Mr. Gaunt steepled his fingers under his chin. “Perhaps it isn’t even a book at all. Perhaps all the really special things I sell aren’t what they appear to be. Perhaps they are actually gray things with only one remarkable property—the ability to take shapes of those things which haunt the dreams of men and women.” He paused, then added thoughtfully: “Perhaps they are dreams themselves.”
–Stephen King, Needful Things
If your job is to sell people stuff, the path of least resistance goes something like this:
1) Sell cheeseburgers to fat people
2) Sell advice on giving up cheeseburgers to fat people
The point here isn’t to poke fun at fat people. The point is that “fat person” is an identity with a lot connotations attached to it. One might go so far as to call those connotations “baggage.”
Other identities with a lot of connotations attached to them include: “retiree,” “former executive,” “doctor,” and “little old lady who wants a good rate on her CDs.”
We’ve all got identities. We’ve all got baggage. We’ve all got cravings.
Salespeople know this.
I opened this with a quote from Stephen King’s novel. Needful Things. In the novel, Leland Gaunt sells trinkets. The trinkets take the form of something that matters to you. Whatever triggers your deepest desires and fears. And, of course, Leland Gaunt’s willing to give you a deal on that particular item. All he asks in return is a little favor…
You go into Leland Gaunt’s shop thinking you’ll shell out some cash for a trinket. A rare baseball card. A lampshade. A religious relic. But the true cost is your soul.
Investment products, too, are things that matter. They trigger powerful emotions. You come to associate them with your aspirations, hopes and dreams.
People who sell financial products know this. People who sell deals know this.
“Oh, so you’re a Little Old Lady Worried About The Market? We’ve got an equity indexed annuity for you.”
“Sophisticated allocator? I see private equity co-invests have caught your eye.”
“Tech entrepreneur? Have you ever looked at crossover biotech funds?”
I hate to break it to you purists, but most investments aren’t sold on the basis of future expected cash flows. Most deals are sold as little gray things that will satisfy whatever cravings you’ve got as a retiree or endowment CIO or little old lady looking for the best rate on a CD. Whatever matters to you, there’s a broker out there who will sell it to you.
When it comes to risk management there is one consideration that towers over all the others. That is liquidity.
The word “liquidity” can mean different things in different contexts. Sometimes it literally means “cash.” Other times it refers to your ability to quickly convert the full value of another asset (like a stock or a mutual fund share) into cash. This post will reference liquidity in both contexts.
Liquidity (“cash”) is the lifeblood of our financial lives. It is the medium through which we move consumption forwards and backwards in time. It is the bridge that links spending, saving and investment.
You don’t fully appreciate the importance of liquidity until you need it and don’t have it.
Poor people understand this intuitively. For a poor person life is a never-ending liquidity crisis. It is the global financial crisis on repeat. There’s a reason the foundation for all financial planning is the net cash emergency fund. The net cash emergency fund is your liquidity buffer. It’s loss-absorbing capital. It’s what keeps you from getting caught in the vicious cycle of dependency on short-term, unsecured, high cost debt like credit cards and payday loans.
Funnily enough, there are plenty of rich people who live life on the edge of a liquidity crisis. Some of these people have a large amount of their net worth tied up in real estate or private business ventures. You can have a lot of paper wealth but still very little liquidity.
When the shit hits the fan, your paper net worth is irrelevant. If you don’t have enough cash on hand to meet your financial obligations, you are toast. This is the story of every banking crisis in the history of finance.
Sure, you can sell the illiquid things you own to raise cash. But that takes time. And the less time you have to sell the worse your negotiating position gets.
There is nothing a shrewd buyer delights in more than finding a forced seller who’s running out of time. This is the essence of distress investing. Distressed investors are often able to buy good assets for fractions of their value because the sellers are desperate for liquidity.
Does this mean you should never own illiquid things?
It means you should never assume you will be able to sell an illiquid thing at a favorable price at a place and time of your choosing.
As an individual, how do you know if it’s okay to own an illiquid thing?
If you can write it down to zero the moment you buy it, and it will not impact your ability to make good on your day-to-day obligations, it is okay to own the illiquid thing from a liquidity standpoint. The thing may still turn out to be a terrible investment, but that’s a separate issue.
