James Coney  

Follow the black swan for future rewards

James Coney

James Coney

What is the cost of diversification?

Is it possible that the amount you lose in gains from a diversified portfolio is greater than what you would save if one market or sector tanks?

Is there perhaps another way? That’s certainly what hedge fund manager Mark Spitznagel is trying to convince us all of.

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The founder of the Universa fund, based in Miami, is one of the leading advocates of black swan investing, and he is pitching his tail risk strategy as an alternative insurance for asset managers.

Based on his performance in the Covid crash, it is a lot more effective than any other insurance policy on the market.

In March, with stock markets across the globe plummeting, Mr Spitznagel’s Universa fund rose by 3,612 per cent.

Over a year it has risen more than 4,100 per cent.

His sales pitch is that asset managers should have around 3 per cent of their funds in his fund, instead of banking on traditional diversification strategies.

I have seen no analysis of the strategic cost of diversification, but on his example alone he makes a good case.

For the uninformed, the black swan theory of investing came to prominence in 1987 after the Black Monday Wall Street crash.

Investors realised that some stock options were not priced correctly: they were being bought and sold on the basis that they would deliver regular returns, when as a result of events such as stock market crashes, many were not.

As a result, traders started to price stocks to take account of wilder swings in the market.

These became known as ‘out of the money’ options, because they were valued beyond what traders would typically expect.

Opportunists began to scour the globe to find stocks that would deliver spectacular returns should the market fail.

It was accepted that this strategy would only work in the event of a stock market crash, which, it had been assumed, happens once a decade.

This is rapidly proving not to be the case.

Mr Spitznagel is a protege of the former bond trader Nassim Taleb, who in 2007 wrote the influential (though at the time, widely derided) The Black Swan: The Impact of the Highly Improbable, the idea of betting on a doomsday scenario.

Mr Taleb argued that black swan events happen much more frequently, but existing financial models are not picking them up.

Humans should not try to predict these events, but insure against them and exploit them.

This is why traditional diversification does not work, because it leaves your portfolio too exposed and reaping too much of a cost for the benefit you get when markets fail.