The Government is Bailing Out Investors & Managers Not You

by Nassim Nicholas Taleb with Mark Spitznagel)
Medium.com
March 26, 2020

The U.S. government is enacting measures to save the airlines, Boeing, and similarly affected corporations. While we clearly insist that these companies must be saved, there may be ethical, economic, and structural problems associated with the details of the execution. As a matter of fact, if you study the history of bailouts, there will be.

The bailouts of 2008–9 saved the banks (but mostly the bankers), thanks to the execution by then-treasury secretary Timothy Geithner who fought for bank executives against both Congress and some other members of the Obama administration. Bankers who lost more money than ever earned in the history of banking, received the largest bonus pool in the history of banking less than two years later, in 2010. And, suspiciously, only a few years later, Geithner received a highly paid position in the finance industry.

That was a blatant case of corporate socialism and a reward to an industry whose managers are stopped out by the taxpayer. The asymmetry (moral hazard) and what we call optionality for the bankers can be expressed as follows: heads and the bankers win, tails and the taxpayer loses. Furthermore, this does not count the policy of quantitative easing that went to inflate asset values and increased inequality by benefiting the super rich. Remember that bailouts come with printed money, which effectively deflate the wages of the middle class in relation to asset values such as ultra-luxury apartments in New York City.

If It’s Bailed Out, It’s a Utility

First, we must not conflate airlines as a physical company with the financial structure involved. Nor should we conflate the fate of the employees of the airlines with the unemployment of our fellow citizens, which can be directly compensated rather than indirectly via leftovers of corporate subsidies. We should learn from the Geithner episode that bailing out individuals based on their needs is not the same as bailing out corporations based on our need for them.

Saving an airline, therefore, should not equate to subsidizing their shareholders and highly compensated managers and promote additional moral hazard in society. For the very fact that we are saving airlines indicates their role as utility. And if as such they are necessary for society, then why do their managers have optionality? Are civil servants on a bonus scheme? The same argument must also be made, by extension, against indirectly bailing out the pools of capital, like hedge funds and endless investment strategies, that are so exposed to these assets; they have no honest risk mitigation strategy, other than a trained naïve reliance on bailouts or what’s called in the industry the “government put”.

Second, these corporations are lobbying for bailouts, which they will eventually get thanks to the pressure they can exert on the government via lobby units. But how about the small corner restaurant ? The independent tour guide ? The personal trainer? The massage professional? The barber? The hotdog vendor living from tourists near the Met Museum ? These groups cannot afford lobbyists and will be ignored.
Buffers Not Debt

Third, as we have been warning since 2006, companies need buffers to face uncertainty –not debt (an inverse buffer), but buffers. Mother nature gave us two kidneys when we only need about a portion of a single one. Why? Because of contingency. We do not need to predict specific adverse events to know that a buffer is a must. Which brings us to the buyback problem. Why should we spend taxpayer money to bailout companies who spent their cash (and often even borrowed to generate that cash) to buy their own stock (so the CEO gets optionality), instead of building a rainy day buffer? Such bailouts punish those who acted conservatively and harms them in the long run, favoring the fool and the rent-seeker.
Not a Black Swan

Furthermore, some people claim that the pandemic is a “Black Swan”, hence something unexpected so not planning for it is excusable. The book they commonly cite is The Black Swan (by one of us). Had they read that book, they would have known that such a global pandemic is explicitly presented there as a white swan: something that would eventually take place with great certainty. Such acute pandemic is unavoidable, the result of the structure of the modern world; and its economic consequences would be compounded because of the increased connectivity and overoptimization. As a matter of fact, the government of Singapore, whom we advised in the past, was prepared for such an eventuality with a precise plan since as early as 2010.

Reuters
by Svea Herbst-Bayliss, Lawrence Delevingne
March 18, 2020

The New York hedge fund manager, seasoned by past financial crises and spooked by seemingly endless quarters of ever-higher markets, had for years set up for financial calamity, even if it meant sometimes poor returns.

When panic over the coronavirus spread to global financial markets in late February, Weinstein swung into action.

