What You Need to Know About Black Swan Funds

What You Need to Know About Black Swan Funds

To some, it may seem like the world is about to end at any moment: Greece’s debt crisis, natural disasters like the earthquake in Japan and the wildfire in Los Alamos, sweeping political uprisings, not to mention that rumor of rapture last month …

Meet the Bird

For those worried about economic crises, new exchange-traded funds called black swan funds promise to act as insurance against rare, unforeseen events that market models fail to predict—known as black swans in the financial world. The concept was described in finance expert Nassim N. Taleb’s 2007 book, The Black Swan. (So, no, it doesn’t come from the recent movie starring Natalie Portman!) The financial black swan was named after the surprising discovery of the birds in Australia, after years of thinking that only white swans existed.

How It Works

For a long time, diversification (investing in a variety of stocks, bonds and other assets) was touted as the best way to protect investments against market failure. That all changed when the recent financial crisis, an event some have called a black swan, demonstrated that unrelated assets could fall all at once.

Now, investors are increasingly buying into black swan funds to protect themselves if such an occurrence—or some other equally unpredictable catastrophe—occurs again.

The way it works is similar to buying insurance: investors pay premiums every year to avoid “tail risk,” or the big downward dip in a portfolio’s value that occurs when the market falls (such as during a black swan event). There are several different ways to hedge this risk, but the most well-known strategy is to make derivatives that will do poorly during normal times but prosper when the markets plunge.

Several banks and asset managers have also begun to offer products and advice for protecting against tail risk.

Bird-Brained?

The current generation of investors has witnessed the gory results of both the dot-com bubble burst in 2001 and the financial crisis beginning in 2007; they know that the world is risky and variable. A small but growing population (call them the Chicken Little group) has decided to feather their nest with such funds in the event of economic Armageddon.

Times are tough, and the stock market is uncertain. Black swan funds offer a sense of security, but they have their drawbacks. Critics have denounced black swan funds as pricey, complicated and unnecessary. The funds tend to lose around 15% every year during normal market conditions. Think about it: if your investment loses 15% annually for five years, you would need a return of 125% in the sixth year just to break even again. Doesn’t seem like a very sure deal in terms of making money.

If you’re worried about future black swans, we recommend that instead of simply buying a black swan fund, you focus on diversifying your investments. We stand by the idea that diversification lowers the risk of losing money on your overall portfolio. If you’re just getting started with investing, try our Investing Bootcamp.

And remember: stock market plunges do happen (that’s why knowing your risk tolerance is so important). But in the long run, your returns are expected to be better than if you hadn’t invested at all.

Want to know more? Check out our other article about black swans.

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