INVESTOR NOTE Taming Black Swan Risk in Your Portfolio...showing a very conservative capital preserving investment portfolio which consists only of US Treasuries. Portfolio #1 as managed

GIVE YOUR PORTFOLIO THE OPPORTUNITY TO ZIG WHEN THE MARKET ZAGS

1 | P a g e © 2017 RAVENSVIEW CAPITAL MANAGEMENT, LLC

INVESTOR NOTE

Taming Black Swan Risk

in Your PortfolioBy: Joe Eberhardt, 10/10/17

SUMMARY

Alternative Investments are an important inclusion in an investor’s portfolio for protecting against Black Swan events in the capital markets. Black Swan events are defined as “an event or occurrence that deviates beyond what is normally expected of a situation and is extremely difficult to predict”; the term was popularized by Nassim Nicholas Taleb, a finance professor, writer and former Wall Street trader (Investopedia 2017). This Investor Note focuses in on recession induced Black Swan events and how Alternative Investments can help mitigate or avoid the potential damage to an investor’s portfolio. Investors in stocks have enjoyed good returns since the last recession (the Great Recession) ended with an average real return of 5.2% for the S&P 500 index for the period from October 2007 through May 2017. Many of the economic indicators that often prelude a recession have recently began appearing such as: rising interest rates, low unemployment, and highly elevated P/E ratios for equities. Because Black Swan events are so rare, because the exact timing of Black Swans cannot be predicted, and because the resulting market drop is so great, Black Swans can ruin a portfolio’s performance for years to come afterwards. It takes years to recoup the losses from a single Black Swan event - this lost time is unrecoverable and equates to lost compounding on a higher base. Many investors may be unaware that their portfolios may be susceptible to market Black Swan risk associated with a potential recession. In life you don’t always get “do-overs”, so proper preparation for these events is critical. Employing Alternative Investments, such as commodities, pairs trading and options, can increase the diversification of a portfolio and better prepare the investor for the unknown. Individual investors can now have access to Alternative Investments and full integration in their portfolio through investment counsel provided by Ravensview Capital. Alternative Investments used in a directed and meaningful amount may reduce risk while offering increased stability of returns over the long-term and provide new sources of growth giving the investor a potential to beat a more volatile investing strategy.

WHAT IS A BLACK SWAN EVENT?

Market Black Swan events result in sudden and dramatic drops in the market valuation of the broad investment markets, as can be represented by the S&P 500 index. True Black Swan events are extremely rare, to the point of surprising the observer, and are often catastrophic to the general market (e.g. the Great Recession). Most market participants have a self-delusional perception that Black Swan events are rare and unexplainable (Wikipedia 2017). Though single event triggers may be rare and sometimes obscure, the susceptibility of the S&P 500 index to these events make them not so rare when viewed as a collection of possible significant risks. Investment market “Black Swans” are therefore a misnomer as the deepest market drawdowns have always been the result of the systemic risk associated with the looming forces of economic recession. Systemic risk is that part of an investor’s portfolio risk that cannot be diversified away, and leaves their returns vulnerable to the impacts of broad market corrections and bear



markets. It is the observed impact resulting from the trigger that gets the most attention from investors, a market price drop event, which is more common. Regardless, we continue to use the common misnomer in this Investor Note and define here a market Black Swan event as (-50%) market drawdown in the S&P 500 index. Market Black Swans, as well as their brother Gray Swans which are defined here as (-30%) market drawdowns, in fact happen with regularity and for known economic reasons that should not make them a complete surprise in the real world of investing given there is a basis for their periodicity and the historically high number of such occurrences.

Figure 1 (a, b and c) below displays the S&P 500 index price level for the last 44 years highlighting past recession periods with black bands for recessions that were market Black Swans losses and gray bands for market Gray Swans losses. Market Black Swans and Gray Swans are the subject of many academic papers and online blogs. The better references define a Black Swan event correctly as a surprising event with dramatic consequences, but consequences that are not always broad market movers (e.g. Brexit in 2016). A good guide to such recent true Black Swan events was described in the Business Insider listing nine headline grabbing events (Business Insider 2016). Our narrower definition we are using in this Investor Note is to focus attention on broad market systemic risk that is difficult to reduce and is present in an investor’s portfolio even when using diversification. The unmanaged systemic risk hiding in investor’s portfolios leaves them vulnerable to Black Swan events. Left unmanaged, systemic risk may create dramatic losses which will derail an investor’s path to reaching desired long-term investment goals.

