Horizons recently launched two new Exchange-Traded Funds (ETFs) that provide passive exposure to the Canadian and US stock markets while overlaying an active options strategy that seeks to take advantage of sudden downward movements in stock prices.  The two ETFs are:

Horizons Universa Canadian Black Swan ETF (TSX: HUT), which will provide exposure to the S&P/TSX 60 Index and an actively-managed put options strategy that will be profitable when markets experience a significant decline. The management fee is 0.95 percent plus a performance fee of 20 percent of outperformance over the S&P/TSX 60 index with high watermark.

Horizons Universa US Black Swan ETF (TSX: HUS.U), which will provide exposure to the S&P 500 index and an actively-managed options strategy. The management fee is 0.95 percent plus a performance fee of 20 percent of outperformance over the S&P 500 index with high watermark. The ETF is denominated in US dollars and does not hedge the currency exposure.

The interesting part of these ETFs is the options overlay provided by a firm called Universa, which counts Nassim Nicholas Taleb as an advisor. In his book Fooled by Randomness, Nassim Taleb defined Black Swan (the term refers to the once prevalent old world belief that all swans are white, which was proven false when black swans were discovered in Australia) as a rare event that is (1) unexpected (2) carries an extreme impact and (3) believed to be predictable in hindsight. In financial markets, a Black Swan event is one which causes a sudden and dramatic decline in stock prices such as the terrorist attacks of 9/11 or the bankruptcy of Lehman Brothers.

The Black Swan ETFs aim to take advantage of a sudden decline in equity prices by purchasing out-of-the-money put options. A put option gives the investor the right but not the obligation to sell a security at a certain price within a certain period. The fund managers aim to reduce the cost of buying put options by also selling puts further out of the money. Here’s an example provided by Horizons: The S&P500 index is currently trading at 1,350. The ETF will buy a put option with a strike price of 1,100 and sell a put option with a strike price of 1,000 and the net cost of the put options is $1.10.

The Black Swan ETFs can be expected to lag a long-only strategy by the net cost of the options strategy in bullish and slightly bearish markets. The ETFs are expected to outperform plain-vanilla ETFs when the monthly losses exceed 10 percent with the maximum gains accruing when equity values decline 25 percent.

There is some value in eliminating the negative fat tails in equity returns but it is unclear whether the advantage of outperformance in severe bear markets will be worth the cost of insuring the portfolio against dramatic declines at all other times. A Black Swan event is, by definition, rare, which means that most of the time the put options will expire worthless but will occasionally pay off in spades. The question facing investors will be whether the dollars earned once in a blue moon will be worth the nickels spent in option premiums and extra fees.

Related reading:
Horizons Black Swan ETFs Prospectus
Bloomberg story featuring Universa, the sub-advisor to the Horizons Black Swan ETFs.
The Wall Street Journal story on the sudden popularity of Black Swan products.

This article has 20 comments

  1. CC

    The precise event (crash) the ETF is trying to make money on could make it lose a lot of money. The further out of the money puts the fund is selling the premium could easily expand @ a higher percentage rate then the closer to the money premium expands. This is more suited for markets that are not going to drop fast. @ max momentum down in crash of 1987 or 2008 I would have wanted to have sold the puts that were closer to the strike price on a market rally before the crash & bought the puts that were further out in time. An hour latter after crash low in 1987 & the max momentum point down in 2008 option premium dropped aprox 50%. So one must be fast & sell @ max momentum down. Even if option is far out of the money the prenium explodes & the farther out can explode @ a far faster rate.

    These funds I think are totaly misleading & most investors have not studied option prices on puts prior to, during & after a crash such as 1987 or 2008 & have no idea of the dangers.

    Elliott wavers the best time to buy out of money puts is top of a wave 2 rally & sell in middle i.e., 3 of 3 or end of a wave 3 down. Secound best place to buy top of wave 4 sell @ bottom of wave 5

  2. CC

    If you want a service to make you a lot of money in options I would consider doing the following.

    1) Set up an a account with a brokerage that has auto trading from your own account (your money is not pooled like in a mutual fund)

    2 subscribe to “cycle spreads by Chris Wilson” they do bull or bear credit spreads

    Track record on one of there methods

    2007 +50.8%
    2008 +39.3%
    2009 +35.9
    2010 +34.5%
    2011 +24.6%
    2012 +11.3%

    Of course who knows what will be future results will be. Options use leverage so guys be carefull.

    You do not want to put a lot on the table if its going to work long term a lot of money does not need to be put down to make a lot of money & if it blows up your losses are limited.

  3. Looking at the information on these new ETFs, I got a sense of how severe a downturn in stocks markets has to be before these ETFs offer protection, but I couldn’t get a sense of what the option drag is likely to be in most years.

  4. I should have mentioned Iam not certain if auto trader is available in Canada like it is in the U.S
    But @ some point it could become available

  5. @darren: I have no experience with options and I know my limitations, so I’m staying out of this game. However, this is a retail product and I’d like to understand how it works. Like Michael points out, it is hard to get a sense of what the option drag will cost over the years. Horizons has provided some information on how they expect the strategy to perform in the event of a drop in the markets but it looks like you are saying that the options that are short will increase in value substantially compared to the long options, thereby decreasing profits.

