The black swan hedge funds - A fund in need?

When non-finance people first read through this title, most of them must have recalled the academy award winning performance of Natalie Portman in Black Swan. Even for finance majors, they might be tempted to find linkage between the movie and hedge funds, like I did when I first came across this term in Wall Street Journal. However, in finance, “A black swan is highly improbable event with three principal characteristics: it is unpredictable, it carries a massive index and after the fact, we concoct an explanation that makes it appear less random and more predictable than it was.” (Taleb, 2007). Although unpredictable, at least in terms of when exactly such event may occur, however, there are funds that can offer protection. And you guessed it right, those are the Black Swan Hedge Funds (BSHFs).

Nasim Taleb first popularized the term “Black Swan” in his book The Black Swan - The Impact of a Highly Improbable, which is a NY Times best seller. The author currently works as an advisor to Universa Investments that sells BSHFs. According to Business Insider, a BSHF suggested by Taleb made a billion dollar last week.

The underlying mechanism of such hedge fund is simple. Buy a put option whose value rises high when the market falls. If the market is stable or increasing, one only pays the price of put option, which is analogous to premium paid to insure against risk. For the inflow of money to the investors,the market has to fall. Eg. 2007/08 Financial Crisis, 2010 Flash Crash. These are times when BSHFs come into limelight as word is spread that certain funds have earned millions of dollar while the rest are losing.

BSHF can be seen as type of insurance policy to hedge against risk. It basically operates using a person’s emotion of fear and greed. And it is a good bet. It’s a win-win situation for both the parties. The firm gets a hefty fee for its service and the customer is insured against the downfall risk. When the market is bullish, such firm can utilize public’s emotion of fear. Highlighting the past financial crisis and the amount of money that one can lose when the market turns red, these firms can market itself. It’s even easier when the market is bearish. Firms get a lot of publicity when news about so and so firm making so and so amount of money amid such turmoil is spread. As is the case currently, BSHFs are getting ample coverage that has attracted attention of investors who lost money recently.

So is it a friend in need? At the moment, yes. With the second largest economy taking a hit, emerging markets slowdown, influential CEO of Bridgewater Associates, Ray Dalio, predicting a round of Quantitative easing rather than interest rate hike and a lack of a clear understanding on the Fed’s stand on the interest rate, BSHF seems a viable tool to hold in the short run. However, in the long run, just as the Black Swan events are unpredictable, so is the decision to invest in BSHF. It all depends on one’s personal preference i.e. how much are you willing to pay and till when?

“Black Monday” – what, why and what next?

Trillions of dollars were wiped out from the financial market on Aug 24, 2015. Starting from China, it had its effects on other major markets of Europe, Asia and USA. The Shanghai composite index dropped by 8.5%, the biggest one day percentage fall since 2007, wiping out all the gains for the year. This raised fear of a near recession among the global investors, leading to a global sell off. Here’s what happened in the major economies on Aug. 24:

USA: Dow Jones lost more than 1000 points and ended the day down by 588 points

UK: £74 billion value was wiped off from the FTSE 100 index

Europe: Stock market suffered their worst trading day since 2011

Japan: Nikkei fell off by 4%. (The Guardian 2015)

Meanwhile, China in an effort to save the stock market plunge decided to cut the interest rate and inject liquidity to the banking system by lowering the bank’s reserve requirements. Despite, the move, Shanghai Index fell further by 1.3% the next day. As of now, a slightly bullish trend in most of the major economies can be seen.

Why?

Economist have long been predicting a slump in the Chinese financial market. It was just the question of “when?”. One of the major question of concern was “Is China really growing at a rate of 7%?”. Several prediction expected growth to be lower than that, raising concern on the reliability of the statistics provided by China, thereby indicating a slowing Chinese economy.

The Yuan Devaluation. In a move to put a stop to wiping off of huge amount of money in the financial market in recent months, China decided to devalue the Yuan, the biggest fall since 1994. Although this move was expected to boost the economy and stabilize the stock prices, it backfired. Investors interpreted this as a sign of slowing Chinese economy. It was evident that there was a stock bubble in the securities prices, the question only remained as of when the burst would occur? On Aug.24, when prices began to drop combined with the signal of a weak economy(evident through Yuan devaluation), there was a huge sell off, leading to stock market depreciation, not crash though! China can put in huge amount of money available in its reserves, before the stock market crashes, which might not be a scenario that shall occur anytime soon.

What Next?

The Fed has an important card to play on the interest rate. The much expected rate hikes in September is now a bit less expected following this turmoil. William Dudley, NY Fed Chief and a close ally of Yellen said that the September rate hikes look less likely. But these statement may just be a move to inspire rally in the equity market. Strong economic data from consumer confidence, housing data and the like signal a rate hike would be appropriate in context of United States. But before deciding as such, Fed Chair Janet Yellen has to weigh in on whether to hike interest rate based on strong economic data of US or postpone it for future date to play a more global role in the world economy and also protect the American firms with significant chunk of money coming from overseas.

It is all about wait and watch the Fed’s next move, which is most likely to postpone the rate hike decision to the end of year.