Bloomberg
22 September, 2018

Ten years after the financial crisis, with the bull market now the longest on record, "black swan" fund Universa Investments chief investment officer, Mark Spitznagel, spoke on Bloomberg TV and said that "we are going to continue to see deeper and deeper [crashes], simply by virtue of the fact that the degree of interventionism is larger and larger."

In other words, trading for "the end of the world"... but not expecting it to come tomorrow. In fact, his advice to traders is simple: "you mustn’t fight the Fed. What you must try to do is sort of jiu-jitsu the Fed. You need to sort of use the Fed’s force against it."

Easier said than done?

For most, yes: founded in 2007, Universa quickly rose to fame the very next year when it made huge profits in the crash of 2008. On the other hand, as the WSJ wryly notes, "being skeptical and making money on that view are two different things." Fellow financial crisis standout John Hussman, who predicted both the 2000 and 2008 bear markets, is convinced an even worse one is coming, yet his own fund has performed dismally since 2009, eroding its crisis gains and then some.

This is where Universa stood out.

Unlike John Paulson, David Einhorn and Steve Eisman who made stellar returns during the crisis but have failed to repeat their success since, Spitznagel has enjoyed several mini-bonanzas along the way. During the ETFlash Crash of August 2015, his fund reportedly made a gain of about $1 billion, or 20%, in a single, unforgettable day.

But was that performance repeatable, and could it beat the market in the long run... and certainly before the inevitable crash?

To be sure, as the WSJ's Spencer Jakab writes, "talk is cheap in investing punditry and predicting a decline without saying when it will happen is cheapest of all." Yet Universa’s stance warrants attention, and not only because it backs its views with billions of dollars: Spitznagel isn’t betting on some unpredictable event causing a crisis but instead a predictable one—an eventual blowback from unprecedented central-bank stimulus.

And while so far the "final crash" has yet to come, what has made the "fat tail" fund unique - recall that Universa is advised by author Nassim Nicholas Taleb of "Black Swan" fame, and best known for his prediction that six sigma "fat tail", or black swan, events happen much more frequently than they should statistically - is that it has not only not lost money, but has actually outperformed the S&P in the past decade:

According to a letter sent to investors earlier this year and seen by the WSJ, a strategy consisting of just a 3.3% position in Universa with the rest invested passively in the S&P 500, had tripled the money, generating a compound annual return of 12.3% in the 10 years through February, better than investing in just the S&P 500 itself. It also was superior to portfolios three-quarters invested in stocks with a one-quarter weighting in more-traditional hedges such as Treasurys, gold or a basket of hedge funds.

This is how the fund described its performance:

In our ten-year life-to-date, a 3.33% portfolio allocation of capital to Universa’s tail hedge has added 2.6% to the CAGR of an SPX portfolio (the SPX total CAGR over that period was 9.7%). To put this in perspective, this is the mathematical equivalent of that same 3.33% allocated to a ten-year annuity yielding about 76% per year. In contrast, each of the other risk mitigation strategies actually subtracted value over the same period, regardless of their allocation sizes.

The 3.33% portfolio allocation size to Universa was chosen because it is (and has always been) the approximate effective allocation size recommended in practice at Universa (relative to a client’s total equity exposure). The 25% portfolio allocation size to the other risk mitigation strategies was chosen to be meaningful and realistic for an average investor (relative to their total equity exposure). That turned out to be insufficient for any of those strategies to provide a level of downside protection anywhere close to the level Universa provided.

There is no magic to this outperformance: Spitznagel has traditionally buys put options, especially when they are cheap, like now for example, when despite bubbling trade wars, Donald Trump’s legal peril and sputtering emerging markets, have failed to dent the market's ascent to new all time highs.

By pointedly ignoring headlines and embracing long stretches when his fund loses small sums for months on end, he draws on similar patience and conviction.

As shown in the chart above, Spitznagel's small crash bets have paid off repeatedly, offsetting the "theta bleed" associated with a portfolio such as his.

Which may also explain why Spitznagel is so happy: it isn’t because he sees an imminent crash, though he doesn’t rule it out. It is because almost no one else is preparing for one.

“I spend all my time thinking about looming disaster,” says Mark Spitznagel, chief investment officer of hedge fund Universa Investments, who predicts a major decline in asset prices but can’t say when. He admits that the bull market could keep going for years. “Valuations are high and can get higher.”

