How to best prepare for black swan & other catastrophic events

I manage a non-directional system that trades options on the Nasdaq 100 index that I am trying to use as the basis of starting a hedge fund. When I talk to potential investors one question that consistently gets asked is "how would your fund behave if some catastrophic event were to occur?" Many references are made to Taleb and his black swan concept as well as six sigma events. Examples given are a nuclear bomb explosions, terrorist attacks, etc.

It seems to me that there are only a few protective measures against something like this: 1.) be hedged 50/50 long and short, because ANY directional exposure (even 1%) could be enough to temporarily wipe out a fund, 2.) to go to cash as fast as possible if the market will permit it taking massive permanent losses, 3.) to have a highly diversified portfolio. Of these, the first two appear to be highly impractical.

Based on what I have seen historically, these events are extremely rare and while violent, very short in duration because something like this would go way beyond crippling an economic system, it would devastate the system of governance as well, and that can't be permitted if a country hopes to survive. There are safeguards in place to contain the damage.

Given this situation, what measures, other than those already listed above, can be taken to minimize such an event, especially for a fund that trades only one financial instrument? For those who have survived such events in the market, how did you manage it and what lessons did you learn? Also, for those fund managers out there, how do you address this question when asked by investors?

Any other thoughts or guidance are welcome.

Thank you for your consideration in this matter.

Sincerely,
Daryl

 

how much do you envisage having under management and what is the instrument you will trade?

 

My system trades equity options on only the Nasdaq 100 index. I would start the fund only if I could raise US$10 Million. I estimate the fund is scalable up to US $500 Million and would hope to be there someday.

 

The problem, WC, is that your fund only trades positively correlated instruments. In fact, many granters of capital will say that the focus is way to narrow to run a fund and that it would probably do best as 1 strategy within a multi-strat fund. There is no way that this strategy is scalable up to 500MM. While you may be showing good returns, and may have risk parameters in place, the high positive correlation of your system will be a deal-breaker for you.

Because the market has a long-bias over time, most are concerned with down-side risk in a 20SD event. The only thing you could do is hedge the downside risk using OTM options with "acceptable" risk. Or you could do strangles. Although this will almost certainly eat into your returns and make the strategy not as attractive.

The other alternative is to test your strat on other instruments that are negatively correlated and incorporate them into your overall portfolio. You best bet is to try to get picked up by an already established multi-strat fund and go from there.

 

I employed 1 & 3 and considered option 2 as unrealistic, but I was only managing $60m. It made for a very good sales pitch! I was trading stocks so it was easy to balance the portfolio.

I was wondering what your instrument was to see how to hedge it, but you strategy does make that difficult without diversification and then there are questions about how successful you would be in different markets.

You could always take Buffet’s approach and buy some very long dated options and tell the clients you have a 10 and 20-year view as well as a short-term strategy. This hopefully would encourage clients to hang in there after a black swan event.

However if I were in your position I would try to add another string to my bow and diversify.

 

Thank you Yoohoo and Hilojack for your informative replies. Your suggestions of diversification are excellent and I was just wondering if you knew of a financial instrument that was highly uncorrelated with the Nasdaq 100 index, yet that was also very liquid and offers options (also liquid) that I might use?

Thanks,
Daryl

 

You could carry out of the money puts or long out of the money calls on the vix as a hedge, as long as your overall performance could overcome these costs. Theoretically, these out of the money options should actually be profitable (but rarely) and enough to make up for the small losses you take normally.

 

Sorry options are not my field so I'm out on this one

 

If ANY directional move of as little as 1% can be enough to wipe out your fund, I suggest you address this prior to proceeding.

 

I was speaking in generalities in order to reflect the magnitude of such a serious event. Good point, none-the-less.

Thanks,
Daryl