Glued to a battery of computer screens to transact in three time zones for 15 hours a day, the former Deutsche Bank AG trader scored on bond and credit default swap-related bets and cashed in on old insurance-like derivatives products for a steep market decline, according to people who know him.

By Friday, Weinstein had produced the best returns in $2.7 billion Saba Capital Management LP's history. Its Tail Fund gained more than 175% through March 13; other Saba funds gained between 53% and 67%, according to a client letter reviewed by Reuters here

“I certainly did not expect it to come from a virus, but I have had the conviction – for a long time – that investors needed to be ready for an extreme market decline,” Weinstein wrote in the letter that was sent to investors on Sunday.

A spokesman for Saba declined to comment.

Saba is among a small group of firms that have scored major returns for clients in recent weeks through so-called tail risk products.

The CBOE Eurekahedge Tail Risk Hedge Fund Index gained 14% in February alone and, combined with estimated March performance, is likely up between 32% and 41% for the year, according to a Eurekahedge analysis.
Goldman Sachs Group Inc estimates that the average stock-focused hedge fund, by comparison, is down about 14% for the year through March 17, compared with a 25% benchmark stock market loss.

Tail products - including hedge funds, customized portfolios and exchange traded funds (ETFs) - typically use credit default swaps, stock options and other derivatives to profit from severe market dislocations. Generally they are cheap bets for a big, long-shot payoff that otherwise are a drag on the portfolio, much like monthly insurance policy payments. Such funds have been around since the 2008 financial crisis, but they gained limited traction by producing mixed returns during the bull market.

‘MULTIPLES’ OF 1,000%

A client of Universa Investments LP, a $4.1 billion [correction: $13 billion - Lionscrest] Miami-based risk mitigation specialist, saw money allocated to the firm’s tail hedging strategy gain around 1,000% in February and “multiples” of that in March, according to Claude Bovet of Lionscrest Capital. That implies a gain of at least 3,000%; the net return on Lionscrest’s total portfolio was not available.

“This has been a great period for us and our clients,” Universa chief investment officer Mark Spitznagel said via a spokesman, who declined to comment on performance.

Other big winners include Capstone Investment Advisors, whose $7 billion firm runs tail risk strategies for clients that have gained 280% this year through Monday, according to a person familiar with the returns; 36 South Capital Advisors’ volatility strategy, which rose 35% over January and February, according to data from Societe Generale; and the $126 million Cambria Tail Risk ETF, which is up about 25% this year through Tuesday.

“Our tail risk products are doing exactly what they are designed to do,” said Meb Faber, chief investment officer at El Segundo, California-based Cambria Investment Management LP.

Representatives for Capstone and 36 South declined to comment.

These types of portfolios are always popular during a crisis but when no next terrible event happens, investment managers and boards often lose patience and exit, complaining of low returns or losses. Last year, when the S&P500 stock index gained 30%, the benchmark CBOE Eurekahedge index lost 10.4%.

The gains this year are likely to spur renewed interest. Weinstein’s Saba has seen $500 million come in this year and told investors that he will limit inflows into his funds to an aggregate of $1 billion for 2020. Weinstein said Saba was now “finding extraordinary new investments” amid the turmoil.

Winning managers were mindful that their gains came as a result of a health crisis that has sickened nearly 200,000 people around the world and killed 7,500 as of Wednesday, according to the World Health Organization (as referenced here).

“We provide protection, an effective safe haven,” said Universa’s Spitznagel. “But we certainly didn’t need nor want this tragedy to happen.”

‘Black Swan’ fund Universa made huge gains in February as markets swooned from coronavirus risk without making any assumptions about the epidemic

by Spencer Jakab
Updated March 4, 2020 8:02 am ET

Imagine that an investor knew back in early December that a deadly coronavirus was spreading in Wuhan, China, that could become a pandemic. Or imagine that he at least heard and heeded the warning by the tragically muzzled Dr. Li Wenliang at the end of that month.

Acting on that information by, say, shorting the highflying Nasdaq Composite might have sounded like a good idea, but the results would have been disastrous. By the time the index hit its intraday record on Feb. 19, a forewarned investor would have trailed that index by about 30 and 20 percentage points, respectively.

