How to Tame a Grey Swan

Coverage of the 2016 Global Investment Conference

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Gret SwansWhen it comes to different economic and investing regimes, not all asset classes are created equal. “Certain asset classes do better or worse in different regimes,” explained Lynn Haffner, managing director with Franklin Templeton Solutions. During her presentation, she illustrated how quickly market events can play out and the impact that can have on the assets in any given portfolio. “In 2015, many asset classes didn’t make their hurdle rates,” she said, adding that shocks in the energy market, central bank moves and issues with the Swiss franc hit asset classes and, as a result, pension portfolios hard.

Investors today struggle to understand the impact of geopolitical risk on asset classes at a time when volatility is high and many of the risks are unknown (until they’re known, that is).

That’s where grey swans come in.

Based on Nassim Taleb’s now-famous black swan analogy for seemingly impossible risks, Haffner’s grey swans are actually evident — they’re just hard to spot. “We live in a world of grey swans,” she explained. “They’re buried in the back pages, until they happen. At which point they end up on the front page.”

Grey swan events can be anticipated to a certain degree — they’re just slow-moving. If and when they do materialize, they can have a sizable impact on the valuation of a security or the health of the overall market.

While the impact of black swan events is hard to predict, it is possible to at least determine the properties and potential impact of grey swans.

To see a grey swan in action, Haffner pointed to U.S. demographics. An aging population affects consumer spending and raises the cost of funding entitlements for governments — it’s a long-term trend that will take years
to play out, creating much uncertainty in the process. Other incidents that don’t tend to make the front pages include U.S. – China fly zone incidents in the South China Sea and Saudi Arabia expanding its price war into refined products as Iran brings more supply into the market.

These events happen — they’re just easy to miss because they don’t create a lot of noise. Their impact can be significant however.

What should investors do? Haffner recommended investors understand their portfolios’ DNA, starting with exposure to tail risk. That starts with quantifying stress beta — identifying what part of the portfolio is exposed to major losses and what parts of it can be managed.

“Investors should ask what the biggest drawdowns in a portfolio were in a given time period,” Haffner advised. “Because 10-year storms will always happen. You need to ask whether you are happy with the drawdown risk.”

“You also need to look for any asymmetry — are the up months stronger than the down months?” she added, noting that the answers to such questions will reveal a portfolio’s basic DNA.

Haffner explained that there are tools to help manage a portfolio in uncertain times. “Systematic global macro hedge funds move their betas around,” Haffner explained. “They have a high negative correlation — and they repeat.” So when right tail assets were doing well, these managers did well. But when markets were down — this group
of managers were up. “It makes a difference,” she added.

Another hedge fund tool that investors can use to bolster their portfolios against uncertainty are volatility arbitrage hedge funds: “When correlations go to one, these funds perform,” she explained. “They trade around the positions so they don’t lose too much money.”

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