These days there are lots of things being marketed to regular folks that are illiquid things disguised as liquid things. These are things like interval funds–the mutual fund world’s answer to private equity. These are also things like non-traded REITs with redemption programs that allow you to withdraw, say, a couple percent of your investment every quarter.
Perhaps your financial advisor has pitched one of these things to you.
Read the fine print!
The underlying assets in these funds are illiquid, and the fine print always allows the investment manager to suspend your redemption rights. Third Avenue Focused Credit investors thought they had daily liquidity, like in any other mutual fund.
My last post on risk management was somewhat impractical. It was critical of the shortcuts we often take in analyzing risk but didn’t offer anything in the way of practical alternatives.
The theme of the last post was that in spite of the sophisticated-sounding calculations underlying most analyses, they are at best crude approximations. In general, these approximations (e.g. assumption of uncorrelated, normally distributed investment returns) make the world seem less risky than it really is.
So, what are we supposed to do about it?
We should take even less risk than our statistical models indicate is acceptable, building in an extra margin of safety. For example, holding some cash reserves even if we have the risk tolerance to run fully invested.
We should not have too much conviction in any given position.
Also, in theory, the more certain you are of an investment outcome, the larger and more concentrated you should make your positions. If you knew the future with total certainty, you would go out and find the single highest return opportunity out there and lever it to the max.
Given we live in a world where a 60% hit rate is world class, most of our portfolios should be considerably more diversified with considerably less than max leverage.
I don’t think any of that’s particularly controversial.
But I’m not just talking about individual stocks here. This goes for broad asset classes and the notion of “stocks for the long run,” too. I’m not arguing we should all be capping equity exposure at 50%. But it’s prudent to stress portfolios with extreme downside scenarios (this is unpopular because it shows clients how vulnerable they are to severe, unexpected shocks).
How robust is the average retiree’s portfolio to a 30% equity drawdown that takes a decade to recover?
“It was so painful,” says William M.B. Berger, chairman emeritus of the Berger Funds, “that I don’t even want my memory to bring it back.” Avon Products, the hot growth stock of 1972, tumbled from $140 a share to $18.50 by the end of 1974; Coca-Cola shares dropped from $149.75 to $44.50. “In that kind of scary market,” recalls Bill Grimsley of Investment Company of America, “there’s really no place to hide.” Sad but true: In 1974, 313 of the 318 growth funds then in existence lost money; fully 123 of them fell at least 30%.
“It was like a mudslide,” says Ralph Wanger of the Acorn Fund, which lost 23.7% in 1973 and 27.7% more in 1974. “Every day you came in, watched the market go down another percent, and went home.”
Chuck Royce took over Pennsylvania Mutual Fund in May 1973. That year, 48.5% of its value evaporated; in 1974 it lost another 46%. “For me, it was like the Great Depression,” recalls Royce with a shudder. “Everything we owned went down. It seemed as if the world was coming to an end.”
Are we building portfolios and investment processes taking the possibility of that kind of environment into account?
Are we equipped psychologically to deal with that kind of environment?
I conclude with this evocative little passage from George R.R. Martin:
“Oh, my sweet summer child,” Old Nan said quietly, “what do you know of fear? Fear is for the winter, my little lord, when the snows fall a hundred feet deep and the ice wind comes howling out of the north. Fear is for the long night, when the sun hides its face for years at a time, and little children are born and live and die all in darkness while the direwolves grow gaunt and hungry, and the white walkers move through the woods.”
Yesterday I was discussing some risk analysis with a colleague. Specifically, quantitative risk scores for fixed income funds. The details of the scoring are not important for the purposes of this post. Suffice it to say it is along the lines of sorting funds into quartiles based on statistics such as rolling volatility and drawdown.
The point of our discussion was that soon the financial crisis period will roll off the risk scores, penalizing more conservative portfolios in the ranking system. The scores will implicitly reward excessive risk-taking.
This is a great metaphor for the state of markets today.
Collectively, we have forgotten what it means to be afraid. Today, it is all about squeezing as much return as possible out of a portfolio. Fear has rolled off our collective memory. And what’s worse our lack of fear is justifiable according to the trailing 10-year data.
This at a time when:
Credit spreads are tight.
Covenants are weak.
Leverage is high.
Oh, and interest rates are rising.
There is an inherent tension in risk management between simple statistical measures (which people prefer) and the true nature of risk (which is nuanced and difficult to quantify). In fixed income in particular, the payoffs are negatively skewed. As an extreme example: “I have a 94% chance of earning a 6% yield on my $100 principal investment and a 6% chance of losing the $100 of principal.” Only in real life we don’t know the probability of default in advance.
