Dear Mr. Market:

In all of our “letters” to you a recent market event perhaps best sums up how nasty and volatile you can be. This time you really pulled one-off and caught the entire financial world flat-footed. If such a world were painted as a lake we have been enjoying a fairly pleasant view with relatively calm and peaceful waters. Now, without any warning, you have sent not one, but rather two black swans to land on the lake and alter the serene setting…

First off, what is a “black swan”? InvestorWords defines it as:

Definition

“Colloquial term for any extremely rare event. The term was popularized by a book by Nassim Nicholas Taleb, entitled “The Black Swan”, and was based on a previous belief (now a misconception) that all swans were white and that black swans did not exist. The term is frequently used in the finance and investing sectors to denote an event that is unexpected, and impossible to accurately predict.”

INVESTOPEDIA EXPLAINS ‘BLACK SWAN’

“Black swan events are typically random and unexpected. For example, the previously successful hedge fund Long Term Capital Management (LTCM) was driven into the ground as a result of the ripple effect caused by the Russian government’s debt default. The Russian government’s default represents a black swan event because none of LTCM’s computer models could have predicted this event and its subsequent effects.”

Not only have we been talking about the recent black swan of falling oil prices and the associated impacts on the markets, but we literally just witnessed another black swan unexpectedly fly in. What’s remarkable about this second black swan is that the majority of people out there have absolutely no idea what happened yet it was perhaps the most dramatic and volatile financial event in history!

What happened?  Did the stock market crash?  Was there a major corporate bankruptcy?  Did a financial scandal occur?

Earlier this month the Swiss National Bank (SNB) announced it would abandon its three-year old peg of 1.20 Swiss francs per euro. Within minutes the Swiss franc skyrocketed over 30% in value against the euro. At one point in the day it also gained about 25% versus the dollar. Not only were currency markets rattled but the Swiss stock market also got stung for a drop of about 10% in one day.

Currency markets, like any other, can be volatile but never in history have we seen such a dramatic move. What was most odd about this event is that central banks normally telegraph their moves and make incremental changes. These adjustments are typically well thought out and often take weeks, if not months to materialize. Several very savvy currency traders we interact with have described the move by the SNB as unprecedented but also almost “irresponsible”.

The fallout has been disastrous to several hedge funds and financial firms. The largest US retail currency firm, FXCM, had to be rescued from bankruptcy with a $300 million loan (lifeline) from Leucadia. Other firms, like Everest Capital, weren’t so fortunate; their $830 million Global Fund was completely wiped out on the news.

Obviously with every trade there is someone on the other side who profited. In this case, however, there still isn’t anyone climbing out from under the rubble proclaiming that they predicted or prepared for this. Nobody did…and that’s exactly why this black swan has rattled the world.

Currency markets are perhaps the most liquid in the world but in one day they showed that nobody was even remotely protected from a “Flash Crash” type event. Interestingly enough, those currency traders and hedge funds that had stop losses in place to hedge the risks of dramatic moves may have been stung worse than those who didn’t as the Swiss franc did come back down before everything settled on that dramatic “Black Thursday”. When central banks make policy moves thousands of computers automatically adjust within seconds but on this day the world witnessed a move like no other.

Does this news mean that you should stay away from currency exposure? Does it mean you need to learn what or how this will impact your other “mainstream” investments? We believe it’s actually the perfect opportunity to learn why currency exposure should make up part of your overall asset allocation. Most people, including experienced financial professionals, have no clue how or why you should invest in currencies.

On an absolute basis investing in currencies seems like a roller coaster ride on par with a trip to Las Vegas. Believe it or not, investors can potentially enhance their overall portfolio returns while actually reducing risk. This topic deserves an entirely separate article but for now take note on the key benefits to having proper exposure to the currency markets:

• Enhanced diversification: True diversification is more than owning five large cap US stocks that Jim Cramer is barking about. A truly sophisticated portfolio will have exposure to a variety of asset classes.
• Lower Volatility: What’s more volatile? Stocks, Bonds or Currencies? Believe it or not, currencies provide the least amount of volatility as measured by standard deviation between these three asset classes!
• Uncorrelated Returns: An intelligently designed portfolio should have instruments that don’t move in tandem with everything else. Currencies offer returns that have low correlation to the traditional asset classes that almost every boilerplate model allocation recommends.

This article isn’t suggesting that you go out and buy things you don’t know or understand. As with anything, perform your due diligence and be aware that there’s not a single financial professional who is an expert in all asset classes. For reasons such as this the hiring of an expert is critical. If you would like more information on currencies or how they can be incorporated into your portfolio, please let us know.

In the meantime, be prepared to digest the next “black swan” because even our friend “Mr. Market” was completely caught off guard this time…