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.