The August 21-22, 2010 Wall Street Journal article, “Preparing for The Next ‘Black Swan’“ discusses what investors are doing to protect portfolios against a “black swan” — an unforeseen event that can wreak havoc on the financial markets.

This is just the latest in a number of recent articles on the attempts of institutional and private investors to deal with and, in some cases, exploit the heightened volatility in equity markets.  Most of these approaches are either too expensive or don’t provide meaningful protection.

While the article rightfully cautions against such products, what is not discussed is that some approaches actually do provide an effective safety net without the problems cited.

We have been researching and analyzing this area for several years, and we have developed a demanding set of three criteria that we want any safety net to meet, in order for us to consider it for our clients.

Our criteria are:

1. Sudden appreciation in severe market downturns

• - “Severe” denoting sudden, substantial, unexpected decline in market value across most major asset classes, as in 4Q08 (i.e., when diversification doesn’t help)
• -  Appreciation to a degree sufficient to meaningfully offset the decline
• -  No “give-back” during market recovery (this is important — puts, for example, don’t meet this criterion)

2. Very low cost

• -  Minimize diversion of funds from productive use
• -  No sacrifice of upside portfolio potential (this is an “indirect cost” not fully appreciated by most buyers of protection)
• -  I.e., it is “insurance” we expect not to use

3. Minimal disruption to portfolio

• -  Maintain what works in vastly more likely markets
• -  “Don’t throw the baby out with the bathwater”

We have reviewed a large number of potential solutions from a large number of providers. In our view, the DB EMERALD product mentioned in connection with Brinton Eaton in the article, as we have customized it for our clients, comes closest to meeting our three criteria. Barclay’s Capital has recently released a very similar product.

For more information on how DB EMERALD is structured, and how we have customized it within a structured note for our clients, read Asset Allocation Changes and Portfolio Protection – February 12, 2010. Our website also includes a 10-minute podcast on the subject.

We hope you found this informative. As always, we welcome your feedback.