Another quirk: in 2017, when volatility dropped to all time lows, buying crash insurance was seen by many as throwing away money. But Spitznagel said he was “like a kid in a candy store” because volatility, and hence options prices, were so subdued. At least they were until February of this year, when the VIX underwent a record explosion, soaring from the single digits to an all time high handing Universa's clients another outsized return with a true market hedge.

Just sitting out the market in the long run is costly, which is why optimists triumph. Universa’s typical client suspects that the end may be nigh but wants to stay fully invested anyway. The occasional windfall, such as the one in 2015, is icing on the cake.

Ultimately, the math behind Spitznagel’s investing philosophy is a simple bet on human nature: investors are "more confident after a long stretch of smooth sailing and hefty gains for markets, that is when the odds of something going horribly wrong are highest."

And with the S&P at all time highs, Spitznagel has to be delighted: after all, both investor confidence, and the odds of that "horribly wrong" moment are just as high.

"This is a very good time for us," he said. Now all he needs is a crash.

One might have expected that the near-death experience of most investors in 2008 would generate valuable lessons for the future. We all know about the “depression mentality” of our parents and grandparents who lived through the Great Depression. Memories of tough times colored their behavior for more than a generation, leading to limited risk taking and a sustainable base for healthy growth. Yet one year after the 2008 collapse, investors have returned to shockingly speculative behavior. One state investment board recently adopted a plan to leverage its portfolio – specifically its government and high-grade bond holdings – in an amount that could grow to 20% of its assets over the next three years. No one who was paying attention in 2008 would possibly think this is a good idea.

Below, we highlight the lessons that we believe could and should have been learned from the turmoil of 2008. Some of them are unique to the 2008 melt-down; others, which could have been drawn from general market observation over the past several decades, were certainly reinforced last year. Shockingly, virtually all of these lessons were either never learned or else were immediately forgotten by most market participants.

Twenty Investment Lessons of 2008

1. Things that have never happened before are bound to occur with some regularity. You must always be prepared for the unexpected, including sudden, sharp downward swings in markets and the economy. Whatever adverse scenario you can contemplate, reality can be far worse.
   
2. When excesses such as lax lending standards become widespread and persist for some time, people are lulled into a false sense of security, creating an even more dangerous situation. In some cases, excesses migrate beyond regional or national borders, raising the ante for investors and governments. These excesses will eventually end, triggering a crisis at least in proportion to the degree of the excesses. Correlations between asset classes may be surprisingly high when leverage rapidly unwinds.
   
3. Nowhere does it say that investors should strive to make every last dollar of potential profit; consideration of risk must never take a backseat to return. Conservative positioning entering a crisis is crucial: it enables one to maintain long-term oriented, clear thinking, and to focus on new opportunities while others are distracted or even forced to sell. Portfolio hedges must be in place before a crisis hits. One cannot reliably or affordably increase or replace hedges that are rolling off during a financial crisis.
   
4. Risk is not inherent in an investment; it is always relative to the price paid. Uncertainty is not the same as risk. Indeed, when great uncertainty – such as in the fall of 2008 – drives securities prices to especially low levels, they often become less risky investments.
   
5. Do not trust financial market risk models. Reality is always too complex to be accurately modeled. Attention to risk must be a 24/7/365 obsession, with people – not computers – assessing and reassessing the risk environment in real time. Despite the predilection of some analysts to model the financial markets using sophisticated mathematics, the markets are governed by behavioral science, not physical science.
   
6. Do not accept principal risk while investing short-term cash: the greedy effort to earn a few extra basis points of yield inevitably leads to the incurrence of greater risk, which increases the likelihood of losses and severe illiquidity at precisely the moment when cash is needed to cover expenses, to meet commitments, or to make compelling long-term investments.
   
7. The latest trade of a security creates a dangerous illusion that its market price approximates its true value. This mirage is especially dangerous during periods of market exuberance. The concept of “private market value” as an anchor to the proper valuation of a business can also be greatly skewed during ebullient times and should always be considered with a healthy degree of skepticism.
   
8. A broad and flexible investment approach is essential during a crisis. Opportunities can be vast, ephemeral, and dispersed through various sectors and markets. Rigid silos can be an enormous disadvantage at such times.
   
9. You must buy on the way down. There is far more volume on the way down than on the way back up, and far less competition among buyers. It is almost always better to be too early than too late, but you must be prepared for price markdowns on what you buy.
   