The standard deviation of a high yield bond fund does not do a great job of describing its risk. In the absence of defaults the volatility will be fairly mild. If defaults tick up in a recession, losses could be catastrophic–particularly if liquidity dries up and twitchy investors decide to redeem en masse. None of the most significant risks to a high yield investment are properly captured by its standard deviation.
Statistical risk analysis is popular because it uses straightforward inputs and is easy to run at scale. Looking at a portfolio and puzzling out how it might behave in future states of the world, without relying on correlation and volatility statistics, takes a lot of time and energy. It is a “squishy” process. Your peers might think you are a bit of a crank because you aren’t sufficiently “data-driven.”
Oh, and much of the time things will run smoothly anyway.
Diligent risk management is a thankless task. No one pats you on the back for the things that didn’t go wrong. In fact, in a market environment like this one, a little extra prudence can get you fired.
Whenever I am looking at an investment one of the things I think long and hard about is under what conditions it might explode spectacularly like a dying star. Excluding fraud, these kinds of blowups are generally caused by leverage (too much debt or financial derivatives with embedded leverage a.k.a convexity) and asset/liability mismatches.
It should be fairly straightforward for a competent analyst to identify and control these risks. More importantly, as analysts we should be getting these things right more often than not as they are triggers for catastrophically bad outcomes. What’s more, none of them is captured by backward-looking statistical measures.
Here is a recurring theme from this blog: “risk can never be destroyed, it can only be transformed and laid off on someone else.”
Or, in the words of the late, great Marty Whitman: “someone has to pay for lunch, and I don’t want it to be me.”
Often people think they’ve destroyed risk when they buy a financial product with a guarantee attached. In finance, “guarantee” is just a fancy word for “promise.” When you buy a financial product with a guarantee attached, you’re swapping market risk for something else. Usually it’s a stream of payments with its own set of risks.
The person selling you the stream of payments will tell you that you’ve gotten rid of your risk. And you have, to an extent. You’ve gotten rid of A risk. You’ve traded your market risk for credit risk (your counterparty might not make good on their promise) and purchasing power risk (your stream of payments might not keep up with inflation).
Some of you will say, “but the counterparty is contractually obligated to keep is promise!”
To which I say, “so are bond issuers and individual borrowers. Yet they default all the time. Sometimes they even commit fraud.”
Others will say, “you don’t know what you’re talking about! The government has insurance funds for deposits and pensions!”
To which I say, “promises, promises, all the way down.”
How does the government fund its promises? With tax revenue, partly. But more importantly, with debt. Like I said–promises, all the way down. Dollar bills are themselves promises. What is the “full faith and credit of the United States government” but an elaborate series of promises?
Anyway, for normal people the most common example of “risk transformation” would be buying an annuity or whole life policy from an insurance company. But there are more exotic examples.
Banks like to sell structured notes to their wealth management clients. These are difficult products for the average person to understand. They usually promise a return based on the price performance of some index, subject to certain limitations. For example there will be a guaranteed minimum return and a cap on the high end.
(Notice that I said price performance. If you buy a structured note, no dividends for you!)
Banks like this opacity because the complexity makes it easy for them to bake profits into the structures, which are literally designed by mathematicians (actuaries). The products are sold based on the guaranteed minimum return, and the chance of modest upside. As the buyer, you overpay for the downside protection (the guarantee). When you buy a structured note, you are basically lending the bank money so it can write options and eke out some trading profits. In return you get a more bond-like risk profile.
Meanwhile, you are an unsecured creditor of the bank. If the bank goes bust, your investment is toast. So much for guarantees. Get in line with the rest of the unsecured lenders. Ask the people who bought structured notes from Lehman Brothers how it worked out for them.
In general, the more complicated the product, the worse a deal you are getting. Of course, there can be good reasons to swap market risk for a guaranteed stream of payments. Just because you overpay for downside protection doesn’t make you a sucker.
I also learned at Quantico that complex linear planning fails in warfare because the profession involves “the shock of two hostile bodies in collision, not the action of a living power upon an inanimate mass,” as Clausewitz reminds us. In the military-industrial exuberance of the post–Cold War decades, we invested heavily in exotic platforms such as drones, cyber capabilities, and billion-dollar strike fighters. Our low-tech but moderately street-savvy opponents in this millennium decided to fight us precisely where and how these assets were near useless. With few exceptions, the most useful equipment for this environment came from the Vietnam era and the most enduring lessons from the time of the Spartans.
