It might seem hard to believe, but you could have beaten the S&P 500 over the past 15 years by being 90% invested in U.S. Treasuries and 10% in long-dated in-the-money S&P 500 call options. Even better, you would have been sleeping like a baby all along even when your fellow equity investors were sweating buckets.
I’m referring to the so-called Black Swan strategy proposed by Nassim Nicholas Taleb, a professor of risk engineering at New York University and author of the 2007 book Black Swan: The Impact of the Highly Improbable. I mentioned this strategy in my column at the beginning of March, just as the Covid-19-induced bear market was gathering steam. I am revisiting the strategy in this column because it has worked even better that I had imagined.
In introducing the strategy in his book, Taleb argued: “If you accept that most ‘risk measures’ are flawed, because of the Black Swan, then your strategy is to be as hyperconservative and hyperaggressive as you can be instead of being mildly aggressive or conservative. Instead of putting your money in “medium risk” investments… , you need to put a portion, say 85 to 90 percent, in extremely safe instruments, like Treasury bills… The remaining 10 to 15 percent you put in extremely speculative bets, as leveraged as possible (like options).”
Consider an exchange-traded fund that mechanically follows a version of this strategy: The Amplify BlackSwan Growth & Treasury Core ETF (SWAN) - Get Report. Year-to-date through March 30, this ETF has gained 0.5%, in contrast to an 18.2% loss for the S&P 500. Lest you think that this ETF only does well when there is a Black Swan event like Covid-19, consider its performance in 2019: In contrast to the S&P 500’s total return of 31.5%, the Black Swan ETF gained 22.8%.
You will be hard pressed to find another conservative fund that beats the market by as much as it has during the recent bear market and which also does as well when the market rises.
These returns are broadly in line with the strategy’s past performance, Christian Magoon, Amplify’s CEO, told me in an interview. He said that the strategy historically has participated in approximately 60% of the S&P 500’s upside and just 20% of its downside. Though this approach lags the S&P 500 during bull markets, it compensates for this lag during bear markets. Over the past 15 years it has not only held its own against the S&P 500, as you can see from the accompanying chart, but even slightly outperformed it.
(Note that the chart plots the performance of the S-Network Black Swan Core Index Total Return, in contrast to the ETF itself. That’s because the ETF was launched in November 2018; the index’s performance prior to then was the result of a back test in which the same strategy was applied retroactively.)
To be sure, part of the Black Swan strategy’s impressive return over the past 15 years derives from the strong performance of the bond market. It’s hard to imagine how the bond market will do as well over the next 15 years, however, given today’s record-low interest rates, so a potential worry is that the ETF will not do as well going forward, either.
Magoon says he’s not particularly worried about the impact of rising rates on the ETF, however. The investment rationale for the fund’s 90% allocation to Treasuries is not to produce capital gains but instead, following Taleb, to be hyperconservative -- a safe haven during a Black Swan event. The ETF’s upside potential comes not from the bonds but from the 10% invested in S&P 500 call options.
The primary impact of today’s low rates on the ETF, Magoon argued, will be to reduce the fund’s yield, which over the past 12 months has been 1.3%, according to Morningstar.
In what scenario would the ETF perform particularly poorly, I asked Magoon? Stagflation was his response, such as what the U.S. experienced in the late 1970s. During those years, of course, the stock market was range bound and interest rates rose markedly. Though the index to which the ETF is benchmarked hasn’t been calculated back to that era, it’s safe to assume that neither the bond nor the S&P call option allocations would have performed well.
So if you’re afraid of stagflation, the Black Swan strategy may not be for you. The strategy instead responds to a different kind of fear: A fear of missing out on a strong equity bull market coupled with the fear of another Black Swan event.
That pretty much summarizes the current fears of most investors.