30 | Professional Adviser | 7 July 2011

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INVESTMENT STRATEGY
Cumulative daily % return

he phrase a black swan was coined by the Latin poet Juvenal, and at that point in time no-one had ever seen one. Seventeen centuries later, a Dutch explorer sailed up a river in newly discovered Australia to find to his amazement a black swan. The term was popularised in financial circles by Nicholas Taleb, a finance professor and former Wall Street trader, who used it describe an event which falls beyond the bounds of predictability and leads to unforecastable consequences. Hard, in fact impossible to predict, such instances include: a natural disaster such as the 26 December 2004 Asian tsunami, a coup dtat, the invention of the internet, or a terrorist attack such as 9/11. This year we have seen two examples of Black Swans in the political upheaval in the Middle East, the so-called Arab Spring, and the Japanese earthquake. These have presented investors with difficult decisions around how to tackle a key issue: how can a portfolio be protected from the impact of the unpredictable, or at least cushion it from the immediate decrease in investment returns that follows any shock?

there is an increasing need for fund managers to try and plan more effectively their range of responses to such anomalies in building their investment strategy.

Case study
Taking the Japanese earthquake as a case study, from an investment standpoint the impact does not appear to have been as calamitous as first anticipated. This is assuming, of course, there are no long term effects from nuclear fallout. As might be expected, following the quake the forecasts for growth in 2011 were downgraded. However, the numbers predicted for Japan in 2012 are more optimistic as reconstruction will provide a fillip for Japans economy. Although news headlines have focused on the colossal power of nature, human suffering and nuclear anxiety, the Japanese economy is recovering steadily from the

Black swan
Simon Brett, head of investments at Parmenion Fund Research, looks at how the unexpected can affect investment opportunities

catastrophic event and is not showing any long term signs of derailing the world economy. The Japan earthquake also highlights the reality that when certain markets or economies are affected by a Black Swan, other areas and sectors can reap benefits. Consequently, should investors look to realign their portfolio following a Black Swan, it is key to remember that there will be areas of great opportunity just alongside others which should be completely avoided for a period of time. The two largest economies in the world, China and the US for instance, offered immediate alternatives to investors looking to combat the impact of the Japanese earthquake. In reacting to the unexpected, it is vital to consider which markets will only be impacted by a freak event in the shortterm. In the case of the Japan earthquake, stock markets across the globe, such as the FTSE 100,

BENCHMARK INVESTMENT RETURNS MARCH 2011

5 0 -5 FTSE 100 GTR FTSE World Index GTR FTSE Japan Index GTR 1 March 13 March DAY IN MARCH 29 March
Source: FE Analysis June 2011

-10 -15 -20

took a drop. However, and as seen in the above graph, several markets were very quick to rebound and in the process provided an opportune moment to invest when stock prices were low. How well a fund manager responds to unexpected events and how successful their decisions will be depends upon an immediate and insightful analysis of the impact upon economies, markets and companies. Will the effects be short lived? Have the fundamentals of an economy changed? Who will be the winners and losers? These are all questions that need to be answered in a very short space of time, under intense pressure. During the period of flux, markets become inefficient in their pricing and present valuable investment opportunities

Political changes
Just as world economies started to show signs of recovery following the 2008 financial crisis, political changes in the Arab world and the Thoku earthquake on 11 March 2011 have hindered an upturn in economic activity and recovery of world stock markets. While it is difficult, by definition, for a fund manager to plan for any type of unthinkable, unimaginable event,

investing
for an investor. This is where an experienced, skilful fund manager can add value through their detailed knowledge of economies and the companies that operate within them.

Expect the unexpected

In summary, the next Black Swan will appear when we least expect it, but there is a growing need to evaluate in our due diligence and fund selection process, how a portfolio is constructed and overseen in order to react to the impact of an event like the Thoku earthquake. Following such an event, stock markets may plummet. However, for a number of them this is only a temporary phase, and it will not spell doom and gloom for all types of investment for a lengthy period. It is also worth noting that the next unexpected might even be positive news.

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