Figure 1(a)

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Figure 1(b)

Figure 1(c)

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HOW DANGEROUS IS A BLACK SWAN EVENT?

Two well-known market Black Swan events are the Great Depression (1929 – 1939) and the more recent Great Recession (2007 – 2009). Following the (-86%) fall in the market that precipitated the Great Depression (NBC News n.d.), it took the S&P 500 about 25 years to return to “break even” (Macrotrends 2017). In the more recent (-56%) fall in the market that defined the Great Recession (NBC News n.d.), it took the S&P 500 about 5 years to return to “break even” (Macrotrends 2017). The depth of the fall in the S&P 500 index dramatically affects how quickly it may take to recoup portfolio loss and get back to even. Additionally in the case of the Great Depression, it is suspected that the quick return to tightening monetary policy strangled any chance of a sustained recovery thus furthering the time required to break even. Such a miss-step has been distinctly avoided by Ben Bernanke and Janet Yellen as leaders of the Federal Reserve during the recent recovery from the Great Recession. Their collective reservation to tighten monetary policy and Ben Bernanke’s repeated quantitative easing efforts have instead created the opposite situation of an over-inflated asset bubble in securities. The busting of an asset bubble in securities that is wide-spread across all traditional investments of bonds and stocks would result in large losses for most portfolios with nowhere to hide, no other asset class to rotate to, and large losses.

The cost of a large loss was highlighted by Jason Zweig in his commentary on the classic The Intelligent Investor by Benjamin Graham (Graham & Zweig 2003). Zweig’s analysis has been conceptually recreated in the graph below as Figure 2. The graph includes two data streams representing i) an example Portfolio #1 with a black line showing a moderately aggressive investment portfolio designed to track the broad equities market using ETFs or mutual funds and ii) a second example Portfolio #2 with a gold line showing a very conservative capital preserving investment portfolio which consists only of US Treasuries. Portfolio #1 as managed is subject to significant market Black Swan event risk, whereas Portfolio #2 is much less exposed to Black Swan event risk because of the US Government guarantee.

Figure 2

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THE COST OF LOSS (in real returns)

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The Figure 2 graph demonstrates that after a large loss in Portfolio #1, (-50%) which is typical of a deep recession, it would take almost three decades to catch up with the performance of Portfolio#2 with its lower more consistent average return of 2.6% even if the makeup return rate of Portfolio #1 at an average 5.9% is 2.3x the rate of Portfolio #2. It may come as a surprise to the reader, but both examples reflect the actual real average returns from 1973 to 2017 as i) Portfolio #1 is the S&P 500 index, and ii) Portfolio #2 is the US Treasury 10-year Note. To compound the risk and the harm, during the 24 year catchup period of Figure 2, it is possible that the next deep recession could happen back to back or that multiple recessions could occur with greater frequency which would affect the “break even” date.

The cost of a loss from a Black Swan event has such a disproportionate impact on long term portfolio performance that avoiding such losses should be paramount to the investor. The graph in Figure 2 clearly illustrates that the cost of the loss should deter most investors from pursuing aggressive portfolios that allow for significant Black Swan risk exposure. In other words, investors are best served when they employ investment strategies that prevent or lessen the risk of ever incurring a (-50%) loss.

WHEN WILL A BLACK SWAN EVENT HAPPEN?

Recessions of varying degrees have occurred frequently during the last 44 years, with a gap of 7 to 13 years in between each market Black Swan or Gray Swan event. Table 1 below details the five US recessions over the last 44 years (Yardeni, Abbott and Quintana 2017), classifying each deep recession as a Black Swan (approximately a (-50%) fall) and each moderate recession as a Gray Swan (approximately a (-30%) fall).

Table 1

HOW MUCH TIME CAN YOU AFFORD TO LOSE? Years Annualized Real Return to Next

Recession (or date) S&P 500 Losing Period

Swan Type?

