Herding Swans and Derivatives to manage uncertainty
Where have all the White Swans gone? The paradigm of the Black Swan provides useful insights to the nature of uncertainties and the associated risks for any investment.
The use of derivatives might be a means to navigate the Swan-infested waters in the current environment of increased volatility and ballooning asset values.
Herding a bevy of Swans and Derivatives
A discussion of “Swans”, as they pertain to risks, has become topical as of late. One could draw the conclusion from the media chatter that they have all become black. The reverse is probably more correct. The range of derivatives provides its own challenges of choice
Gate Capital provides solutions for its investor-clients by managing uncertainty: it is at the heart of our service. Hence our passion to share ideas and perspectives to sharpen decisions to improve investor’s net returns.
The Black Swan and nuanced paradigm
Nassim Taleb’s ‘Black Swan’ definition is based on the statistical distribution of outcomes, power laws, “fat tails” and one’s approach to them. He stated that a Black Swan represents a highly improbable event which had three characteristics
it is unpredictable.
It carries a massive impact.
Post-event, one creates an explanation that makes it appear less random, and more predictable, than it actual was.
Taleb further added that “lack of knowledge when it comes to rare events carries with it serious consequences.” This lack reflects a paucity of learning and poor communications are embedded in Black Swan-upping.
Taleb’s paradigm provides insights with regard to how to manage such “risky” events and their outcomes. The gyrations of equity markets and related investment strategies are just one arena of outcomes.
It could be argued that true Black Swans are rare: a meteor-strike; earthquake or volcanic eruption. A meteorological event, such as a hurricane or drought might qualify, but in these days of advanced data-modelling, use of algorithms and AI it is debatable.
A more nuanced approached would be to expand the risk-flock to include Grey and White swans. The interplay of factors (relevant metrics; transparent monitoring; preventative measure; crisis management capabilities; and productive communication) have exacerbated ‘unforeseeable disasters’ into common occurrences – turning the rare Black Swans into a multitude of lighter shades.
Grey Swan
A Grey Swan would be a highly probable event; with three characteristics.
Predictable.
Carrying an impact of magnitude that can easily expand; and,
after the fact, while recognising the probability of occurrence, shifts the cause to errors in judgment or some other human cause.
A Grey would reflect a lack of judgment when it comes to high probability events that have the potential to cascade in effect.
The ongoing Covid-19 pandemic is being badged as a Black Swan but that classification seems to reflect a combination of emotional and sloppy thinking to suit political agendas. The medical human suffering is distressing; the economic damage is self-inflected.
While some authors would like to see the Covid-19 pandemic as a ‘Black Swan’; a growing body of evidence would suggest it is poor judgement and mismanagement rather than a divine act.
A recent study published in ‘Nature’ of 79 countries’ national responses to managing the Covid19 crisis reveals that the correct sequencing of Non-Pharmaceutical Interventions (NPI) has had positive influence. Such correct sequencing is: reducing infection as well as mortality rates, with limited use of the option of ‘lockdown’ and its radioactive economic effects. These NPIS and their use are well known and documented in existing medical emergency playbooks.
Compare the relatively low mortality rates, number of deaths and mild economic fallout being experienced by Sweden, Korea and Taiwan using the correct melody of NPIs. This outcome contrasts sharply with the cacophony of NPIs utilised by the UK and US and the associated economic catastrophe. Poor, grey, judgement.
In a financial market the sequencing of the NPIs is akin to utilising a full suite of ‘options’ (calls and puts) on top of an underlying investment in equities or bonds.
White swan
A White Swan is a highly certain event, its characteristics being:
Certain occurrence.
Carries an impact, that while sizable, can easily be estimated; and,
after the fact, the explanation recognizes the certainty of occurrence, but shifts the focus to errors and failures to act: pre and/or post.
Such an albino would reflect ineptness and incompetence when making decisions and managing the certainty events and their effects.
In time, Covid-19 might be reclassified as a “white”; to be determined.
However, many so-called “financial crises” are certainly white swans: certain-consequential- and retrospectively predicable
Financial turbulence is the nature of the equity market; with its Bulls and Bears, Booms and Crashes - they are manifestations of the cycle. They are “knowns”, can be measured and managed. Taleb himself believed the LCTM crisis of 1987 was not a Black Swan: its demise well documented.
Two diametrically opposed, throw-away, statistics serve as additional White Swan warnings:
Bank of America recently released a report on a well-documented phenomenon (trading of good/bad days). Since the 1930s, If an investor
Missed out on the 10 best trading days per decade the returns would total just 17%.
Stayed in the market, their portfolios would've swelled by 16,166%.
From a different angle and source: 80+% of retail day traders lose money
Current market: not a White Swan but a great white whale
Goldman Sachs’ latest projections see a further increase in the S&P into 2021; to a level of 4,300 However, within that ‘Easter Egg’ prediction is a stinger. With company dividends being reduced (issuances and magnitude) the average dividend yield of 1.65% is fast approaching a central bank’s interest rate level of 1%. The traditional risk-premium is being sacrificed.
The classic ‘balanced portfolio’ approach (with its 50-40-10 split) to manage investment risk is being compromised as the supply of a key component, debt, is being constricted. Such a process will divert investor funds into commodities, alternative asset classes or back into the equity markets. The asset bubble continues to inflate.
Seeming over valuations are driven in part by: this lack of supply and alternatives; SPAC based IPOs and get-rich-quick behaviours of Robin Hood style investors inflates the asset bubble. To quote the tribal cries of ‘Wall Street Bets’: “To the Moon, baby…YLO!
The S&P500’s 12-month forward P/E is 21.2; well above its averages for the last 20 years. Tesla enters the S&P and adds 40% to its already dominant market capitalisation in under 3 weeks. The prospect of further QE type funding and negative interest rates adds the possibility of additional volume. One might ask: a bubble; a tulip? Perhaps a White Swan?! More like Ahab’s whale.
Derivatives to the rescue?
Whatever the colour of the bevy, volatility brings with it opportunity.
The underling shape of the Swan’s ‘bell curve’ also provides the same rubric for managing the flock in the form of Derivatives.
Employing a robust derivatives strategy provides, for those still wishing to invest in the public markets, a means to navigate and manage risk for above average returns in swan-infested waters. “Robust” being: carefully chosen directional equities with well-structured positions and limits; implemented with discipline. At a minimum a covered-call approach such as The Written Fund might offer a safe haven from the inevitable White.
The discussion of Swans (be it bevy or wedge) does not deride forecasts of the future level of financial markets; as they gyrate forwards. Rather, Swan-ese is a reminder that above average rewards are associated with outsized risks. The successful investor plans and acts accordingly. How can we help an investor make better financial decisions? The heart of Gate Capital’s client service is providing solutions to manage uncertainties to net benefit.
©Justin Jenk
(Image inspiration by: Abdulaziz Al Ghannami)
RISK WARNINGS
The views expressed are those of the author alone.
Investing in any financial instrument carries risks. Your capital may be at risk. Certain investments maybe long term and may not be readily realisable. Please consider all risks before investing. Gate Capital Group Ltd is authorised and regulated by the Financial Conduct Authority (FCA Number 189170).