Largely because of their significant gains last year, managed futures have been viewed by some as a possible panacea for black swan events. However, last year's financial meltdown occurred over a period of time rather than in a single moment allowing managed futures programs to take advantage of what they do best-invest in established trends.
Managed futures do not attempt to predict events. Rather, they take advantage of discernible trends that continue for a reasonable length of time to produce maximum results. In fact, their worst performance historically has tended to occur at sudden and unanticipated inflection points, the very definition of a black swan event.
The investment community has responded to the recognition of black swan events in several ways. The introduction of 130/30 investments and the promotion of dormant market neutral investments represented the first response of financial companies to the existence and ramifications of a black swan universe. More recently, financial companies have introduced strategies such as absolute return investments that allow the manager discretion to migrate to any asset, including cash, in an effort to avoid the impact of severe declines and to participate early in unique opportunities that the manager might foresee.
Other approaches include strategies based on technical analysis that again allow a manager to have full discretion, though the investment universe may be restricted to stocks, bonds, ETFs and cash. While all of these alternative strategies deserve consideration, they do not represent an answer to the black swan issue.
As investment advisors, it is our obligation to perform due diligence on new products and strategies in an effort to prevent another round of severe portfolio losses. Many analysts contend that we are unlikely to experience another meltdown of the magnitude last year. However, I believe that the financial system continues to represent the 21st century's version of Russian roulette. Recently, some major Wall Street firms repaid their TARP money, and were free once again to pay exorbitant bonuses to executives and traders and to engage in some of the dangerous trading activities that led to last year's meltdown. While anger and outrage has led to a call for an overhaul of the regulatory system for securities, the Obama administration seems to be preoccupied with health-care reform, Afghanistan and the economy. And the globalization of the securities markets creates inextricable ties that can replicate the events that caused last year's calamity.
Some advisors have responded to Taleb's call to anticipate meltdowns and seek to take advantage of their occurrence. The action of some advisors to short Treasurys and use leverage to enhance possible returns represents a strategy to position portfolios to potentially benefit from the predicted bubble in long-term Treasury bonds. Allocations to gold can be viewed as another attempt to take advantage of black swan events.
While I am not suggesting that modern portfolio theory be discarded, it is imperative that it be re-examined in light of the danger in this fragile global financial system. Modern portfolio theory is effective during "normal" market behavior. But in an era where black swan events are likely to become more common, advisors operate at their own peril if they fail to install appropriate safeguards. In the past, many of us have relied on modern portfolio theory as the explanation and, perhaps, the excuse for all portfolio actions.
Going forward, I do not believe that clients will be satisfied with small changes to the portfolio for rebalancing purposes in an effort to maintain strict percentages in the various asset classes. Furthermore, I contend that since black swan events create great opportunities for seismic gains for prescient advisors, the current and future era of investment performance will result in a clear line of demarcation between advisors who remain devotees of modern portfolio theory and those who incorporate black swan strategies.
In our competitive and shrinking industry, those advisors who adjust to this new reality will most certainly be the big winners for themselves and their clients.