George Sokoloff, founder and CIO of Carmot Capital, recently explained why typical asset allocation strategies, including those employed by most "sophisticated" hedge fund managers, end up getting slaughtered during market shocks despite perceptions of being "well hedged". One has to look no further than the last "great recession" to get a glimpse of just how well the typical "hedged" portfolios fared during the last "Black Swan" event.

Unfortunately, large pools of institutional capital have grown increasingly accustomed to making allocation decisions based on short-term returns and relative performance rather than absolute returns over extended periods of time. Therefore, massive losses are ok as long as everyone is losing money at the same time, right? Absolute returns only matter to the suckers that are actually planning to use those pension assets to retire at some point. And, as for the hedge fund manager, don't worry if your relative returns suffer as that's not such a big deal either...simply shut your fund down...go on a really long vacation then come back and raise even more assets than before. But we digress.

In an interview with International Business Times, Sokoloff points out that most investment strategies follow a Taleb distribution that provide the appearance of low risk and steady returns but in reality offer investors a high probability of a small gain and a small probability of a devastating loss. Unfortunately, as Sokoloff points out, the majority of institutional capital across the globe is levered to such strategies. Just like in the "great recession," funds that rely on "diversification" as a hedging strategy have a rude awakening during Black Swan events as correlations converge to 1 and the benefits of such diversification are erased.

"You could be making 5% per year but then there could come a year that you lose 30% or maybe more, and that's kind of the big nature of the Taleb distribution," said Sokoloff. "Unfortunately most investment strategies actually follow that, including very sophisticated hedge funds, risk parity funds etc. Essentially the whole endowment model, big endowments, family offices and institutions, all of them have investments and their portfolios unfortunately follow the Taleb distribution and they do have a fat left tail. "They try to hedge it as much as they can just by purely diversifying. But liquidity events are so insidious that your benefits are gone simply because your correlations start converging to one."

Sokoloff uses a very simple analogy to illustrate the risks of typical portfolio allocation strategies by looking at what would have happened to a prudent money manager, based in 1912 Geneva, who constructed a diversified portfolio of developed and emerging market stocks and bonds:

Imagine being a wealth manager out of Geneva in 1912, trying to create a nice diversified portfolio of developed market bonds, and emerging market bonds, says Sokoloff. Say 39% of client assets would be split between stocks of Great Britain, France, German Empire, Austria-Hungary and Italy: truly mature, developed markets. Some 21% of assets would go into stocks of the two fastest growing economies: Russian Empire and North American United States. The wealth manager might also put a smidge into emerging economies like Argentina, Brazil or Japan. In bonds, allocation would be somewhat similar. Gilts with sub-3% yield would be the benchmark, with the rest of developed and emerging bonds trading at a spread. Alternatives investment could be in anything ranging from arable land in central Russia or the Great Plains, to shares of new automotive or aeroplane startups in Europe and America, to Japanese manufacturing ventures.

As Sokoloff points out, this "prudent" portfolio would have faced drawdowns of as much as 80% over the next decade. People tend to rely on historically stable relationships between bonds and stocks, and when that relationship breaks down – as often happens in a liquidity event – even complicated strategies involving some arbitrage, essentially blow up.

The typical problem with strategies designed to profit during Black Swan events is that funds that are genuinely hedged against systemic risk tend to under-perform during periods of relative market stability due to the costs of hedging. And given the focus on short-term performance in today's market, most institutional capital does not have the patience to stick with fund managers that consistently under-perform during stable markets even if the payoff could be huge during a down cycle. But, Sokoloff notes there are strategies that provide minimal returns during "normal" market periods and stellar returns during "Black Swan" events, strategies which he refers to at the "Holy Grail."

There are a number of types of strategies which make good candidates for the Holy Grail. Many derivatives like conditions when volatility jumps. During a stockmarket crisis credit spreads between different quality bonds start increasing as people see higher chance of default on lesser quality bonds. This is where you can play on the derivatives space that hinges on the credit spreads; so credit default swaps for instance. Commodity trading advisors (CTA), or people looking into the movement of futures of different kinds and taking bets on either side, would be another candidate class of assets for this type of hedging. Another interesting hedge would be the sub-class of macro managers, the much maligned macro investors that are really contrarians. They believe there will be will be some economic shocks going forward, especially with emerging markets like China and others; or that Japan's unusual policy will backfire. The best-known in this camp are the likes of Hugh Hendry at Eclectic and Kyle Bass of Hayman Capital. Sokoloff said: "Those are the managers that use a lot of macro instruments that are convex in nature and they are just trying to time when things start going south. They have not really been good performers; they have been hated in last seven years and have lost assets as well. But still, they are a very good hedge." The last candidate would be algorithmic traders that benefit from prevalence of fear in the market. When fear strikes markets people start acting in very chaotic fashion. Sokoloff points out that the human psyche is really tuned in a certain way, which makes humans very predictable when they panic. That makes a ripe field to harvest with algorithmics. "There are algorithmic traders that also provide convex returns, tail risk hedging returns and that allows you to also benefit very strongly from any sort of collapse, slide or risk situation. And that is the camp we are in."

Finally, Sokoloff points out that our current environment is ripe for a Black Swan event while the only thing missing is the proper catalyst.