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Black swan investing using ETFs

Before discovered in Australia, people in Europe were convinced that all swans were white, a belief that was confirmed by empirical evidence at the time. The sighting of a black swan when Australia was first settled by Europeans was a surprise. It also confirmed that one single observation can invalidate a general belief coming from the sighting of millions of white swans.

Investors for years saw lots of white swans until Nassim Nicholas Taleb published his now famous book in 2007 entitled, "The Black Swan: the impact of the highly improbable". Prior to publishing the book, investors believed that all investments could be placed on a bell curve based on their potential risk and return. A basic assumption in the Black-Sholes Model for investing is that the bell curve works. Mr. Taleb noted that is does not work all of the time. Completely unexpected "Black Swan" events can occur that substantially impact equity markets beyond bell curve expectations. Mr. Taleb explains a Black Swan event as follows:

"First, it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility. Second, it carries an extreme impact. Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable".

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In his book, Mr. Taleb offers lots of examples that impacted the investment world, including start of the two world wars, the market crash in 1987 and the terrorist attack on Sep. 11, 2001. More recent events include the meltdown of the financial system in late-2008 and the tsunami/earthquake that struck Japan last year.

What is Mr. Taleb saying now in light of the financial crisis in Europe, the slew of negative U.S. economic data released last week and the meltdown by world equity markets late last week? Mr. Taleb noted the following during an event sponsored by the Alternative Investment Association in Montreal last week:

"A breakup of the Euro is not a big deal. When they break it up, there will be a lot of fun currencies. This is why I am not afraid of Europe, or investing in Europe. I'm afraid of the United States. Of course Europe has its problems, but it's in much better shape than the United States. Rising interest rates would make things worse for the U.S. We have zero interest rates. If interest rates go up in the United States, you can imagine what the deficit would be. Europe is like someone who is ill, but is conscious of it. In the United States, we are ill, but we don't know it. We don't talk about it".

Last week, Horizons Exchange Traded Funds launched two Exchange Traded Funds based on Black Swan basics. Mr. Taleb serves as a distinguished scientific advisor for Universa, the managers of the two funds. The funds are designed to protect investors against Black Swan events that will impact the S&P 500 Index and the TSX 60 Index. The Horizons Universa Canadian Black Swan ETF HUT.A-Tand the Horizons Universa U.S. Black Swan ETF will combine traditional exposure to equity indices with an actively-managed options strategy. Black Swan ETFs essentially consist of two components: exposure to broadly based equity indices and a pool of put and call options that utilize the Black Swan Protection Protocol. Mark Spiznagel, founder of Universa manages a fund using the protocol that saw a return in excess of 100% in 2008.

A word of caution: These Exchange Traded Funds are specialty funds that are expected to record long periods of little or no return. However, potential return is substantial if and when a Black Swan event occurs. Consider the ETFs as a form of long term investment portfolio insurance policy.

Don Vialoux is the author of free daily reports on equity markets, sectors, commodities and Exchange Traded Funds. He is also an analyst at Horizons Investment Management, offering research on Horizons Seasonal Rotation Exchange Traded Fund, and a research analyst for JovInvestment Management Inc. All of the views expressed herein are his personal views although they may be reflected in positions or transactions in the various client portfolios managed by JovInvestment. JovInvestment is the investment manager for the Horizons family of ETFs. Daily reports are available at http://www.timingthemarket.ca/

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About the Author

Don Vialoux is the author of free daily reports on equity markets, sectors, commodities and Exchange Traded Funds. He is also a research analyst for JovInvestment Inc. Reports are available at www.timingthemarket.ca and www.equityclock.com. Follow him on Twitter @EquityClock. More

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