Mark Spitznagel beats drum for tail risks as markets stall

by Robin Wigglesworth and Mary Childs
Financial Times
May 16, 2016
 
For most money managers, raking in $1bn in a day would be the pinnacle of achievement. But for Mark Spitznagel it was tied with winning three medals at the World Championship Cheese Contest.

Mr Spitznagel runs Universa, a “tail risk” hedge fund that specialises in profiting from extreme market crashes. On August 24 last year — a day dubbed “Black Monday” by the Chinese media after the local stock market cratered and led declines across global equity markets — the firm rocketed 20 per cent, making its investors about $1bn. But for the former Chicago pit trader the triumphs of his Michigan goat farm at the recent cheese championship tasted just as sweet.
 
The libertarian hedge fund manager sees a close similarity between what he is trying to achieve at Idyll Farms — which he built in 2010 with winnings from the financial crisis — and his investment strategy and deeply-held Austrian economic philosophy.
 
“It’s all about sustainable use of resources. Modern farming has completely broken down the traditional system of agriculture. It’s become a machine. We’ve manipulated away its natural productivity and robustness, just like what we’ve done with markets,” he says. “Markets don’t have a purpose any more — they just reflect whatever central planners want them to.”
 
Tail risk funds — often called “Black Swan” funds — seek to protect investors from losses during times of outsized market moves, often by buying cheap options protecting against seemingly unlikely scenarios, which then pay out if price swings are wide enough.
 
While they can make money during volatile periods, the cost of paying premia for those hedges in the months and years waiting for the volatility adds up.
 
Accepting the capital burn that most tail risk funds entail can be tricky for some investors, points out Andrew Ang, a prominent finance professor who now works at BlackRock. He therefore recommends “low-volatility” funds instead, that invest in blue-chip, defensive stocks that tend to be very resilient in times of turmoil.
 
“If you can stomach the negative carry, by all account go for it, but a low-vol fund doesn’t have that [cost of buying expiring options],” he says
 
Mr Spitznagel says that investors should keep allocations to their funds as a small percentage of their overall portfolio, and another person familiar with the matter said Universa investors should expect to lose 1-2 per cent annually when markets are steady.
 
But Mr Spitznagel says his formative years on the Chicago trading floor was a good training for such a strategy. “I learnt to lose money in the pit. The way I traded, I had to be willing to look like a fool for a long time, taking tiny losses and waiting for a big win,” he says.
 
One of Universa’s claims to fame is its relationship with Nassim Taleb, the author of Fooled by Randomness and The Black Swan. Mr Taleb, a professor at New York University Polytechnic Institute and a celebrity in the world of derivatives, is listed as a “Distinguished Scientific Advisor” on its website and has a stake in Universa.
 
This is Mr Taleb and Mr Spitznagel’s second endeavour together: Mr Spitznagel worked for Mr Taleb at his hedge fund Empirica Capital, which was started in 1999. After some solid gains the fund closed in 2004 after years of subpar returns.
 
“Mark and I have been studying extreme events and protecting portfolios from them together since the 90s,” Mr Taleb told the FT. “People are finally discovering that being protected from fragility in the financial system is a necessity rather than an option.”
 
His latest venture has enjoyed more success. Universa started in January 2007 after its success during the financial crisis, when it reportedly gained about 100 per cent. The firm now protects about $6bn of investor money, backed by about $200m-$300m of capital (the firm declined to say exactly how much because of regulatory issues). Fees are paid on the nominal amount insured against calamity, rather than the capital invested.
 
Still, sometimes it can go wrong. After the financial crisis, Universa bet that the Fed pumping money into the system would spur hyperinflation. So far inflation has been notable for its absence, but Mr Spitznagel is undeterred.
 
“This is the greatest monetary experiment in history. Why wouldn’t it lead to the biggest collapse? My strategy doesn’t require that I’m right about the likelihood of that scenario. Logic dictates to me that it’s inevitable,” he says.
 
While some money managers are critical of a strategy that “sells fear,” there are others who share Mr Spitznagel’s views that another reckoning is imminent. Among those who share his worldview is former US presidential candidate, Senator Rand Paul, and his father Ron Paul.
 
The elder Paul wrote the introduction to Mr Spitznagel’s 2013 book, The Dao of Capital. “As one of the leading voices in the country on economic policy, Mark has been a key friend and ally, and I’m thankful for his always-ready advice,” Senator Paul told the FT. But most investors will be praying he is wrong.