Taleb - Q&A on Tail-Hedging with Yahoo Finance

by Julia La Roche
Yahoo Finance
August 8, 2016

Yahoo Finance: You’re the Distinguished Scientific Advisor at the hedge fund of your longtime friend Mark Spitznagel, Universa Investments, a pioneer in tail risk hedging for institutional clients. What is tail risk hedging?
 
Nassim Nicholas Taleb: The idea at Universa is protecting clients against extreme events, those that are rare and traumatic and can threaten their survival. Counter-intuitively, by minimizing clients’ vulnerability to extreme losses through things like put options, they tend to do much better over the long run.
 
YF: Why is it important for investors to tail risk hedge their portfolios? And how should they do this?
 
NNT: The point is that when someone is subjected to deep losses in a large part of their portfolio, they will spend an enormous amount of their investment time rebuilding that portfolio from those losses, and any future “alpha” that is excess return from the portfolio will diverge and long term it will be much lower. Why? Because unless someone has no “uncle points,” or infinite capital, extreme loss is deterministic and does not let people emerge from it. Look at the state of under-funding of the majority of pension funds after 2008. This problem for them is only worse now. Ruin doesn’t have to be a total loss. It can be something that forces someone out of the market at the worst possible time, or, say, a 60-year old person discovering that he or she can no longer survive on future retirement income.
 
NNT: Also, someone who minimizes their exposure to ruin by tail risk hedging can gain greater exposure to the market in other times, as they don’t have the same risk of getting stopped out as someone else so they can invest larger and for longer. Let me explain with the following example. If 100 people walk into a casino and the people who bet their money on number 27 go bust, those who bet on number 28 will not be affected. The ruin of one person does not directly affect that of others.  But, if on the other hand, a person plans to walk into a casino every day for 100 days and is bust on day 27, there will be no days 28, 29, …100. So it is a mistake to look at returns of the market if you don’t have the perfect staying power, and investors should do things like tail risk hedging to ensure the highest certainty of survivorship.  What Mark is doing at Universa is just that: providing staying power and robustness for clients.
 
YF: You and Spitznagel have been doing this for a long time.  What have you learned?
 
NNT: One should stay consistent, keep an iron discipline. Mark and I have been protecting against extreme risks for nearly twenty years together. During that time, we’ve seen tail hedgers come and go by following whims and not truly focusing long term on hedging. Universa is a true “hedge” fund, as it lowers portfolio uncertainty rather than adding to it. One needs to work very, very hard at calibrating the right kind of exposure and making sure it delivers a payout in a true crash, just like Universa did in 2008, while keeping costs minimal otherwise. Refining both sides of that pendulum is the most important, and it creates its own alpha for investors. Also one can’t view hedging in isolation. The portfolio package is what matters, and investors need to know you can’t achieve one without the other.
 
YF: What are the biggest risks out there right now?
 
NNT: The fact that the world, as a result of quantitative easing, has seen an asset inflation that benefited the uber-rich, and that nothing has been cured. One cannot cure debt with debt, by transferring from private to public sectors. The markets will ultimately crash again, although this time it will hurt a lot more people.
 
YF: A lot of people throw around the phrase ‘black swan’ haphazardly.  What do people most commonly get wrong when talking about black swans?
 
NNT: They don’t get that what matters is to be protected against those tail risks that matter, something easier to do than trying to predict them. The idea is to focus on portfolio robustness rather than forecasts.
 
YF: Finally, you’re very active on social media — Twitter and Facebook. What do you think the role of social media plays in politics, the economy and the markets?
 
NNT: Social media allowed me to go direct to the public and bypass the press, an uberization if you will, as I skip the intermediary. I do not believe that members of the press knows their own interests very well. I noticed that journalists try to be judged by other journalists and their community, not by their readers, unlike writers. This cannot be sustainable. Also, if you say it the way it is, people trust you.  The central modus operandi is to avoid marketing: social media is a way to test ideas and work in progress and give-and-take to and from the readers.