Armageddon Funds: Bullseye or Bullpuckey?

by Paul Springer

Equity markets in the U.S. booked a fifth straight day of gains midday Friday, but the upbeat week made for a sharp contrast with a gloomy backdrop of global political unrest and free floating economic woe.

Grim prospects are driving the discussion of “Armageddon funds,” vehicles designed in anticipation of dreadful and unlikely events.

The New York Times distinguishes two varieties:

Although the names tail risk funds and black swan funds are often used interchangeably, they are distinct. Tail risk events are situations that, while conceivable, are highly unlikely based on mathematical modeling. By contrast, a black swan — a concept popularized by Nassim N. Taleb’s 2007 book “The Black Swan” — is an event that models fail to predict.

The problem with planning for the unknown is simply that you don’t know what the dire outcome will be – or when it will transpire.

Armageddon strategies tend to come down to short plays involving some combination of options, indexes ETFs or volatility products.

Getting short is always dangerous, and execution risk can be an additional problem.  Last year Gaming The Market looked at what happened when investors tried to use Direxion’s Daily Financial Bear 3X Shares (FAZ) to short the ever fickle financial services sector.

The ultra-short product was designed to place bets against the financial sector, but GTM paints an ugly picture of what happened to FAZ holders during last year’s May 6 Flash Crash, when financials took a beating. FAZ owners lost money.

How could this happen?  NASDAQ is the market maker for retail brokers in FAZ.  They control the bid/ask and retail orders go through them.  The problem is NASDAQ froze all exits on FAZ until the market closed.  They canceled trading in 256 names.  What is suspect is FAZ, and many other frozen stocks, are not on that list. The only way to exit FAZ was to sell in the after hours market on Thursday or wait for Friday’s open.  Essentially, Thursday’s crash created a no-bid market for FAZ and many other stocks.  How do you get zero bids on a stock that trades 165M shares in a day?

Of course there are plenty of other ways to plan for an uncertain future, but all come with vagaries attached.

“The ideas like “90% t-bills/go berserk with the rest” are interesting on some level, but not necessarily practical,” Seeking Alpha says: “For whatever one of these black swan funds might cost, someone with enough motivation could probably come up with something on their own for much less money.”

MarketWatch blasts the black swan fund concept, providing seven different critiques.

Among other problems, MarketWatch says, is that you may buy insurance for the wrong risk: “Wouldn’t it just be your luck to buy fire insurance from the town pyromaniac, only to wake up and find he’d flooded your basement instead?”

LearnVest has some common sense for investors: instead of buying into one obscure product, diversify. “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,” LearnVest says. ” We stand by the idea that diversification lowers the risk of losing money on your overall portfolio.”

Use a graphing tool to compare financial products to the S&P 500 and it’s amazing how many seemingly unique and bizarre assets correlate closely to S&P returns – or exactly its opposite in the case of bear-oriented products.

Doing some homework could also help avoid another kind of risk – being sold a book of goods by Wall Street. Reuters concludes its critique of the NYT article and the prospects for Universa’s soon-to-be-released black swan ETF:

The problem with tail-risk hedging is that everybody doing it wants to get healthy returns during good years and then have very little downside risk during bad years. It’s an impossible combination to achieve, and although Wall Street will happily sell tail-risk hedging products to those who want them, there’s absolutely zero evidence that they actually work in practice.

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