Financial markets, made up of people competing for an edge, are precisely the type of environment designed to bedevil static planning. The financial environment is one where valuation multiples persistently mean revert, where income statement growth is not persistent or predictable, where GDP growth does not correlate with equity returns, where market share and moats do not lead to competitive advantage or price return.
So what are we to do in such an environment where outcomes are determined not so much by the very little we can foresee but by what might unexpectedly happen relative to the expectations embedded in the price at which the security is bought? How would we affirmatively strategize and operate differently as investors if all of our most cherished and marketed crystal balls for forecasting price returns are shattered? How should we operate amidst the chaos without operating chaotically?
In Afghanistan, I found that the most consequential assets on our side were the most robust and persistent throughout the history of warfare. An asymmetric but intelligent adversary had refused to engage us on any terms but those where war devolved to a competition of wills, where discipline, resolve, adaptability, and habituated combat-arms tactics dictated the victor, not drones or robot pack mules. Our own persistent behavioral biases were our worst enemy.
UPDATE: After reading and reflecting on this, it seems clear to me it is essentially providing a mental model for what war is and how it is conducted.
At first glance, war seems a simple clash of interests. On closer examination, it reveals its complexity and takes shape as one of the most demanding and trying of human endeavors. War is an extreme test of will. Friction, uncertainty, fluidity, disorder, and danger are its essential features. War displays broad patterns that can be represented as probabilities, yet it remains fundamentally unpredictable. Each episode is the unique product of myriad moral, mental, and physical forces.
Individual causes and their effects can rarely be isolated. Minor actions and random incidents can have disproportionately large—even decisive—effects. While dependent on the laws of science and the intuition and creativity of art, war takes its fundamental character from the dynamic of human interaction.
Also this bit:
War is an extension of both policy and politics with the addition of military force. Policy and politics are related but not synonymous, and it is important to understand war in both contexts. Politics refers to the distribution of power through dynamic interaction, both cooperative and competitive, while policy refers to the conscious objectives established within the political process. The policy aims that are the motive for any group in war should also be the foremost determinants of its conduct. The single most important thought to understand about our theory is that war must serve policy.
We all have our weird niche interests and obsessions. For instance, my quixotic obsession with tail hedging. Conventionally, that means protecting portfolios against “rare” events (the VIX doubling in a single day, for instance). I am interested in tail hedging in a less conventional sense. I am interested in actually making money off “rare” events. I use “rare” in scare quotes here because contrary to the what you might hear from boilerplate financial advice, “rare” events are surprisingly common in financial markets.
If you are interested in the philosophical and mathematical underpinnings of tail risk, you should read Taleb’s Fooled By Randomness and Lo’s Adpative Markets (review forthcoming soon). But if you prefer practical applications, check out the below table:
This is taken directly from the paper “A Comparison of Tail Risk Strategies in the US Market.” The intuition is simple: markets offer the highest expected returns when they are bombed out, when valuations are deeply discounted, when (to borrow a Buffettism) everyone is feaurful. A tail hedge not only provides excess returns in times of crisis that mitigate drawdown, but also a source of liquidity that can be redeployed into equity and/or fixed income securities at firesale prices.
So, hypothetically, you make 2% at the portfolio level off a small-ish tail hedge and reinvest it into equities at firesale prices. Over the subsequent months and years maybe that amount doubles, triples or quadruples.
Sounds great, right? What’s the catch?
The catch is the cost of the hedge and the resulting drag on returns:
If you are interested in a detailed exploration of the strategies in the table, you will have to read the linked paper. However, at a high level the intuition is straightforward. When you are tail hedging you are essentially buying insurance. The person selling you the insurance wants to earn a premium for doing so.
The most common arguments against tail hedging are:
(1) there is no reason to hedge tail risk because in the long run equity markets always go up;
(2) the cost of the insurance is not offset by excess returns over time;
(3) there are better ways of mitigating tail risk.
