
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