Managing Funds for a Doomsday Scenario

Investors today are more alert than ever to the chance of a catastrophic downturn in financial markets, when conventional forms of risk management fail.  “Black Swans” Nassim Taleb called such unexpected and unpredictable events that are not supposed to happen – until they do.

Recently The New York Times surveyed fund managers who are offering investors protection against such financial doomsdays.  In the past, diversification was seen as the best way to guard against market crashes.  But our recent financial crisis showed that seemingly unrelated assets were far more connected than most had thought.  As The Times put it:  “As a result, an increasing number of investors now want protection for financial end times.”  (See “New Investment Strategy: Preparing for End Times”)

“A former partner of Mr. Taleb’s, has raised more than $6 billion for a fund that is awaiting a market calamity.”  The basic strategy is taking out options to sell stocks when their price goes down.  He cheerfully acknowledges,  “it is losing money nearly every day.”

“It takes someone that’s a little bit nuts.” he said.  “I’ll do a trade, then say, ‘This is the best trade I’ve ever done in my career, but I’m quite sure I’m going to lose money on it.’”

One has to admire the ingenuity and determination that goes into such thinking.  But can it really work?  It is “a little bit nuts,” as he said, but not because it goes counter to conventional investment thinking.  It is the very essence of catastrophe to be unpredictable, to be outside usual expectations, larger than our minds.  Those who hope to outrun doomsday run three risks:  Is their plan tenable?  Will it work?  And what about the required scale?

Those who bet against the sub-prime mortgage bubble were anticipating a specific reversal in those investment instruments.  They saw something about the economy that others were ignoring.  But even they couldn’t hold on to many of their investors, as they kept spending on their short positions, while the market kept driving up the price of the derivatives they were trying to short.  Many had to give up their potential gains because they couldn’t stand the strain of keeping it up.

Second, how can these Armageddon fund managers be sure that those who buy their options will have the money to redeem them when the market finally crashes?  It reminds me of the “credit default swaps” that were supposed to insure against losses of sub-prime securities.  The insurers who issued them did not have the required reserves and  went out of business.

Most troubling, though, is the scale of their ambition.  Those who bet against the subprime derivatives focused on just one area of the market, and had trouble holding their position.  Armageddon, by definition, will be worldwide.  Nothing will be spared.  How many options can one possibly buy against the Flood?

The most reliable way to reduce risk is simply “to take things out of the portfolio, not add them,” as Ken Grant said, the president and founder of Risk Resources.  What an old fashioned idea, but it’s one that is fool-proof.