Depth of

Loss

To Break Even

To Next Recession (or date)

of New Growth

Portfolio #1, S&P

500 Return1

Portfolio #2, US

Treasury 10-year

Note Return2

Relative Return

Premium (S&P 500 less 10-year Note

return) 1973-1974 Recession

Black (-48%) ~7 ~8 ~1 (-2.9%) (-4.3%) +1.4%

1980-1982 Recession

Gray (-27%) ~2 ~7 ~5 13.9% 6.0% +7.9%

1987 Recession

Gray (-34%) ~2 ~13 ~11 12.2% 4.0% +8.2%

2000-2002 Recession

Black (-49%) ~7 ~8 ~1 (-0.2%) 2.4% (-2.6%)

2007-2009 Recession

Black (-56%) ~5 >10 as of 06/19/17

>5 as of 06/19/17

5.2% 1.1% +4.1%

Since 2000 Recession to 06/19/17 2.8% 1.6% +1.2% Since 1973 Recession to 06/19/17 5.9% 2.6% +3.3%

Notes: 1-All dividends reinvested. 2-Constant maturity and reinvestment of coupon.

The gold columns show that after a market Black Swan event many years are required to “break even” and subsequently there are few years of new growth. The white columns to the right show that for the deep recessions the subsequent period of years between a Black Swan event until the next recession only renders low single digit real returns for either portfolio, and in fact following the 1973-1974 recession and



the tech bubble recession of 2000-2002 the S&P 500 index Portfolio #1 would have yielded a negative real return during those periods between recessions. It is important to note that even these low returns rely on and are only achievable if Portfolio #1 dividends had been reinvested. A prudent investor with long-term investment goals has to ask of themselves in this repetitive situation given the multiple years invested with often only losses to show for it, “How much time can I afford to lose?!”

The gray final column on the far right of Table 1 compares the annualized real returns between the S&P 500 index portfolio and US Treasury 10-year Notes portfolio during the time periods between recessions as measured from the beginning of one recession to the beginning of the next recession (DQYDJ 2017). Table 1 indicates that the investor would have been almost as well off during the three deep Black Swan recessions and the following recovery period if they had held 10-year US Treasury Notes with their low but guaranteed return rather than suffer the roller coaster of the S&P 500 index over multiple years for which only an average premium of <+1% was achieved for the three select Black Swan events. It is only following Gray Swan events that the S&P 500 index shows a significant premium that may justify its higher risk, and for these select events an average premium of +8.0% over 10-year US Treasury Notes was achieved.

The observation of weak premiums for the S&P 500 index is true in particular of the last 18 years since the tech bubble burst in 2000. Since the tech bubble burst, a mere 2.8% average compounded real return has been achieved by the S&P 500 index compared to the 1.6% return of the US Treasury 10-year Note. The relative annualized return premium is only +1.2% for having held the S&P 500 index over the past 18 years and endured its volatility. By comparison the two moderate Gray Swan events had more modest declines and therefore the recovery period required to “break even” came much quicker. Because the severity and length of the recessions were significantly less for Gray Swan events than for Black Swan events, the period of time following Gray Swans resulted in higher returns for such a period before the start of the next swan event.

As Table 1 demonstrates, deep recessions often thought of as Black Swans are all too common to truly wear that moniker. Further, the risk of losing (-50%) on a portfolio is greater to those invested predominately in equities like the S&P 500 index than those invested in more conservative securities such as US Treasury Notes.

From a behavioral finance perspective, it appears that that the personal experience of having suffered a recession and a deep market loss is a fleeting memory for investors because the length of time to the next deep market loss appears to be no more than about eight years hence. In between recessions, P/E ratios are driven up from prior lows reached during the last recession to levels well above their CAPE ratio (or P/E 10 ratio) as described by Robert Shiller (Shiller 2000). The S&P 500 index rightly does rise during recovery periods after recessions as earnings begin to grow again, but such repeat memory loss by investors raising P/E ratios above their long-term norm exasperates the business cycle effect on the S&P 500 index thus planting the seed for the next deep market loss. As of this writing, the CAPE ratio has risen above 30:1 exceeding that of Black Tuesday (Shiller 2017) the tumultuous market day that preceded the Great Depression. The CAPE ratio has only once been higher which was during the tech bubble of 2000. It is the behavior of the masses that must be protected against when seeking to avoid a recession induced Black Swan market event. If the individual investor succumbs to the hysteria of the masses (mild or extreme, seeding a Gray of Black Swan outcome) and forgets the historical patterns then they are doomed to repeat the mistakes of the past.



