How To Black Swan-Proof Your Portfolio

How To Black Swan-Proof Your Portfolio
Stéphane Renevier, CFA

over 2 years ago4 mins

  • You can protect your portfolio against black swan events by replacing your stocks with a 10% allocation of call options on stocks, and a 90% allocation of US government bonds.

  • Just be aware that interest rate tweaks, the changing relationship between stocks and bonds, and timing issues can all affect the effectiveness of the strategy.

  • To implement the strategy, you can buy the ETF itself, buy a CFD on the ETF, replicate it for yourself, or just use it as a jumping-off point.

You can protect your portfolio against black swan events by replacing your stocks with a 10% allocation of call options on stocks, and a 90% allocation of US government bonds.

Just be aware that interest rate tweaks, the changing relationship between stocks and bonds, and timing issues can all affect the effectiveness of the strategy.

To implement the strategy, you can buy the ETF itself, buy a CFD on the ETF, replicate it for yourself, or just use it as a jumping-off point.

Mentioned in story

Black swans are those rare and unexpected events – like the 2020 coronavirus crash – that have the potential to wipe out all your gains in one fell swoop. And with stock valuations at sky-high levels and new Covid variants on the rise, you might be looking for a way to shore up your portfolio in case another one arrives. Well, look no further…

What is this “black swan-proof” strategy?

There are two steps to this strategy, which has been championed by ETF provider Amplify ETFs via their aptly named “SWAN ETF”.

Step one: replace your stocks with call options on stocks. That’s important because call options not only allow you to profit if stocks continue to go up, but to limit your losses if they crash.

Step two: buy US government bonds. You can use them to finance the cost of the options – and since they’re a safe haven investment, you’ll be able to profit from them when safety-hungry investors pile in after a black swan hits.

Amplify allocates around 90% of its capital to treasury bonds, and 10% to call options on the key US index, the S&P 500. 10% might not sound like much, but remember that options have embedded leverage. In other words, spending a relatively small amount on the option fee gives you the right (but not the obligation) to buy the entire index.

Using this strategy, Amplify aims to capture 70% of the upside of the S&P 500 over a full economic cycle. That’s obviously less than the 100% upside you’d have from stocks, but it’s also significantly less than the downside you’d suffer should one of these black swan events actually materialize.

Does the strategy work?

Amplify only launched its black swan ETF in June 2018, so it’s too early to really assess its effectiveness. But it did pass the 2020 black swan test with flying colors: the strategy (the blue line in the chart below) only fell 5% during the coronavirus crash versus the S&P 500’s 20% drop (the purple line).

It’s also benefited handsomely from the subsequent recovery, which is all the more impressive given that the majority of defensive strategies that worked well during the crash – like, say, trend-following strategies (orange line), or long volatility strategies (yellow line) – faltered come the bounceback.

The strategy passed the 2020 black swan test with flying colors. Source: Koyfin, Finimize
The strategy passed the 2020 black swan test with flying colors. Source: Koyfin, Finimize

What are the risks?

The strategy should work well with the majority of black swan events, as investors reduce their risky bets and rotate toward the safety of US government bonds. But there are arguably three main risks to the strategy:

  • Interest rates: The strategy involves holding such a high amount of bonds in your portfolio that it’ll be exposed to losses if interest rates rise faster than the market’s expecting. And remember, a black swan event could hit the bond market too…
  • Timing: Options are only rebalanced every six months, and their sensitivity to their underlying market changes as time goes by. The strategy, then, would perform differently depending on if a selloff happens at the beginning or at the end of the period.
  • Diversification: The strategy relies on the idea that bonds will be a good diversifier to stocks, which is why you’d want to use them as a hedge. And while that’s been true over the past decade, the correlation between the two hasn’t always been positive. It’s possible to envisage scenarios where both bonds and stocks incur losses if, for example, the US Federal Reserve unexpectedly boosts interest rates.

So what’s the opportunity here?

If you do believe in the merits of the strategy, the simplest way to roll it out for yourself is to buy the Amplify BlackSwan Growth & Treasury Core ETF (Ticker: SWAN). And if you can’t access the ETF, you can always trade a contract for difference (CFDs) on it – just remember that trading CFDs requires careful leverage and margin management on your part.

Alternatively, you could replicate the strategy yourself. It’s actually surprisingly easy, and you can find the exact rules in the fund’s prospectus (and even the current allocation) on Amplify’s website. Or you could just use the principles as a starting point and create your own customized strategy.

You could, for example:

  • Simplify the strategy by replacing the six government bonds with one single position in 10 year government bonds
  • Make the strategy more or less defensive by allocating a higher or lower percentage to stocks, or by buying options that are more or less “in the money” (the more in the money an option is, the more it’ll behaves like its underlying market.)
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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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