Yet one fund that makes its living protecting portfolios from such events may have reaped a bonanza in February without such insights. Universa, managed by Mark Spitznagel, a protégé of “The Black Swan: The Impact of the Highly Improbable” author Nassim Nicholas Taleb, managed a little over $4 billion in assets as of the end of 2018. Claude Bovet, founder of Lionscrest Capital and a long time investor in the fund, estimates that Universa’s tail risk hedging strategy, representing part of its capital, earned more than 1,000% in a matter of days.

“It was a great month for us,” says Mr. Spitznagel, who declined to disclose a dollar figure on those gains. He did point out, though, that the fund’s positions are “convex to the market.” In other words, its strategy of using options and similar instruments can register profits that escalate in much more than a linear fashion, suggesting a handsome payoff indeed. Back in August 2015 the fund made over $1 billion, or 20%, in a single day when the Dow had what was then its largest ever intraday plunge of over 1,000 points, ending down by 588 points.

The index lost 3,583 points last week—its worst such period since the financial crisis and sharpest ever drop from a peak. Yet, even as patients were succumbing to the illness in Wuhan, the cost of placing bets in the run-up to the selloff was extremely low as represented by the Cboe Volatility Index, or VIX. The so-called fear gauge, it represents the cost of purchasing options as expressed by the implied volatility embedded in their prices.

Universa hedged without timing the market or taking a risk, which holds a lesson about risk, reward and complacency. While many reasonable investors were tempted to sell tech stocks or bet against them—2,000 people had died by the day they peaked—Universa ignored the headlines and focused only on what the numbers said. They told it that insurance was cheap.

“If you have a position that can lose 1 to make 100, like Universa’s tail hedge at any point in time, you don’t care about your timing of a market crash, you just don’t want to miss it,” says Mr. Spitznagel.

Buying protection in such a fund is akin to purchasing insurance from an optimistic underwriter—writing small monthly checks and very rarely receiving a big one in return. Returns can be negative for years. Yet even during a mostly excellent run for U.S. stocks, the strategy trounced the stock market in its first 10 years through February 2018, according to a leaked client letter.

Mr. Spitznagel, who acknowledges spending all of his time “thinking about looming disaster,” expressed no view on what the impact of the Covid-19 epidemic might now be on stock prices.

Even so, his advice to those with a bearish inclination is hardly uplifting: “For people who are worried about having missed it, this selloff has only taken back a few months of gains. I expect a true crash to take back a decade.”

Hedge-funder Mark Spitznagel believes the central banks have created a monster they don’t know how to stop. And when it comes (like in 2008) he’ll be ready.

Vanity Fair
by William D. Cohan
February 13, 2020

What do you do when the bond market is basically uninvestable and the stock market keeps hitting all-time highs and you know in your gut that none of this will end well? What do investors—big and small—do in such unfortunate circumstances, like the ones we collectively find ourselves in now? I’ve been racking my brain for years to figure that out. Increasingly desperate and with the end getting near, I called Mark Spitznagel, the founder of Universa Investments, a hedge fund that exists to help investors grapple with the inevitable market crash.

Spitznagel, 48, and a former trader in the Chicago pits and at Morgan Stanley, understands what’s been happening and how for the last decade central banks around the world have been warping our financial markets by keeping interest rates artificially low. “These monetary distortions lead to this reckless reach for yields that we are all seeing,” he tells me. He sees risk being mispriced everywhere. “Randomly go look at a screen and it’s pretty crazy,” he says. “Big caps, small caps, credit markets, volatility; it’s crazy. Reach for yield is everywhere.” He thinks we are in one of those periods where people have lost their collective minds when it comes to the financial markets.

“When the stock market is no longer tethered to fundamentals—that’s the distorted environment we live in, that’s just where we are—when that happens, any price can print,” he says. “Any price can print. We shouldn’t be surprised by anything on the upside at this point because what’s tethering the markets? People need yield and when they pursue yield because of the momentum that we have in the markets today, anything is possible.”

He thinks the yield hunger games, as I like to call what’s been happening for the last decade, “makes people take crazy risks” because “interest rates and prices are wrong” and “otherwise wouldn’t even clear the market. They are just absolutely wrong. But of course, central bankers think they know what the natural rate is and that it will all be fine. They think they’ve got it all figured out.”