TAMING THE BLACK SWAN

There are several strategies investors can employ to reduce the impact of market Black Swan events. The analysis above indicates that “hiding” in US Treasuries is one possibility; however, there are superior ways to try to avoid incurring losses from a market Black Swan. Investors want to both grow and protect their wealth. The 2.6% real rate of return of the US Treasury 10-year Note over the last 44 years gives meager growth and would require 27 years to double the real value of a dollar.

A good defense against a deep loss in any portfolio is through classic techniques of diversification and rebalancing. Diversification can reduce the overall volatility of a portfolio, and rebalancing ensures that diversification is maintained even during big market movements (up or down). It is rebalancing during big market movements that provide the best opportunity to buy securities at a discount or sell at a profit. As demonstrated in the Figure 2 graph and table above, diversification away from a pure 100% position in the S&P 500 index would have greatly diminished the depth of loss that might have been incurred by investors in prior recessions, and with rebalancing would shorten the years required to “break even.” Therefore, diversification and rebalancing are the first lines of defense against losing time to compound portfolio returns.

The key to diversification is not having too many similar assets in a portfolio. Thus, a good mix of bonds and stocks usually fares better than either asset class alone on a risk-to-reward basis. To further diversify, an investor may consider Alternative Investments in their portfolio. Alternative Investments include: i) strategies, such as pairs trading and hedging and also ii) securities, such as commodities and options that are not strongly correlated, imperfectly correlated, or with asymmetrical risk to the debt and equity markets. Institutional investors (aka the Big Money), such as pension funds, endowments, foundations, banks and insurance companies, have been embracing Alternative Investments with increasing allocations since the mid 1990’s, and they have now exceeded $7.5 trillion dollars of investment into this category (Manganaro 2016). Alternative Investments allocations represent an average of 29% of North American institutional investors’ portfolios (Cairns 2017). The addition of Alternative Investments to a portfolio can change the risk profile of that portfolio so that it is better protected from Black Swan events.

WHAT ARE ALTERNATIVE INVESTMENTS?

To carry the bird analogy further, allocating capital to Alternative Investments, which we will call Ravens - a different black bird, is akin to populating a portfolio such that the Ravens clip the wings of Black Swans so that their potential damage to an investor’s portfolio doesn’t go far. Alternative Investments are dissimilar to bonds and stocks, and as metaphorical Ravens they squawk and get agitated (their price or volatility tends to act up) when the broader markets are not doing so well thus acting as harbingers of trouble and protecting a portfolio. Alternative Investments are often characterized by having market-neutral or out-of-sync with market returns during recessions. The very nature of Alterative Investments returns provide new areas of potential growth for an investor’s portfolio that do not rely on the same sources of value, drivers for success, and crowded trades of traditional bonds and stocks. It is important to note that it is both the observation of Alternative Investments behavior as well as their potential inclusion in an investor’s portfolio that provide benefit. Careful selection and management of Alternative Investments should be exercised, and caution should be used to ensure Alternative Investments do not magnify the recession risk through leverage or directional exposure.

An introduction of Alternative Investments to an investor’s portfolio is best done in small steps with strategies and securities that have relatively easily identifiable risk exposures. The following is a list of possible Alternative Investments that fit this description and are for illustrative purposes only:



• Non-standard products: o Commodities. Commodities mostly lead broader markets tending to give an early

warning sign of difficulty ahead as well as an “all clear” once the difficulty has ran its course. Commodities are inputs to production, and by themselves do not provide a dividend or coupon. Therefore, they cannot be assessed using common finance tools like the Dividend Discount Model, and thus must be actively managed based on technical methods and analysis of supply and demand fundamentals related to their use as an input. Commodities can be considerably volatile with sustained directionality. Volatility in commodities is a common result of market shortages and surpluses that can be a result of weather, natural disasters, strikes, wars, trade barriers, etc. Therefore, they can provide significant returns, but can also turn tail quickly. Applying basic principles of frequent rebalancing may help ensure harvesting profits when returns are high and starting positions when they are not. Due to new technology possibilities that can be disruptive and create permanent steps down in price levels for commodities (e.g. shale oil fracking), an investor must be on guard against dynamic changes in commodities. Examples are: copper, oil, gold, silver, and agricultural products.

