Winning with a chance of Winning Bigger, asymmetry versus the illusion of stable returns

With thanks to our friend Keith Pangretitsch at Relevance Wealth

The most recent market fluctuations have returned attention to tail risk managers. Mark Spitznagel, a Nassim Taleb prodigy, posted a 4,144% return in March. Nassim Taleb is the famous author of several books including Black Swan, Fooled by Randomness and Skin in the Game.  To put that in perspective, if you had invested $100 in the S&P500 in 1990, by the end of 2019 you would have received a total return of $1,621 – less than the 1 month return of Mr. Spitznagel. Investors often look at the market in a typical bell curve fashion with a 7% average return and an equal opportunity to earn 0% or 14% if we assume for example a standard deviation of 7%.  It could be interpreted as a zero sum game (minus fees and costs), with the benefit of an average of 7% growth.  It works even if you are average, but is that the way the market works or could you put the odds in your favour by sourcing asymmetric return payoffs like Mark or Nassim?  What do we mean by asymmetry or convexity, and can it be done consistently?  

Asymmetry is simply the absence of symmetry or in investing when the downside and upside are not symmetrical.  An example is where the upside of an investment is 20% but the downside is only 5% or conversely a 5% return opportunity that can generate a 20% downside. The goal is sourcing managers with the skill to find the positive opportunities and who can execute them with consistency. In the example of Mark and Nassim, they have created success from betting on things where the market has priced a small chance of a particular thing happening, but sometimes do.  In the infamous case of Long Term Capital Management, Nobel prize winner Robert Merton explained the fund’s failure to account for a 10 sigma event that should happen once in the history of the Universe.  As investors learned the odds were certainly higher, the market priced it as a 10-sigma event. How do investors get fooled into negative symmetry as in the above example?   First, Investors gain confidence through viewing or experiencing stable returns.  These “stable returns” look good in a normal distribution and help us justify our investments to our investment boards. Initially, or during the life of the investment, we might even be aware of potential negative fat tails – but as time passes without major events, we start to believe in this illusion of stability until a fall of unexpected magnitude occurs.  Managers can often be blind to unexpected risks, as can investors who buy into their return stream that was generated in normal market environments.  We intuitively know skill is often best assessed through the attribution of results in difficult markets and it’s important to reassess when surprises occur as more will likely follow. 

Talib and Spitznagel are willing to lose small amounts of money for years to collect outsized gains during crises when their mispriced risk pays off.  For most of us that have shorter attention spans, the same asymmetry can be achieved on a smaller scale.  The result is above average returns with less risk, but there is a cost.  Positive asymmetric payoffs are generally sourced during periods of market stress. Return streams can be lumpy and sporadic which investors associate with more risk, not less, they may even require an initial give-up of returns or J-curve. While we often think of equity dislocations, credit is an example where asymmetric opportunities can appear.  One investor may look only as far as the yield on a security while the asymmetric manager will look further for price gains to be had from limited price transparency and inefficient auction systems. In less liquid credit markets prices can reflect the most motivated buyer/seller rather than the collective actions of market participants. After longer periods of prosperity and resulting narrowing spreads some also resort to leverage to continue to earn excess returns which can further exacerbate the situation for those unaware of negative asymmetry.

For managers that can source asymmetric payoffs the benefits are above average returns with less risk; investment panacea.  You would think that every manager would be looking for these trades but not all can due to skill, scale or experience. Some unsuspecting mutual funds, REITS and Hedge Funds that had produced stable returns for pension funds, institutions and individuals suddenly fell by 20 – 50% in a single week in March of 2020. Leverage exacerbated the issue as deleveraging is not by choice and limits the ability to recover. For those who strive to be better than average but don’t appreciate rapidly falling back to earth in a crisis look for those investors that are students of positive asymmetry.

How to make sense of data?

We thought it would be interesting to issue our first blog with a question we received from an allocator. The question concerned how we compare the current crisis to the one in 2000 and 2008, and what data sources we use to construct our view on the cycle.

What we always aim to do is go back to the source. Our team does continuous work to understand central bank policy, government support programs through reading public statements such as the US care act, the evolution of ECB balance sheet and asset sheet purchases in their various programs. We understand well that some of these programs may not be efficiently implemented and that things can rapidly change.

Second, and this is harder to replicate for non-active market participants and allocators, we receive a lot of information by being active in the markets. As we do our analysis, determine our target entry price and go to the market, we receive feedback on how our view compares to other market participants, and what bid/ask spreads are. These activities provide an indication of whether people are eager to allocate or whether risk aversion dominates. Doing this each day may provides an indication of a (short term) trend.

Third, we realize that there are elements that we can analyse and predict with a certain degree of confidence but many that we cannot. It is interesting to link this to previous crises – one thing that we have learned is that one will not have all elements and means to construct a fully waterproof prediction, but have to construct a hypothesis to benefit from dislocations. One such hypothesis today is that the time to recovery (of asset prices) might be shorter in credit than it has been in past crises, and therefore one has to move slightly faster when a dislocation occurs. At the same time, we believe that quite some asset disposals in credit may still have to take place as investors face margin calls, credit migration makes it difficult to hold certain assets or because investment funds face redemptions.

Another element, again referring to previous crises, is that we believe the support programs and responses to this crisis are quite different from 2000, and in particular to 2008. For starters, it is not a banking crisis or financial crisis. Banks are “spared” slightly more by the regulator (some reference sources are mentioned in Astra’s “Credit update presentation’’ – please ask our IR for a copy if you are interested). Our explanation for this is that the proper functioning of banks is crucial for them to be a reliable conduit of lending. Many support programs are targeted on the consumer and large corporates. Again, actions, statements, and public balance sheets are a good source of information.

Fifth and last is to ask the question how and what other allocators are doing. There is a lot of capital raised for corporate distressed opportunities. In our experience, bankruptcies happen with a lag to economic weakening. One can look at the distressed indices for reference. Distressed investing is a process driven strategy; restructuring a company takes time. It generally does not pay to be the first mover. Astra’s view is that the attractive part of the markets is found in higher quality credit assets that have technical dislocations because of market dynamics. They may have some uncertainties, but if one can make a double-digit IRR on a high-quality credit asset with high degree of confidence, then that obviously is very attractive.