WSJ - How to Hedge a Coronavirus

‘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.”