• Market-neutral (or market independent) alternative strategies: o Pairs Trading. Pairing very similar securities with one held as a long position and the

other as a short position (either short or through ownership of a put option) allows for a highly hedged trade that exploits the relative differences between the two securities. Arbitraging the relative differences is the goal of this strategy, and it can be applied to individual securities as well as indices. An illustrative pair might be long Ford (F) and short General Motors (GM). Both are major automobile manufacturers with very similar business models. However, each company’s management has a slightly different focus on long-term strategy, and each company has different exposures to international forces both through factories abroad and the non-domestic markets for automobile sales. GM’s recent retreat from international markets reflects a change in their strategy that may reduce their future revenues from abroad relative to F (Wall Street Journal 2017). Thus the pairing, expressed as a formula generally, PAIR = Long - Short, and in this example as PAIR1 = F – GM (the negative sign on GM indicating a short position), creates a hybrid single position called PAIR1 to be included in the investor’s portfolio to arbitrage the difference in management’s strategy while not being directly exposed to the broad market sensitivity of either F or GM alone. Once the relative value has been realized or the initial drivers for creating the paired position disappear, then the position must be closed. Closing the position locks in the value and avoids the potential for the pair to reverse course. Continual observation of the relative value difference and the drivers of the pair requires active management.

o Global Macro. Utilizing both long-only and pairs trading strategies on the international stage is the essence of the global macro strategy. Due to the wide variety of international sources for investing and potential return including debt, equities and currencies, these broad asset classes are usually exploited in favor of individual securities. The arbitrage driver of the global macro strategy is typically a major political change (in leader and/or policy) or central bank policy shift that creates an opportunity to juxtapose two different principle actions undertaken by different geographic regions or specific countries. A first illustration would be that of the China GDP expansion relative to USA or EU GDP growth rates. China’s long expansion has been fueled by government lending to the private sector and establishment of State enterprises. In this case, an investor seeking a higher GDP long-term growth rate in China with a long-only position would have an



expectation of higher returns relative to similar equity index investments in the USA or EU. The latter two (USA and EU) then may have little to no exposure in a portfolio. The world has become more interdependent and the long-only version of global macro is looking less like a market independent strategy. Whether it is suppliers or customers abroad, linkages have become common. Currently, an average of about 46% of sales for the companies making up the S&P 500 index comes from foreign markets (Cheng 2017). A second illustration would be the pairing of two international regions with directionally different monetary policy. Here we can use the current tightening policy of the USA paired with the loose monetary policy of the EU where quantitative easing is still going on. The EU has the easy money policy that usually boosts the economy using it. The USA has the tight money policy that usually slows the economy using it. A pair trade of PAIR2 = EU – USA (the negative sign on USA indicates a short position) could be created to arbitrage this expected difference in monetary policy and its impacts on the two economic regions. A representative index ETF for each of the EU and USA would be selected to reflect the broad market effect of the monetary policy and to provide a vehicle by which to capture the relative difference. The hybrid PAIR2 then has limited global recession exposure in an investor’s portfolio, and yet has exposure to select global opportunities that may provide new value to an investor’s portfolio. Staying abreast of global politics, monetary policy, and worldwide economic growth drivers requires active management.

• Hedges: o Put options. Protective options in the form of owning puts provide a distinct directional

protection for the security they represent which can be an individual issue or an index. Puts have a defined maximum loss exposure known at the time they are purchased, and act for an investor much in the same was as home insurance might for a home owner. Similar to home insurance, put options require renewal as they expire routinely and to maintain the hedge an investor must roll forward the hedge position which requires active management. Further, should a put option go into the money and become of significant value (usually offsetting a loss on the security it is hedging in the investor’s portfolio) then the option has to be exercised or traded out of to realize this value. Finally, active management is also required in the buying, selling and rolling of the options positions to do so in a way that maximizes the value of the hedge relative to its net cost and relative to the portfolio’s needs as driven by volatility in the markets. Active management of options positions can also help reduce their overall cost while maintaining the hedge desired by the investor. Owning put options can take the place of a short position as referenced above under the pairs trading and global macro strategies.

