“This is the central illusion in life: that randomness is a risk, that it is a bad thing.” - Nassim Taleb, Author
Humans use statistical models to make sense of the world. Some activities have simple payoffs and are easy to model. Think the flip of a coin or the outcome of a baseball game. Other activities have complex payoffs and a wider range of outcomes. This is where models are dangerous and can lead to significant consequences. Nassim Taleb's book "The Black Swan" delves into the world of the highly improbable. Taleb argues that having no theory or model is superior when dealing with events of small and incomputable probability.
Black Swans or extreme outliers are defined by two types of outcomes:
Small gains and large losses.
Small losses and large gains.
We prefer the latter much more than the former. However, our desire for certainty and extrapolating positive events (small gains) in perpetuity leads us down the path of small gains and large losses more often than we would like.
What asset classes have historically exhibited "poor Black Swan" payoffs?
We are interested in periods of recent stress...
April 2000 - September 2002: S&P 500 was down -49.1%.
October 2007 - February 2009: S&P was down -56.8%
October 2018 - December 2019: S&P was down -13.5%
We aren't interested in how small cap technology stocks do in extreme market environments. We know those are risky and can get crushed. Rather, what asset classes do investors perceive to be safe (small, consistent gains or income), but have a history of steep losses?
Note: Some of the below asset classes do not have adequate benchmarks that go back to 2000. In those cases, we use the most recent, available index data.
High-Yield or Junk Bonds
Bloomberg Barclays US Corporate High-Yield Index April 2000 - September 2002.
Bloomberg Barclays US Corporate High-Yield Index October 2007 - February 2009.
Bloomberg Barclays US Corporate High-Yield Index October 2018 - December 2018.
Lower-quality bonds have been attractive to many investors due to their above-market yields. Loaning money to a marginal company can work during stable times, but these companies behave much like traditional equities on the way down.
S&P US Floating-Rate Preferred Stock Index October 2007 - February 2009.
S&P US Floating-Rate Preferred Stock Index October 2018 - December 2018.
Floating-rate bonds might be the poster child for Black Swan payoffs we are trying to avoid, small gains and catastrophic losses. The drawdown during the financial crisis was worse than the S&P 500 by ~15%!
S&P US Preferred Stock Index October 2007 - February 2009.
S&P US Preferred Stock Index October 2018 - December 2018.
Banks are the primary issuers of preferred stocks. Therefore, it makes sense they were hit hard during the financial crisis. Many investors were sucked in to preferred stocks due to their juicy yields (sound familiar?).
Listed Private Equity Index
S&P Listed Private Equity Index October 2018 - December 2018.
The above index is comprised of the leading listed private equity companies. The index is designed to provide a tradable exposure to publicly-listed companies that are active in the private equity space. We feel this is relevant because there's a false belief that private investments are less volatile than public companies. Just because an asset doesn't price daily (like a public stock), doesn't mean it's less risky.
Master Limited Partnerships
Alerian MLP Index October 2018 - December 2018.
Master Limited Partnerships (MLPs) round out a common theme here: yield-hungry investors getting lured into an asset class and getting burned when the underlying position craters.
The above graph shows a few yield-centric closed-end funds (CEFs) from October 2018 - December 2018. CEFs have grown popular for their ability to take on leverage to increase income or boost returns. As you can see, that works until it doesn't.
Avoid asset classes that provide small gains, but large losses. Many of these are wrongly positioned as safe, bond-like investments. Time and again, investors are blinded by the allure of high income or yield (especially in our new normal of low interest rates). A truly safe investment will provide cover during times of market stress, not losses that run parallel (or worse) to equities. Don't turn safe into risky.