Dickson On The Best Portfolio Insurance

December 30, 2013

Vanguard’s Joel Dickson argues that when it comes to combating black swan events, nothing does the trick as well as good old government debt.

The economy might be on the mend, and the U.S. Federal Reserve might be taking its foot off the gas when it comes to pumping money into the system, but that doesn’t mean things couldn’t go wrong. “Black swan” events could be lurking for all we know.

The very definition of a black swan event is that it’s an unforeseen one, meaning the only defense against unpredictable tail risk is a strong offense. Joel Dickson, senior investment strategist at Vanguard, who will be discussing this topic at the upcoming Inside ETFs conference in late January, argues that the best weapon of choice when it comes to protecting portfolios from black swans is high-grade sovereign debt, pure and simple.

IU.com: At the upcoming Inside ETFs conference, you’ll be talking about how to prepare for black swan events. Is the Lehman collapse one of the most recent of such events, in your view?

Joel Dickson: Yes. But I have to say that one of my goals for that panel discussion is to try to have some sort of rationality around this theme, because “black swan” has become a bit of an overused term. As a matter of fact, it’s gotten so overused that I’m wondering if white swans are the ones that are rare. We seem to have a new black swan event every year.

From an investment standpoint, we don’t know what the next “black swan” is going to be, but everyone seems to look to complicated strategies for some sort of portfolio insurance, just trying to not have the portfolio crash when everything else around it is crashing

But from what we’ve seen in past events—and certainly the global financial crisis showed this dramatically—is that most risk assets declined together. For all of the uncorrelated assets that were around prior to the global financial crisis, they were basically all very much correlated once we got into the black swan event

If what we’re talking about are really bad black swan events, the one source of stability—at least historically—has been high-quality sovereign debt such as U.S. Treasurys, German bonds, Japanese bonds. That is the flight to safety. In some ways, you don’t have to be more complicated than that

IU.com: That’s all the portfolio insurance you need.

Dickson: We already have the instruments people need to protect themselves from black swans, which is a diversified, balanced portfolio that includes high-grade, sovereign debt

IU.com: To be clear, how do you define a black swan event?

Dickson: I think when people think about insulating portfolios from black swan events, they are thinking about an unforeseen catastrophe. The concern around black swan events is how you, in essence, provide insurance in a portfolio against the small probabilities of very bad events.

IU.com: Beyond Treasurys and, as you suggested, high-grade sovereign debt, what else is there that really, truly offers that kind of insurance?

Dickson: There might be other options. If you are worried about equity market blowups, you can think about put option strategies, like out-of-the-money put option strategies, for example.

Keep in mind that these are forms of insurance that tend to be very costly. You’re going to pay a lot for option strategies that may protect in those outside cases, but it’s not clear that, over time, the insurance is worth the price. And that’s a question that investors have to think about.



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