10. Financial innovation can be highly dangerous, though almost no one will tell you this. New financial products are typically  created for sunny days and are almost never stress-tested for stormy weather. Securitization is an area that almost perfectly fits this description; markets for securitized assets such as subprime mortgages completely collapsed in 2008 and have not fully recovered. Ironically, the government is eager to restore the securitization markets back to their pre-collapse stature.
    
11. Ratings agencies are highly conflicted, unimaginative dupes. They are blissfully unaware of adverse selection and moral hazard. Investors should never trust them.
    
12. Be sure that you are well compensated for illiquidity – especially illiquidity without control – because it can create particularly high opportunity costs.
    
13. At equal returns, public investments are generally superior to private investments not only because they are more liquid but also because amidst distress, public markets are more likely than private ones to offer attractive opportunities to average down.
    
14. Beware leverage in all its forms. Borrowers – individual, corporate, or government – should always match fund their liabilities against the duration of their assets. Borrowers must always remember that capital markets can be extremely fickle, and that it is never safe to assume a maturing loan can be rolled over. Even if you are unleveraged, the leverage employed by others can drive dramatic price and valuation swings; sudden unavailability of leverage in the economy may trigger an economic downturn.
    
15. Many LBOs are man-made disasters. When the price paid is excessive, the equity portion of an LBO is really an out-of-the-money call option. Many fiduciaries placed large amounts of the capital under their stewardship into such options in 2006 and 2007.
    
16. Financial stocks are particularly risky. Banking, in particular, is a highly lever- aged, extremely competitive, and challenging business. A major European bank recently announced the goal of achieving a 20% return on equity (ROE) within several years. Unfortunately, ROE is highly dependent on absolute yields, yield spreads, maintaining adequate loan loss reserves, and the amount of leverage used. What is the bank’s management to do if it cannot readily get to 20%? Leverage up? Hold riskier assets? Ignore the risk of loss? In some ways, for a major financial institution even to have a ROE goal is to court disaster.
    
17. Having clients with a long-term orientation is crucial. Nothing else is as important to the success of an investment firm.
    
18. When a government official says a problem has been “contained,” pay no attention.
    
19. The government – the ultimate short- term-oriented player – cannot withstand much pain in the economy or the financial markets. Bailouts and rescues are likely to occur, though not with sufficient predictability for investors to comfortably take advantage. The government will take enormous risks in such interventions, especially if the expenses can be conveniently deferred to the future. Some of the price-tag is in the form of back- stops and guarantees, whose cost is almost impossible to determine.
    
20. Almost no one will accept responsibility for his or her role in precipitating a crisis: not leveraged speculators, not willfully blind leaders of financial institutions, and certainly not regulators, government officials, ratings agencies or politicians.
    

Below, we itemize some of the quite different lessons investors seem to have learned as of late 2009 – false lessons, we believe. To not only learn but also effectively implement investment lessons requires a disciplined, often contrary, and long-term-oriented investment approach. It requires a resolute focus on risk aversion rather than maximizing immediate returns, as well as an understanding of history, a sense of financial market cycles, and, at times, extraordinary patience.

False Lessons

• There are no long-term lessons – ever.
  
• Bad things happen, but really bad things do not. Do buy the dips, especially the lowest quality securities when they come under pressure, because declines will quickly be reversed.
  
• There is no amount of bad news that the markets cannot see past.
  
• If you’ve just stared into the abyss, quickly forget it: the lessons of history can only hold you back.
  
• Excess capacity in people, machines, or property will be quickly absorbed.
  
• Markets need not be in sync with one another. Simultaneously, the bond market can be priced for sustained tough times, the equity market for a strong recovery, and gold for high inflation. Such an apparent disconnect is indefinitely sustainable.
  
• In a crisis, stocks of financial companies are great investments, because the tide is bound to turn. Massive losses on bad loans and soured investments are irrelevant to value; improving trends and future prospects are what matter, regardless of whether profits will have to be used to cover loan losses and equity shortfalls for years to come.
  
• The government can reasonably rely on debt ratings when it forms programs to lend money to buyers of otherwise unattractive debt instruments.
  
• The government can indefinitely control both short-term and long-term interest rates.
  
• The government can always rescue the markets or interfere with contract law whenever it deems convenient with little or no apparent cost. (Investors believe this now and, worse still, the government believes it as well. We are probably doomed to a lasting legacy of government tampering with financial markets and the economy, which is likely to create the mother of all moral hazards. The government is blissfully unaware of the wisdom of Friedrich Hayek: “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.”)