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 $1 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.