I do not find Argument #1 compelling at all. All the data used to support this argument is subject to path dependency and survivorship bias. This is particularly true in the context of the US market, which is has been the best performing equity market in history. People tend not to respond well to my counterarguments because they imply an uncertain view of the future and they would rather extrapolate from the past (clients don’t like to face up to the uncertainty inherent in markets). People also have a difficult time with skewed payoffs–that is, understanding why a strategy with a 99% probability of a $1 loss and a 1% probability of a $100 gain is a good bet in the long run.
I do find Argument #3 compelling. AQR has a good paper on this that reaches similar conclusions to the Alternative Investment Analyst Review piece. However, AQR’s paper is focused on defensive applications of tail hedging strategies, whereas my interest is in playing offense. In full fairness, AQR addresses that in the paper:
We acknowledge that some investors might buy insurance for reasons other than reducing tail risk. For example, insurance can provide a cash buffer in times of market distress, potentially allowing investors to take advantage of fire-sales and other market dislocations. However, depending on the magnitude and frequency of the dislocations (and the manager’s ability to identify them), this opportunistic approach still might not make up for the negative expected returns from buying insurance. Other investors might occasionally have a tactical view that insurance is conditionally cheap. However, this is simply market timing in another form, and this decision should be made (and sized) in the context of other tactical views in the portfolio.
I have mixed views of Argument #2, mainly due to the issues of path dependency and survivorship bias noted above. If future equity returns look like the past 30 years or so, there is certainly no reason for long-term investors to tail hedge (assuming they have the wherewithal to stay invested in volatile markets). If the world becomes a more volatile and uncertain place over the next couple decades, investors may feel differently.
I have conducted some small experiments with real dollars over time. Most recently, I set up a long volatility trade using the VIXY ETF and ZIV ETN. It performed well during the February volatility spike, but was something of a blunt instrument (I have since closed out the position).
More recently I have been looking at Meb Faber’s TAIL ETF, which purchases a ladder of out-of-the-money put options on the S&P 500. Below is a rough scenario analysis I conducted to assess performance drag vs. crisis performance, as well as some historical monthly performance data for TAIL for context (the ETF has a short track record).
A couple takeaways:
This exposure has to be managed actively. When volatility spiked in early February 2018 the correct move would have been to trim the position on the back of the ~10% up move.
There is a consideration in play for me that is not in play for many retail investors, and that is that my compensation and career prospects are highly correlated to financial markets. For people with “bond-like” compensation (teachers, doctors) there is less benefit to spending portfolio dollars on a tail hedge from a pure risk management POV.
The real downside to putting on a position like this is not getting 18% annualized over a decade if the market returns 20% annualized. The real downside is getting an annualized 3% if the market returns 5%.
Billionaire Doomsday Prepping As Extreme Tail Hedging
Fear of disaster is healthy if it spurs action to prevent it. But élite survivalism is not a step toward prevention; it is an act of withdrawal. Philanthropy in America is still three times as large, as a share of G.D.P., as philanthropy in the next closest country, the United Kingdom. But it is now accompanied by a gesture of surrender, a quiet disinvestment by some of America’s most successful and powerful people. Faced with evidence of frailty in the American project, in the institutions and norms from which they have benefited, some are permitting themselves to imagine failure. It is a gilded despair.
I have a dramatically different reading: billionaire doomsday prepping is just an extreme form of tail hedging.
If you have a net worth of $1 billion, why not spend even $10 million of your net worth on a hedging strategy for the total collapse of civilization? This amounts to a 1% exposure. It’s a pretty good risk/reward tradeoff, if you ask me–especially if you are estimating your max downside as being drawn and quartered by some kind of Proletarian Justice Tribunal. Obviously, a financial hedge is not going to work here. You are going to need things like guns and butter. And some kind of bunker.
I am sure not all ultra-wealthy doomsday preppers look at it this way. But I am comfortable speaking for a majority. Even that New Yorker piece contains the following observation (they buried the lede, IMO):
Yishan Wong, an early Facebook employee, was the C.E.O. of Reddit from 2012 to 2014. He, too, had eye surgery for survival purposes, eliminating his dependence, as he put it, “on a nonsustainable external aid for perfect vision.” In an e-mail, Wong told me, “Most people just assume improbable events don’t happen, but technical people tend to view risk very mathematically.” He continued, “The tech preppers do not necessarily think a collapse is likely. They consider it a remote event, but one with a very severe downside, so, given how much money they have, spending a fraction of their net worth to hedge against this . . . is a logical thing to do.”