ETFs to protect against a black swan event

What is a black swan anyway?

The term "black swan" is closely related to the scientific concept of falsifiability, which posits that any observation which contradicts the assumptions of a theory will positively disprove it. 

The tale goes that in the 16th century, swans were all predicted to be white. That is, until Dutch explorers discovered a black one in Australia, disproving that entire theory. The general gist of the idea is that nothing is impossible – there is always a chance, albeit remote of it being falsified and disproved. 

The term really gained prominence in 2007 when mathematical statistician and trader Nassim Nicholas Taleb published The Black Swan. While Taleb applied the concept of the black swan to events in history outside of the financial markets, he noted three attributes common to all black swans:

1. Black swans are outliers: their form, timing, and consequences cannot be accounted for at large by past experiences or future expectations, or statistical models. 
2. Black swans create outsized consequences: in finance, this occurred in the form of systemic risk affecting the world's economy, like during the 2008 Great Financial Crisis. 
3. Black swans are obvious in hindsight: After the fact, people are great at rationalizing seemingly sound explanations for it that make it appear as though it was predictable. 

Handling black swans

In his book, Taleb cautioned against the "foolishness" of trying to predict and mitigate every conceivable adverse risk event that could occur. When it comes to investing, a good example is an investor who buys pricey portfolio insurance like VIX futures, or SPX put options.

I went over a few of these options in my tail risk article and noted that many of them possessed negative carry, which made them unsuitable for long-term holds, mitigated only specific risks (a sharp decline in the S&P 500 with increasing volatility), and were expensive in terms of fees.

Instead, Taleb argues for building "robustness" against black swan events. When it comes to investing, this usually takes the form of diversification. Practically, this means holding different asset classes suitable to various market and economic conditions. I reviewed a few examples in my article on Ray Dalio's All-Weather Portfolio, so give that a read. 

A portfolio full of different asset classes, each with a positive expected return, yet with low correlation, can be expected to produce more units of return for fewer units of risk. We can also weight the portfolio so that each asset contributes an equal amount of the portfolio's volatility, a practice called risk parity. 

A low-cost, diversified "black swan robust" portfolio might comprise the following assets. Keep in mind that back tests are inherently backward-looking and are an imperfect substitute for true predictability. This asset allocation is not mean-variance optimized or risk-parity weighted. It's meant to serve as an illustration of the benefits of diversification.  

This is all retrospective, of course, but it’s worth noting how this portfolio did an admirable job of surviving the Dot-Com Bubble, the Great Financial Crisis, and the COVID-19 Crash, all while delivering a decent CAGR, less volatility, lower drawdowns, and better Sharpe ratio than the S&P 500.

The following low-cost ETFs from Vanguard and iShares might work for each of the asset classes:

1. U.S. and international stock markets: Vanguard Total World Stock ETF (
   VT
   -0.13%
   ).
2. Long-term Treasury: iShares 20+ Year Treasury Bond (
   TLT
   -1.29%
   ).
3. Short-term Treasury: Vanguard Short-Term Treasury ETF (
   VGSH
   -0.1%
   ).
4.  TIPS: iShares TIPS Bond ETF (
   TIP
   -0.15%
   ).
5. Real Estate:  Vanguard Real Estate ETF (
   VNQ
   -1.03%
   )
6. Gold: iShares Gold Trust (
   IAU
   -0.3%
   )

Exploiting black swans

Sim Segal, Program Director for Columbia University's Master's degree in Enterprise Risk Management program, stated that: "risk concerns both unexpected downside and upside volatility." Taleb himself noted that some of the biggest events in history came from "positive black swans", with massive upside potential. A great example was the 2020 GameStop (GME) short squeeze.

A big factor that comes into play is convexity, which refers to how the returns for some investments scale non-linearly. For example, option prices (especially those out-of-the-money, or OTM) will often accelerate exponentially when the underlying experiences a large movement or increase in volatility. This graph from Simplify explains it well:

Investors can use ETFs like the Simplify US Equity PLUS Convexity ETF (

) to take advantage of this phenomenon. The ETF allocates 98% of its capital to the S&P 500 index, while 2% is rolled into a ladder of OTM call and put options that provide strong upside and downside convexity. During a normal market, SPYC is likely to lag its benchmark. However, when the S&P 500 experiences a sharp up or down movement, SPYC stands to enhance its gains and cap its losses. 

Please note this article is for information purposes only and does not constitute investment advice.