A CASE STUDY OF ALTERNATIVE INVESTMENTS

An illustrative example of the use of these Alternative Investments is shown below as Figure 3 with a real ~$60,000 portfolio (Eberhardt 2017) which has employed all four of the Alternative Investments mentioned above giving further diversification within the category of Alternative Investments asset allocation. This Mini-portfolio is exclusively using Alternative Investments only to illustrate a point. Alternative Investments would normally be used as a portion or component in a larger much more diverse portfolio with bonds and stocks which would be thus somewhat more exposed potentially to the downside risk of the other long-only assets depending on how much portfolio hedging were used. The Performance Graph in Figure 3 displays the example Mini-portfolio’s P&L (profit and loss) on the y-axis. The mark to market valuation shown as a solid white line represents a snapshot as of June 22, 2017 (the time of this writing), indicating the hedge options have a small amount of positive extrinsic value. The



dashed white line represents the settled expectation (based on hedge options expiring on September 15, 2017 about three months hence at current price levels).

Figure 3

By including this Mini-portfolio of Alternative Investments into a larger Master Portfolio, the Master Portfolio’s returns would be expected to fare much better during a moderate to deep loss in the S&P 500 index. Figure 2 analyzes the Mini-portfolio’s expected returns in the event the S&P 500 index (represented along the x-axis by SPX Price) moves above or below its current level around 2,435. The Mini-portfolio is expected to profit if the S&P 500 index moves above 2,467. In the event the S&P 500 index is below 2,467 at the put options settlement, then the Mini-portfolio is expected to have mild, but controlled, losses. The Performance Graph clearly shows the distinct skew of possible negative outcomes should the SPX Price fall below 2,435, creating a flattened floor for losses, and a distinctive hockey stick shaped graph. A portfolio of all equity securities such as Portfolio #2 described above would have a significantly far riskier profile which is represented by the 45-degree straight red line with no bend. Following the red line, a decrease in the SPX Price leads quickly to large P&L losses. This example Mini-portfolio is designed to show how the use of Alternative Investments has created the opportunity for asymmetric portfolio returns for up vs down markets.

Table 2 below further highlights the distinct relative difference in the example Mini-portfolio’s potential gains vs losses based on S&P 500 index moves of up to +/-30% (equivalent to at least a Gray Swan on the downside risk). The cost of establishing the pairs trade is costless and the global macro strategy has been blended into pairs and is also costless to set up. The maximum loss exposure (in essence the cost of insurance) of holding the current options in the alternative focused portfolio amounts to ~(-$800) in purchase costs for the options to execute these alternative strategies and hedges for a four month period (representing 1.2% of the account’s total capital invested in non-cash assets). This base cost to establish the option hedges is indicated under the Current heading in Table 2 describing a market that going forward did not move but stagnated neither rising nor falling and having the options settled at the current price levels. Thus, the estimated maximum annualized cost to use options to hedge the illustrative Mini-portfolio is ~(-3.6%)/year = 1.2% in costs every four months. Option prices and therefore their cost to a portfolio will vary with market conditions, but it is expected that a portion of the option expense can be recouped when rolling the options forward by selling the formerly held options prior to expiry, not waiting till their expiration, and thereby reducing through the sales proceeds the total



annualized cost of the options by maybe 1 to 2%. Good options management involves following the classic philosophy of buying low and selling high, which in this case usually refers to the level of volatility the market is experiencing.

Table 2

The goal of this four-part alternatives strategy blend is to have a well-diversified Alternative Investments exposure and to keep the costs of hedging modest. Moving the Mini-portfolio into a larger Master Portfolio, the portfolio manager’s target is for the annualized cost of the options to be equal to or less than the dividend/income yield of the other securities held. Thus, there is a matching of expected cash inflows (dividends/income) and cash outflows (options payments for puts). The effect of maintaining such a target and achieving it in practice is that the hockey stick P&L floor is raised to a 0 base cost or higher helping to ensure preservation of capital through a cash flow neutral situation. This obviously comes at the cost of some foregone growth from dividends and current income, meaning the Master Portfolio’s hockey stick handle for P&L will have a more shallow slope of less than 45 degrees. Risk management is not free, but as depicted, its cost can be managed prudently while providing significant benefits.