He disagrees. First, he thinks the massive program of quantitative easing—where after the 2008 financial crisis, the Federal Reserve intervened in the debt markets, buying up nearly everything in sight in an effort to raise the price of long-term bonds, driving down their yields—was a mistake. In the process, the Fed’s balance sheet ballooned to $4.5 trillion in assets, from around $900 billion. (These days, the Fed’s balance sheet is around $4.2 trillion.) “I’m a free market guy,” he says. “Whenever the government gets involved in things—and this is pretty much across the board—they make things worse. I can probably prove that. But it doesn’t really matter. We take what we have and this is the world we live in. And we’ve got to deal with it. I don’t want to complain too much about it. But we’d all be better off today had we not done that. There would’ve been more painful at the time but you rip the Band-Aid off, I think we’d all be better off.”

He also thinks central bankers don’t know how to stop the monster they have created. “I do not think that central bankers will ever be able to pull away from this,” he explains. “They will never be able to ‘normalize’ rates. In our lifetime, recessions and stock market crashes really have been instigated or started by central banks sort of pulling away the punch bowl. They raise rates and that has led to a slow down and ultimately has led to these crashes that we see. Every single one, that’s how it’s happened. But we’ve gone so far down the rabbit hole this time, I am absolutely convinced that that is not even on the table this time.” He thinks central bankers are just testing the market when they suggest—as Jerome Powell, the chairman of the Federal Reserve, did throughout 2018 when he raised short-term interest rates four times—that they wanted to try to return to letting supply and demand set the price of money, a position that he reversed in 2019 when he pivoted and then lowered interest rates. “They’re not stupid,” he says of central bankers. “They are reckless. But they are not stupid. And they realize that global economies are in a situation now where central banks can’t pull away. And they’re bluffing if they say they can.”

He doesn’t know when the inevitable crash will come. But he knows that when interest rates start heading up again on their own, which is also inevitable, that “markets are going to crash. It won’t be pretty.”

Working with the economist (and his former professor at NYU) Nassim Nicholas Taleb —the author of the 2007 best seller, The Black Swan (Spitznagel is working on new book, Safe Haven: Investing for Financial Storms, for which Taleb is writing the foreword)—as an adviser, Spitznagel’s hedge fund has come up with a strategy to help big investors—for instance pension funds and endowment funds—protect their portfolios against the coming correction. Essentially, he offers his clients low-cost, high-deductible fire insurance, the kind you might buy on your house to sleep comfortably at night knowing that if a fire destroyed the place you would be able to replace it with a minimal cash outlay. He essentially offers his clients peace of mind, allowing them to continue participating in the roaring debt and equity markets while also knowing that, for a relatively low cost, they will be protected when the inevitable crash comes.

His solution is what he calls “explosive downside protection,” things like far out of the money bets that the stock markets will fall that cost very little to make and to hold onto but that will pay off big time when the shit hits the fan. “Really explosive downside protection is really the only risk mitigation that’s able to move the needle for people,” he says, “because it’s the only risk mitigation that doesn’t cost you as you are waiting for it to happen.” He likes to focus on his clients’ total portfolio returns, inclusive of the cost of the insurance he offers them. “When the market crashes,” he continues, “I want to make a whole lot and when the market doesn’t crash, I want to lose a teeny, teeny amount. I want that asymmetry. I want that convexity. And what that means is I provide insurance—crash insurance—to my clients so they can put a sliver of their portfolio liquidity into it and then, because of the downside protection I provide, they are allowed to then take more systematic risk.”

Historically, Spitznagel has delivered. He was a big winner in the aftermath of the 2008 stock market crash—portfolio up more than 115 percent—even though people like hedge fund manager John Paulson and the proprietary trading desk at Goldman Sachs got more attention. In a March 2018 letter to his investors, which tracked his decade in business, he revealed that a small—3%—allocation to him and his strategies —to pay for the “explosive downside protection” even though there has not been a crash since 2008—has allowed his clients’ portfolios to consistently outperform the S&P 500 year after year. “That’s incredible,” he says. “We’ve outperformed the S&P which is a crazy thing to say.”

