Is Black Swan Protection Worth The Cost?

Horizons recently launched two new Exchange-Traded Funds (ETFs) that provide passive exposure to the Canadian and US stock markets while overlaying an active options strategy that seeks to take advantage of sudden downward movements in stock prices. The two ETFs are:

Horizons Universa Canadian Black Swan ETF (TSX: HUT), which will provide exposure to the S&P/TSX 60 Index and an actively-managed put options strategy that will be profitable when markets experience a significant decline. The management fee is 0.95 percent plus a performance fee of 20 percent of outperformance over the S&P/TSX 60 index with high watermark.

Horizons Universa US Black Swan ETF (TSX: HUS.U), which will provide exposure to the S&P 500 index and an actively-managed options strategy. The management fee is 0.95 percent plus a performance fee of 20 percent of outperformance over the S&P 500 index with high watermark. The ETF is denominated in US dollars and does not hedge the currency exposure.

The interesting part of these ETFs is the options overlay provided by a firm called Universa, which counts Nassim Nicholas Taleb as an advisor. In his book Fooled by Randomness, Nassim Taleb defined Black Swan (the term refers to the once prevalent old world belief that all swans are white, which was proven false when black swans were discovered in Australia) as a rare event that is (1) unexpected (2) carries an extreme impact and (3) believed to be predictable in hindsight. In financial markets, a Black Swan event is one which causes a sudden and dramatic decline in stock prices such as the terrorist attacks of 9/11 or the bankruptcy of Lehman Brothers.

The Black Swan ETFs aim to take advantage of a sudden decline in equity prices by purchasing out-of-the-money put options. A put option gives the investor the right but not the obligation to sell a security at a certain price within a certain period. The fund managers aim to reduce the cost of buying put options by also selling puts further out of the money. Here’s an example provided by Horizons: The S&P500 index is currently trading at 1,350. The ETF will buy a put option with a strike price of 1,100 and sell a put option with a strike price of 1,000 and the net cost of the put options is $1.10.

The Black Swan ETFs can be expected to lag a long-only strategy by the net cost of the options strategy in bullish and slightly bearish markets. The ETFs are expected to outperform plain-vanilla ETFs when the monthly losses exceed 10 percent with the maximum gains accruing when equity values decline 25 percent.

There is some value in eliminating the negative fat tails in equity returns but it is unclear whether the advantage of outperformance in severe bear markets will be worth the cost of insuring the portfolio against dramatic declines at all other times. A Black Swan event is, by definition, rare, which means that most of the time the put options will expire worthless but will occasionally pay off in spades. The question facing investors will be whether the dollars earned once in a blue moon will be worth the nickels spent in option premiums and extra fees.