The emphasis on the Mini-portfolio example is for illustrative purposes only. The Mini-portfolio would normally be integrated in a larger well diversified Master Portfolio creating three distinct impacts: 1) the alternatives option cost as a percentage of the Master Portfolio would be less than ~(-3.6%) on a pro rata basis, 2) the bend in the P&L outcome would be less pronounced and thus the floor is tilted some (no longer fully clipping the potential for significant loss, but greatly reducing expected losses), and 3) the possibility of profit achieved becomes a lower angle slope than the pure 45-degree angle indicated by the S&P 500 index (reflecting the many assets in the Master Portfolio of which Alternative Investments are but a portion). As part of a diversified asset allocation where the Mini-portfolio represented say one-third of the Master Portfolio, the cost of employing the Alternatives Investments strategy is expected to be low ([3.6% gross cost – 1% recovery arbitrage] x 1/3 allocation = 0.87% net cost annually to the Master Portfolio).

A well-integrated Alternative Investments blend into a portfolio is not just a bolt on to the portfolio or a simple allocation to these new strategies and securities. Instead the portfolio manager must look at the entire portfolio in order to capture cross product benefits that may reduce hedging costs while at the same time seeking to capture any remaining prominent risks from the portfolio that may require additional hedging or a shift in hedging focus. Determining the appropriate balance of Alternative Investments in a larger Master Portfolio requires the deep insight and experience of a qualified investment adviser. Much like salt in cooking, too much spoils the dish and too little leaves your taste wanting.

Reviewing the rest of Table 2 on the Mini-portfolio, at +/-10% the outcome relative ratio is 2.7:1 favorable, at +/-20% the outcome relative ratio is 6.7:1 favorable, and at +/-30% the outcome relative ratio rises to 10.7:1. Note that the probability weight of the greater positive outcome is not considered here, but only the focus on preserving upside benefit while carving off downside risk. The reader should not construe from this that there is equal probability of a +30% move to that of a (-30%) move. For clarity, the probability of a +30% or a (-30%) move in the S&P 500 index within a 4 month period is low relative



to a +/-10% or +/-20% move. However, it is the suddenness of a (-30%) or greater decline that the alternatives strategy is designed to mitigate regardless of its low probability and to do so at a low cost.

Clearly from Table 1 above, the 44 year historical occurrence of a recession and a falling S&P 500 index only averages about a 1 in 9 chance for a given year. The economy though follows a business cycle and an average statistic is a misleading indication of probability of a Black Swan at a particular point in the business cycle. In the later stage of a business cycle, like the current environment in 2017, the probability of a recession is generally higher than the 1 in 9 historical average. Likewise, during the recovery period immediately following a recession the probability of a back-to-back recession is generally lower than the 1 in 9 historical average. The goal of a hedged portfolio is to help alleviate the uncertainty of when a recession will happen by always being hedged. Active management of hedges will usually bias a portfolio manager to employ greater hedging in the later stage of a business cycle when it is likely to be needed most.

CONCLUSION

Any long-term investor will encounter deep recessions at some point, and possibly multiple recessions over a portfolio’s investment horizon. Investors may consider using Alternative Investments to further diversify and protect their portfolios against such near certain events. Properly crafted and hedged portfolios can not only mitigate or avoid Black Swans, but also allow the investor to take advantage of discounted market securities during Black Swan events. If the investor’s goal is to maximize compounding opportunities while avoiding significant losses, Alternative Investments offer the gift of time. The market-neutral or out-of-sync returns of Alternative Investments may also provide a new source of growth especially at a time when traditional bonds and stocks may be faltering. Finally, by crafting a portfolio to include Alternative Investments, the prepared investor will be less stressed and may be able to avoid anxiety that would lead to irrational investment decisions, such as selling at the bottom.