And even though he is betting there will be a crash—and offering protection for his clients if there is one—he doesn’t care if it happens or not. He’s all about freeing up his clients to make the big bets in the market and then protecting them if a crash comes. He’s the designated driver so that his clients can party like its 1999 and know they’ll have a safe ride home. “I don’t need the markets to ever crash again,” he says. “I’d be pretty hunky-dory if there’s never a crash again and that, from now on, every year looks like last year or the last 5 years or the last 10 years. I’d be just fine with that…. My investors would benefit so much from that because I allow them to take more systematic risk. In other risk mitigated portfolios, like hedge fund portfolios and even stock-bond mix, they are going to look really bad compared to my risk-mitigated portfolio.”
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Spitznagel is not shy about criticizing his fellow hedge fund managers who don’t provide the kind of “explosive downside protection” that he does. “Hedge funds underperform when times are good and they don’t make up for it when times are bad,” he says. “I aim to lose tiny amounts when times are good, and I more than make up for it when times are bad.”

Spitznagel spends most of his time these days in Miami, where Universa is based, but he also owns Idyll Farms, a goat-cheese farm in Michigan that is said to make some of the best goat cheese around. He also practices ashtanga yoga and is an aficionado of Austrian economics and, in particular of the Austrian economist Ludwig von Mises. Universa manages around $5 billion, so it’s far from the biggest hedge fund. But, he says, he’s gaining traction among pension fund investors who see the wisdom of his approach.

I confess that I also see the wisdom of his approach and regret that it’s not really an option for small investors who remain vulnerable to the coming market correction in ways that Spitznagel’s investors are not. Is there some way that the little guy can benefit from his wisdom? “I get asked this every day,” he says. “Every day. And I should do something for them. But I have a handful of really big clients. Yeah, if I wasn’t so preoccupied, I would do that. I should do that. I should do that.”

A 30-year analysis raises fundamental questions about hedge funds’ future

Institutional Investor
by Julie Segal
February 10, 2020

Investors are bailing on hedge funds after their recent spate of underperformance. But an analysis of hedge funds over the last 30 years by Universa Investments, itself a hedge-fund firm focused on risk mitigation, shows that the vehicles have never really delivered on their promise of protecting investors’ capital.

Universa compared the performance of a “hedged” portfolio — one with 75 percent of its assets in the Standard & Poor’s 500 (SPX) index and 25 percent in a custom hedge fund index — to the SPX itself.

The hedged portfolio included nine HFR indices and one from Barclay/Hedge as proxies for hedge funds. The annualized outperformance of these hypothetical portfolios from 1990 to the end of 2019 ranged from a disappointing negative 1 percent to 0.4 percent relative to the S&P 500. (The hedge fund indices themselves, which included managed futures, market neutral, macro, and other strategies, delivered outperformance of between negative 5.4 percent to 1 percent.)

“Putting that all together, the way to gauge hedge funds’ success is through the risk mitigation value they add to a portfolio,” according to the report, sent to Universa clients and obtained by Institutional Investor.

An investor wanting protection from equity risk and a market crash could have built a portfolio with 75 percent of assets in the S&P 500 and 25 percent in bonds. According to Universa’s research, this portfolio has outperformed the S&P 500 by 0.1 percent annually since 1990. 

Mark Spitznagel, president and chief investment officer, explained in the report that he wanted to determine the “portfolio effect,” essentially whether or not they have raised the geometric mean returns (or more familiar compound annual growth rate) of their end users’ entire portfolios by mitigating their systematic risk. 

When hedge fund results from the dot-com bust of 2000 to 2002 were removed from the 1990-to-2019 period, hedge funds were even more of a drag on the hedged portfolios,  In Spitznagel said in an interview. The hedged portfolio lagged the S&P 500 by 0.2 percent to 1.9 percent without those years.

From 2000 to 2002, the 10 hedge fund indices that Universa analyzed returned from 4.4 percent to 23.4 percent annually, even as the S&P 500 lost 37.6 percent. Those eye-popping returns spurred billions in flows from investors. But hedge funds never again replicated those results. 

