A New Way to Fend off Black Swans

08/18/2009 11:30 am EST

Focus: FUNDS

Russel Kinnel

Editor, Morningstar FundInvestor

Russel Kinnel, director of fund research for Morningstar and editor of Morningstar FundInvestor, says a new PIMCO fund aims to protect investors against unusual risks.

PIMCO Global Multi-Asset Fund (PGMDX) is designed to combine tactical asset allocation with “tail-risk” protection—something no one else has tried. They’ve assembled an all-star team, [including] Mohamed El-Erian, current chief executive officer and co-chief investment officer of the firm, and former head of Harvard’s endowment.

Tail risk, also known as black swans, refers to the unusual, extreme events at either end of a normal distribution curve. Last year was laden with tail risks as [several] extreme outcomes that history indicated were very rare, all happened together.

Co-manager Vineer Bhansali says tail-risk insurance is quite cheap, provided you have the foresight to buy it before the crisis begins. Moreover, it means you have less of a drag on your portfolio than you would if you had more money tied up in short positions, as those will be a drag on performance most of the time because stocks generally go up.

How do they do it? They use options and other derivatives similar to buying out-of-the-money puts on markets and credit defaults. Only financial Armageddon will make these pay off, but then they’ll pay off when you need it most.

Bhansali says another strategy is to “invest in positions with negative correlation to tail risk, such as momentum strategies that move with volatility indicators, including the VIX (CBOE Volatility Index).” In other words, bet on volatility.

A third idea is to buy Treasury and eurodollar futures because those securities rally sharply when there’s a flight to quality or easing of monetary policy. Finally, they can reduce risk exposure where the risks are greatest. Bhansali says they don’t need to predict precisely what the risk is, but only to protect against its likely consequences, such as a market sell-off or a spike in volatility.

The fund does tactical asset allocation as it chooses among stocks, bonds, and commodities here and abroad. For broad asset allocation, they use the institutional shares of PIMCO’s enhanced index funds. Those funds buy futures of the index they want to track and then invest [the] remaining capital in a short-term bond portfolio that is designed to outperform Treasury bills.

OK, I know that got a little complicated, and usually I hate complication, but in this case it’s required given the tricky task at hand. You’re really getting expertise you couldn’t duplicate, and with PIMCO’s trading desk you’re getting access and prices for these derivatives that you couldn’t possibly get on your own.

The only disappointing thing is that PIMCO isn’t cutting you a great deal on fees. The cost is around 1.50% for retail investors.

However, given the added price you’d pay just in trying to buy those out-of-the-money derivatives in the first place and, of course, the expertise of knowing when they are most attractively priced, it still looks like the cheapest way to do this.

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