    @Michael: I agree. I’m also not certain that drops of 20% or more are as common as outlined in the Horizons material because losses in rolling periods are not the same as losses in independent observations. I’ll have to think a bit more about this though.

  6. These are just dumb. You can’t substitute for a good asset allocation plan. Own less equities if big drops are a problem.

    The other problem is that if you are a long term investor and the market always comes back after a big drop – where is the benefit?

  7. CC more should do like you & invest in only in products they understand. In 2008 I made money hand over fist with options. I have only a small understanding of all the differnt ways these products can be used but I fully understood how I was using them & some of the stratagies are just to complicted for me to ever use. (prector has an excellent video but kinda expensive & of course it might not suit everyones personality)

    The further out of the money options can cause the investment to lose a lot of money if the market drop is fast enough. The drop has to be a goldilox drop not to fast & not to slow to make money. Fast enough so the closer to the out of money puts increase in value more then the farther out of the money puts but not so fast that the farther out of the money puts increase in value more then the closer to the money out of money puts.

    CBOE website a huge amount of educational infoe can be found on options.

  8. For some reason I forgot to mention for these products to make money not only is the speed of the drop imporantant but also the size of the drop. They can make a lot of money though but I hate to see someone buy a product like this & think they will make money in all types of crashes.

  9. CC I will tell you how I would use options if I was a long term coach potatoe investor holding etfs which if memorary is correct is your style.

    I would use spy (small contract) or spx (large contract) for most of my stock portion of portfolio (reason most liquid , goes out long time, can buy deep enough in the money, Canada has no product that works well for this style). But I would not use the underlying I would use a deep in the money leap call going out 2 years or more that the price of leap would consist of little or no premium but consisted mostly of intrinsic value. These are not for trading Bid ask spreads wide. I would purchase them when vix was low i.e., not in the Sept – Oct time period for setting up position.

    To be continued

  10. I would not go crazy with the leverage but only hold the same number of shares so they would give me the same amount of dollar increase equal to a dollar increase if I was holding the underlying in an up move i.e., if delta @ 90 buy 10 % more shares then you would have if you were holding underlying. I would go deep enough so your @ least 90 delta. By going deep enoug in the money so there is little or no premium the option has no choice but to increase in value as the market moves in your direction. As the market moves farther & farther against you the delta becomes smaller & smaller because the premium expands & time decay will take little away from the option because if the option is deep enough there will be little premium to decay & theta is slow being so far out in time ( theta is the reason I would only hold a year then roll over & buy 2 years out)

    will continue

  11. This can give your postion a positive curvature market moves up in your direction you make dollar for dollar & as the market moves against you you lose less money point for point. In a crash such as 2008 the option premiums accross the board expand so you lose less money point for point as well as have less money on the table.

    Warning few have the disapline to give options the respect they deserve & will get blown up by buying to many contracts. This system just reduces risk.

  12. Perhaps it would be wise to carefully consider the stock we place in Darren’s counsel. “Do not be surprised when those who ignore the rules of grammar also ignore the law. After all, the law is just so much grammar.”

  13. I wonder how much it would cost a DIY investor to set up their own downside protection using options. When buying puts on a basic portfolio, would this amount to > 0.7% of the holdings value per annum (the effective cost of this product)?

    Until I see some evidence that Black Swan event frequency is high (which by definition it is not), then I would avoid such a strategy. Like buying extra insurance when you don’t need it. Like Mike says, adjust your portfolio allocations to limit downside risk.

  14. @Mike: It is interesting to think of cash/bonds as Black Swan insurance. Cash has a bit of a drag and provides rebalancing opportunities when deviations are significantly from target.

    @darren: Mark Wolfinger’s The Rookie’s Guide to Options is on my reading list for a long time.

    @Raman: I’m not tempted in trading options at all. If I were to do some tweaking, I would first look into providing value and/or small cap tilts to the portfolio.

    @Sampson: I’ve been investigating the frequency of Black Swan events (defined somewhat arbitrarily as a 20% monthly decline in stock prices). For the S&P 500, I found that since 1950, we’ve had just three Black Swans: 1987, 2008 and 2009. That’s quite a bit less than the once in 2 years indicated in the Horizons materials. I will probably do a story on that sometime.

    • @CC Options are great and worthwhile. Don’t be a negative Nancy. Worst case scenario you lose your premium and your contracts expire worthless. It is important to note that no ‘strategy’ can help you unless it is also combined with a truly intimate knowledge of the history of the stock that you are buying the options on, or a the very least the sub-industry.

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  17. Raman I agree with you & Iam happy you pointed that out because I do not want anyone to invest based on something I say if they blindly accept what I say is true without out understanding & yes I do make mistakes. (in fact I might have made on above if the black swan fund ratio of puts being bought & sold is set up right they might not lose more money in a crash)

    Everyone that posts on here as well as any book written I kinda think each reader should do thier own thinking & judging to determine the truth.

    That being said my sister is an english teacher for 30years makes close to 100 grand & is flat broke with debt. I failed 2 grades by grade 12 english was my worst subject & I have made most of my money by having it work for me & for the last 5 years live a happy life off of aprox half my income from money working for me

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