‘Black Swan’ funds cleaned up as coronavirus laid waste to the markets – but are they worth the sacrifice of missing out on big returns during the good times?
One of the longest-running bull markets in financial history took place between 2009 and early 2020. The S&P rose 468 per cent in a decade. The FTSE World reached all-time highs. Life was good.
Then, in a wet market in Wuhan, a virus called Covid-19 jumped from a bat or pangolin or something to a human and everything changed.
Almost every class of asset fell: equities, bonds, real estate and commodities. Oil tanked and gold didn’t rally the way investors quite hoped. The world economy is expected to contract by more than 3 per cent as a result this year.
But as most investors nurse losses, a few are having their moment in the sun. These funds, known as ‘Black Swan’ funds for their crisis-hunting strategy, have made jawdropping returns on the back of the crisis.
Also known as tail funds, the Black Swans are designed to profit from extreme market dislocations. Such funds have been around since 2008 but produced mixed returns during the long bull market. They hit peak performance in 2011 before falling 55 per cent on average by the end of 2019, and are increasingly considered bets for long-shot payoffs that are otherwise a drag on portfolios.
Black Swan investors who stuck to their guns (or simply managed to survive years of stock gains) are now reaping the rewards. Capstone Investment Advisors, Capula Investment Management and 36 South Capital Advisors have all enjoyed blowout returns, as has LA-based Cambria Investments, whose Cambria Tail Risk ETF is up around 15 per cent since the start of the crisis.
‘A lot of our ideas are based on value investing that goes back over 100 years,’ says Cambria co-founder Meb Faber. ‘If you look at returns from 1900, the normal state of affairs is crisis. The markets have survived a litany of problems. You have to be prepared for the volatility and drawdowns.’
Sydney-based Levitas Capital does not classify itself as a Black Swan fund, but it is a beneficiary of this crisis. Its $60 million ARVIX Fund, which buys and sells options in the volatility index, or VIX, on the Chicago Board Options Exchange, was up 15 per cent as the S&P and ASX 200 were down 26 per cent.
Portfolio manager Trevor Easterbrook lived in Hong Kong during the 2003 Sars outbreak and saw how rapidly fear can take over. So when things started unfolding in January, he could barely believe his eyes: ‘Hedging costs were very cheap, no one thought they needed it. The worse the news coming out of China, the more money was being put into the US equities. I couldn’t quite reconcile it.’
In January, the VIX was trading at two and a half times less than what it was in 2003 – in other words, at a fraction of what it should be. ‘I put out a note to our client base saying, “Look, we think the market is asleep at the wheel,”’ Easterbrook recalls. ‘Then, sure enough, as soon as the disease hit a Western country, the whole thing reversed course.’
Putting money into volatility meant the ARVIX gained 20 per cent during March. Like Faber, the Levitas portfolio manager likens the strategy to health insurance: ‘Do I enjoy paying the annual premiums? No. But you have to pay them.’
However, the ARVIX is not a tail fund. In fact, Easter – brook thinks the idea is fundamentally flawed. ‘Black Swan funds have had terrible returns because there has been no sustained volatility,’ he explains. ‘Unless you are constantly topping up your allocation to them, you draw down hard and then just maybe you’re out of bullets when the move comes. Have you ever seen The Big Short? When Christian Bale is losing 10 per cent every month and his investors start pulling out – that’s the equivalent of the Black Swan guys.’
Easterbrook believes there should be something in every portfolio for a tail event, but it is just as important to consider how badly that protection is going to affect performance if the event doesn’t happen. When confronted with the idea that tail funds ‘bleed’ in the good times, Faber takes it on the chin.
‘Car insurance is a waste of money if you don’t get into a car wreck. But would anyone say that it wasn’t prudent to have the insurance?’ he says. ‘When everything is going down six, seven, eight per cent in a day, you need something in your portfolio that is green.’
He does, however, have a strategy in place to mitigate losses when markets are up, which is by pairing put options with bonds. ‘Historically, when bonds yield at four or five or six per cent, that balances out the cost of the puts. We now live in a world of lower interest rates, so it doesn’t offer as much protection, but it’s still some.’
A world away from Cambria or Levitas, London-based Ruffer appears to share in some of the same bearish preoccupations. April was its best month on record thanks to years of defensive positioning, which allowed it to switch to cyclical investments as others grappled with major losses.
However, the firm also forfeited capital during the bull market; it achieved 50 per cent returns in the past decade compared to the 126 per cent rise in the FTSE 250. When Covid-19 arrived, however, the firm was able to pivot to higher-beta names to capture the upside of the market, and April saw net asset value rise by 5.8 per cent.
Chairman Jonathan Ruffer’s investor report puts it succinctly: ‘Capital preservation may sound boring in advance of a shock, but it enables us to make good money in its aftermath.’
It’s a bittersweet victory, agrees Easterbrook, when confronting the world’s deepest recession in 300 years. ‘For years I’ve been bashing my head against a wall, and now it’s all starting to pay off.’
However, unlike Christian Bale’s character in The Big Short, Levitas didn’t predict Covid-19. It had insights about volatility, but ultimately its process is one designed to navigate through a cycle, which is exactly what it has done.
Faced with the same quandary, Faber is more defensive: ‘I don’t think anyone is purely buying these funds to try to make money on the downside. Almost universally, it’s a hedge against the rest of the portfolio. Something is always doing terribly and something is always doing well. The point is to put enough pieces of the puzzle together that the experience of investment is doable.’