About 'Black Swan' Funds ...

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July 1, 2011, 12:58 p.m. EDT · CORRECTED

Why you don’t need a ‘black swan’ fund

Commentary: Seven reasons to avoid Wall Street ‘protection rackets’

NEW YORK (MarketWatch) — A “protection racket” is where a group of people puts you at risk of disaster and then generously offers to sell you protection against that very risk, usually at a very high price.

Now hold that definition in mind while you contemplate the fact that Wall Street is trying to sell you insurance against another financial crisis.

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According to a front-page report in the New York Times , Wall Street banks and hedge funds are raising billions by selling “tail risk” or “black swan” funds that will keep you solvent, in case some unnamed reckless greedheads somehow crash the markets like they did back in 2008.

You couldn’t make it up. It’s like the town pyromaniac going door to door selling fire insurance.

Goldman Sachs Group Inc. GS -1.38% , writes the Times, is raising money for one such fund. Hedge-fund manager Mark Spitznagel, a partner of “Black Swan” author Nassim Taleb, has raised more than $6 billion for another. A firm called Capula Investment Management has raised $2 billion. Pimco, the bond giant, has about $23 billion in financial-disaster funds, according to the Times.

But for sheer chutzpah you can’t beat the details in this paragraph in Azam Ahmed’s article:

“Boaz Weinstein, a former trader at Deutsche Bank who lost more than $1 billion of the bank’s money during the financial crisis, began raising money for his own Armageddon fund late last year. It has since grown to $400 million of mostly institutional money, part of the $3.3 billion he has raised for his hedge funds.”

What players these people are. What magnificent characters. They make me think of Zero Mostel’s Max Bialystock in the 1968 comedy “The Producers.” No shame at all.

You do not need to buy any of these black-swan funds. You do not need any of these ridiculous funds in your portfolio. Do not worry that you are being left out. You aren’t.

Here’s why:

1. They’re a racket. See above.

2. The fees. Hedge-fund managers don’t get rich outperforming the market. They get rich by charging their clients high fees — typically 2% of the money each year just for breathing, and then 20% of the profits, if any. (Note that they do not cover 20% of any losses.) These fees will come out of any money you pay for insurance, which means you will have to pay a lot more for the actual insurance than it’s worth

3. They may not work. As strategist James Montier of investment-management firm GMO points out in a new, well-timed paper about these funds, what risks are your tail-risk fund covering? Global government defaults? Deflation? Inflation? The outright sale of the White House and Congress to Goldman Sachs? Wouldn’t it just be your luck to buy fire insurance from the town pyromaniac, only to wake up and find he’d flooded your basement instead?

4. The cost. If you want to insure your portfolio adequately, you’re going to need to buy a fair amount of insurance. That’s going to wipe out most of the returns from the rest of your investments. Think about it: The long-term “real return” from stocks may be as low as 4% to 5% over inflation. For a balanced portfolio of stocks and bonds, it may be around 3% over inflation. How much of your portfolio are you going to devote to “black swan” funds?

5. The insurer may go bust. When the meltdown comes, what is the guarantee your hedge fund — or the counterparties — will still be solvent? Montier reminds us of John Maynard Keynes’s observation that “there is no such thing as liquidity of investment for the community as a whole.”

6. It’s all about timing . Buying financial-disaster insurance shortly before a disaster will help your returns. Buying it every year will probably end up costing you more than it’s worth.

7. You don’t need it. That’s because if you are worried about the risk of another financial crisis — and this is a genuine risk — there are cheaper, simpler ways to reduce your exposure. Montier mentions two of the most obvious ones: selling some of your shares and owning more cash, and selling your riskiest stocks.

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A portfolio with a lot of cash will do well in a crisis. So will a portfolio that is light on high-risk investments, and is weighted toward high-quality and value-type stocks. (Montier finds that a portfolio that bet on quality stocks and bet against “junk” stocks did very well in 2008 — although it has performed poorly since.)

Montier didn’t add, but I will, that there are some other alternatives too. Long-term, inflation-protected Treasury bonds offer one low-risk investment. The yield is just 1.8% over inflation, so they are not exciting, but they will do well in a crisis. Gold bullion is another cheap form of insurance. Some very reputable investors recommend always having about 5% of your portfolio in gold.

For those who like more action, you can construct your own disaster insurance very cheaply. Just buy out-of-the-money “put” options on high-risk stocks or something like the PowerShares QQQ Trust QQQ +0.89% , the exchange-traded fund that tracks the Nasdaq 100 Index NDX +0.69% . These options will balloon in value in a crash. If there is no crash, they will expire worthless.

Brett Arends is a senior columnist for MarketWatch and a personal-finance columnist for the Wall Street Journal.