ABOUT RAVENSVIEW CAPITAL

Ravensview Capital is a specialty investment adviser that provides ongoing advice and a focus on integrating alternative strategies and securities into a client’s portfolio. Ravensview Capital employs strategies aimed to both grow and protect wealth for clients. Through Alternative Investments, a client is able to greatly diversify their portfolio with new areas of potential growth while reducing risk, and further can reshape the risk profile with hedges to minimize the impact of a Black Swan event.

Joe Eberhardt [email protected] 503-714-1393 www.RavensviewCapital.com

REFERENCES

Business Insider 2016. 9 Black Swan Events that Changed Finance Forever. Jeff Desjardins. October 6, 2016. http://www.businessinsider.com/9-black-swan-events-that-changed-finance-forever-2016-10.

Cheng 2017. “Here’s Why Earnings are so Outstanding Even Though the US Economy is Barely Growing”. Evelyn Cheng. CNBC. April 30, 2017. www.cnbc.com/2017/04/30/heres-why-earnings-are-so-outstanding-even-while-the-us-economy-is-barely-growing.html?view=story&%24DEVICE%24=native-android-tablet&trk=mostpopular%3A4%3A101864001.

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DQYDJ 2017. Calculated by online tool created by DQYDJ and posted on their website. May 7, 2017. dqydj.com/treasury-return-calculator/ and dqydj.com/sp-500-return-calculator/.

Eberhardt 2017. Private account with ~$60,000 of invested funds as a Mini-portfolio. Interactive Brokers. Figure 2 and Table 2 are screen shots from the Interactive Brokers trading platform of this Mini-portfolio as of June 22, 2017. The portfolio consisted of two pair trades, one of which was a global macro trade, both of which were paired using owned put options against long only positions. Common index-based ETFs were used for both the long only positions and the put option positions. Pairs trades were: 1) long EFA with long EEM put paired, and 2) long SPY with long MDY put paired. Additional commodity ETF positions also existed in OIL and SLV equating to ~35% of invested funds. Positions were established about four months before the put options expiry of September 15, 2017, and show only three months remaining to expiry as of the time of these snap shots.

Graham & Zweig 2003. The Intelligent Investor, the Definitive Book on Value Investing. Benjamin Graham and Jason Zweig. Pages 525-526. First Collins Business Essentials edition 2006. Harper Collins Publishers. New York.

Investopedia 2017. Black Swan. September 9, 2017. www.investopedia.com/terms/b/blackswan.asp.

Macrotrends 2017. 10 Year Treasury Rate -54 Year Historical Chart. June 21, 2017. Macrotrends. www.macrotrends.net/2016/10-year-treasury-bond-rate-yield-chart.

Cairns 2017. The Case for Alternative Investments: Broadening Your Investment Universe. Patrick Cairns. September 27, 2017. Investing. www.moneyweb.co.za/investing/the-case-for-alternative-investments/.

NBC News n.d. 11 Historic Bear Markets, from the Great Depression to the Great Recession. No date. NBC News.com.

Manganaro 2016. Institutional Investors Setting Alterative Investment Trends. John Manganaro. July 2016. PlanSponsor. Data and Research. www.plansponsor.com/institutional-investors-setting-alternative-investment-trends/.

Shiller 2000. Irrational Exuberance. Robert Shiller. Princeton University Press. Princeton.

Shiller 2017. Shiller PE Ratio. October 10, 2017. www.multpl.com/shiller-pe/.

Wall Street Journal 2017. “After Defeat in Europe, GM is Picking It’s Battles”. Mike Colias and Nick Kostov. Wall Street Journal. August 1, 2017. www.wsj.com/articles/gm-signs-off-on-its-retreat-from-europe-1501573108.

Wikipedia 2017. Black Swan Theory. September 9, 2017. www.en.Wikipedia.org/wiki/Black_swan-theory.

Yardeni, Abbott and Quintana 2017. Market Briefing: S&P 500 Bull & Bear Markets & Corrections. June 19, 2017. Yardeni Research, Inc. www.yardeni.com/pub/sp500corrbear.pdf.

DISCLOSURES

Ravensview Capital Management, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.

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INVESTOR NOTE Taming Black Swan Risk in Your Portfolio...showing a very conservative capital preserving investment portfolio which consists only of US Treasuries. Portfolio #1 as managed