Black Swan Fund Trading Strategy

Betting on a black swan event

You know that one trader friend who is always bearish?

Yeah, that guy… well if that trader could be a fund, he would be the Black Swan Fund.

Firstly… let’s get clear.

What is a Black Swan?

A “black swan” is a term used to describe an event that is very rare, extremely impactful, and generally unexpected or unpredictable.

The idea comes from the fact that historically, people in Europe believed all swans were white because they had only ever seen white swans….

When black swans were discovered in Australia, it was a complete surprise and changed people’s understanding of what swans could look like.

In trading, a black swan event often refers to unpredictable events that can cause massive consequences for markets or economies, such as the 2008 financial crisis or the COVID-19 pandemic.

Ok cool, so:

What the heck is a Black Swan Fund?

Also known as tail risk fund a Black Swan Fund is a fund that is focused exclusively on making money during Black Swan events.

Typically they lose money during the good times and make a killing during the bad.

So, they are often used by other funds as a kind of insurance policy.

How do they perform?

Well as you might expect, a lot of these funds just disappear…

“The Simplify Tail Risk Strategy ETF (ticker CYA) late Friday said it was calling it quits and liquidating after losing 99.8% since it was started in September 2021.”

There’s only so long you can make losses hoping for a catastrophe before you run out of money.

But one of the longest-standing Black Swan funds is Universa (the website tells you nothing sadly…)

These guys have been operating since 2007 and have AUM of around $19 Billion.

So they must be doing something right…

In fact they stated in March 2020 that they had a return of 3,612% on invested capital (due to the Covid crash.)

NB: There’s a bit of controversy here… a return on invested capital isn’t usually how hedge funds report. It’s usually a return based on assets under management.

So, if a fund has say $1bln AUM and makes $100m that’s a 10% return…

If Universa used that traditional way of reporting, with $19bln AUM, a 3,612% return would be… erm $705 billion.

So it’s not that.

Actually, it seems like they are using our way of reporting…

Risk vs Reward Ratio

They don’t use all their capital at once of course.

Eg: They risk say $ 5 million on a trade and made 3,612% on that risk. The return on “Invested capital” would be $185 million. More feasible.

Anyway…

What’s the Black Swan trading strategy?

Usually, it’s going to be

Far out of the money put options on SPX
VIX calls
Treasuries

That type of thing. Anything that gains when markets go into freefall.

If you or I were to replicate it, we could buy VXX, or buy a far out-of-the-money put option.

Actually, there’s also an ETF called the Amplify BlackSwan Growth & Treasury. (SWAN)

This ETF has some exposure to the S&P 500, whilst ‘buffering’ against significant losses.

So, perhaps not a true Black Swan fund but they’ve found a way to make some money during ‘normal’ times yet still have that significant loss hedge.

Problems with a Black Swan trading strategy

The problem you have with a black swan strategy like buying far out of the money put options on SPX is that you are going to consistently lose money every month for potentially years until something goes wrong.

So from an investor perspective, you need to be pot-committed… you can’t play for a bit and then bail.

Sunk cost fallacy and all that…

As for the fund manager, really, the “trading” side of the job is easy.

Put on a blend of positions that will make a boatload of money when the sh1t hits the fan.

But attracting new investment… and soothing existing investors,

That’s tough.

(When I get tired of screen time and set up my own hedge fund I think the black swan strategy will be last on the list…)

Black Swan events are almost impossible to predict.

So is Black Swan a viable trading strategy for traders?

Maybe…

You could come up with a systematic way of getting exposure each quarter to a big sell-off. (Say via VIX or SPX Puts as mentioned)

And of course, you’d make bank if we had a crash.

But until that day you’d bleed money as those unlikely trades either expired worthless or drifted against you.

Just look at the VIX ETF (VXX) – Made a mint in 2020, then just drifted lower and lower…doing 1 for 4 splits along the way.

Personally, I think there are better ways to make money.

The Black Swan trade is probably best left to funds trying to mitigate tail risk.

But hey, how you choose to allocate your risk capital is up to you

If you prefer audio, my latest podcast episode talks about the Black Swan Fund here.