“Black Swan” Funds Demonstrate Why Shorts Go Best with Longs
For so-called “Black Swan” funds, March 2020 was the best month in years.
And yet, after a multi-year stretch of poor performance, a lone burst of gains underscores why bearish wagers should pair with bullish ones — that is to say, why shorts work best in a supporting role for longs.
The term “Black Swan” was popularized by a best-selling book, The Black Swan, in 2007. In the book, author Nassim Nicholas Taleb described a black swan as an unexpected and unforecastable event, typically a major crisis event.
Due to the fortunate timing of the book — just before the 2008 financial crisis — the term “black swan” immediately entered the Wall Street lexicon, though Taleb objected to the way it was used.
(Technically speaking, if you can see an event coming, then it isn’t a black swan. As Taleb points out, the global pandemic is thus not a black swan, because so many people anticipated it years in advance.)
Black Swan funds, also known as Tail Risk funds or Crisis Hunting funds, have a strategy of making low-cost bearish bets on a regular basis.
The portfolios of these funds typically behave like an insurance policy. The portfolio typically loses a little bit of money, month in and month out, in the manner of paying an insurance premium.
The payoff for this market insurance comes during a crisis and a big market drop — causing the low-cost bearish bets to explode in value.
That is why Black Swan funds had an excellent month of March, and why 2020 has been their best year ever as a fund category. “Funds that seek to profit from collapses have gained 57.2 percent so far in 2020,” the Financial Times reports, “reflecting the damage inflicted by the coronavirus pandemic.”
Some of the best Black Swan performers are up hundreds of percent, and Universa Investments, a top performer, saw gains of more than 4,000%.
But the 2020 gains are only half the story, because these funds tend to lose money most of the time — and the losses can pile up for years.
“Such funds on average lost money every from 2012 to 2019 inclusive,” the Financial Times observes.
And even if you start the clock with 2008 — encompassing the global financial crisis, the eurozone debt crisis, and now the global pandemic — Black Swan funds are down an average of 24% for the period, as tracked by the CBOE Eurekahedge tail risk index.
This is akin to paying a monthly insurance policy for years, finally seeing the policy cash in, and then discovering the gains are less than what was paid.
And yet, in fairness to Black Swan funds, they are not meant to be used in a vacuum. Instead, they are meant to reduce volatility when paired with a bullish investment portfolio.
Black Swan funds are expected to make money in exactly the type of market conditions where long investment portfolios are losing money. They are not always there as a profit source, but they are meant to provide profits when investors need them most.
For individual investors, a similar logic applies to shorting stocks or exchange-traded funds, or buying long-dated put options, or otherwise making bearish wagers on the market.
While bearish investments and trades can be highly profitable in the right circumstances — with large percentage gains in a narrow window of time — their real value is in making it easier to be long.
Whether directly via short selling or indirectly via put options, making money on the bearish side is such a challenging exercise that most investors and money managers don’t mess with it.
To short well generally requires tactics and timing, along with guts and contrarianism and the confidence to challenge popular views. In addition to all that, the potential gains on the short side are capped.
Making money on the long side, in contrast, is far easier in most cases. A long investment that is working well can be held with no added effort for months, years, or even decades. Long investments also have the potential for open-ended growth, and compound gains in the thousands of percent over time.
Last but not least, when you are long, Wall Street and company management and fellow shareholders are typically on your side. If you are lucky, the central bank is on your side, too (when monetary policy is actively helping the longs).
For all those reasons and more, going long is easier than going short, and bullish bets are easier to make and maintain then bearish ones.
With that said, knowing how to short is a useful skill because, sometimes, shorting is almost the only thing that works. In the same vein, crisis insurance is a good thing to have when crisis potential looms large.
This also speaks to the way bearish positions can add balance and stability to an overall bullish portfolio. If optimism is dominant and a bullish mood prevails, then the long holdings should be going up on balance (and perhaps going up a lot).
If the mood turns dark or fearful, on the other hand, gains from bearish holdings can kick in — thus making it easier to handle volatility from the longs.
In our view the best bearish positions have merit and profit potential in their own right, meaning they aren’t just placeholders in the event a new crisis comes along.
At the same time, though, the main role of shorts is to dampen portfolio volatility and make it easier to be long — because outsized long positions are where truly stellar gains can materialize over time.