In 2008, the vehicles disappointed investors looking for protection from the global financial crisis. The 10 hedge fund indices studied lost between 26.7 to 14.1 percent, as the S&P 500 fell 37 percent. The 75/25 portfolio lost 34.4 percent to 24.2 percent, according to Universa.
“Since 1990, our hedge funds’ range of value-added came from the risk mitigation that they provided in 2000-2002. “Whether we call this ‘crash-alpha’ or ‘crash-beta,’ outside of what they did from 2000-2002, none of our hedge-fund indices moved the needle through any observable edge,” wrote Spitznagel. “Okay, we’ll give them that — because this is actually how risk mitigation is supposed to work. In that, hedge funds represented a risk mitigation cost to portfolios when the markets weren’t plunging — sort of like paying an insurance premium.” 

Spitznagel said there’s a misunderstanding around low volatility and mean variance: lowering volatility is not synonymous with risk mitigation. Hedge funds’ role in a portfolio should be to mitigate risk in a way that maximizes wealth. But that is not happening. “That’s the fundamental misunderstanding and modern portfolio theory is to blame,” he said.

By Ksenia Galouchko
April 30, 2019, 9:34 AM CDT

There’s a silver lining for bears getting destroyed by record U.S. stock prices and the relentless credit boom: Prepping for Armageddon has rarely been so cheap.

Just ask Mark Spitznagel, the Miami-based investor whose $11 billion black swan fund specializes in hedging against cataclysms on the scale of the dot-com crash and the 2008 financial crisis.

“It’s funny that the richer the markets get, which ultimately leads to crashes, the cheaper the insurance,” said Spitznagel, whose Universa fund counts Nassim Taleb as scientific adviser. “I love low vol like this.”

It’s the other side of a U.S. stock-market rally that has continued to defy naysayers on the way to notching one of the quickest turnarounds in history. After equity volatility spiked briefly at the end of last year, dovish monetary officials have helped squash swings across asset classes, making derivatives such as those scooped up by Universa historically cheap.

“Low implied volatility, low VIX is always a good a thing for me,” Spitznagel said in an interview in London.

Funds like Universa focus on protecting client portfolios from tail events, typically defined as those that are more than three standard deviations from the norm, or which have a 0.3 percent chance of coming to pass. Along with the likes of Richard “Jerry” Haworth’s 36 South Capital Advisors LLP, these niche managers skyrocketed to fame after posting outsize returns during 2008’s rout.

These players rely on far out-of-the-money put options that are likely to gain in value only in extreme market scenarios and possess “convexity,” or extreme sensitivity to price movements.

Subdued expectations of a volatility maelstrom have made these contracts considerably cheaper. CBOE’s SKEW index, one measure of the cost of tail protection, sits below its five-year average. Gauges of implied volatility across rates and currencies -- which inform options prices -- have also dropped to multi-year lows.

Strategists at BNP Paribas SA and JPMorgan Chase & Co. have recommended that investors take advantage of these conditions to stock up on cheap protective hedges in the event of a downturn.

Spitznagel says central banks and their “unprecedented period of monetary interventionism’’ are firmly behind the low-vol trend.

“All assets are priced where they are today because of central banks,” he said. “That’s modern finance -- it’s not about psychology or flows anymore, it’s about what the central banks are going to do next.”

With the post-crisis bull market defying incessant talk of its demise and the credit supercycle extending in earnest, there’s been a shift in demand for black swan strategies, according to Spitznagel. Clients today are donning protection in order to up their risk exposures elsewhere in their portfolio rather than in anticipation of a near-term market collapse, he said.

Spitznagel declined to reveal inflows or returns for this year. A 2018 investor letter seen by Bloomberg showed that an equity portfolio with a small allocation to Universa posted a compound annual growth rate of 12.3 percent over the previous decade. The worst annual performance was 0.6 percent.

“What I allow investors to do is take more systematic risk and not suffer the consequences in case of a crash,” he said.

Despite the meteoric post-crisis rise in exchange-traded products tracking volatility, Spitznagel slams investors who buy them them as portfolio hedges.

“They don’t even begin to understand them,’’ he said. “It’s just a really bad retail product. It’s probably a bad institutional product for most.”