Over the course of several short months, a novel coronavirus exploded onto the global scene as the COVID-19 pandemic. Long-volatility and put-option strategies have garnered significant attention in the wake of the 2020 Q1 selloff as managers with exposure to market downside protection reported truly remarkable returns. This has reignited debate over the utility of hedging strategies.

A recent Bloomberg article contrasted doubting Thomas $143 billion quant pioneer AQR Capital with the comparatively diminutive Universa Investments, a tail-risk mitigation hedge fund that was the subject of an earlier post. It’s also a clash of ideologies among very bright fellows with matching egos. AQR’s chief, Cliff Asness, is a quant-world luminary whose erudite and often stinging critiques on all things financial bear close scrutiny. The shadowy Mark Spitznagel, Universa’s chief investment officer, is nearly the equal of his mentor and advisor to Universa, Nassim Taleb, in immodestly suffering no fools. Dismissive of AQR’s warnings against tail-risk hedging, Taleb responded, “It’s a waste of time comparing boxed wine and a French Bordeaux.” In short, it’s not all business in the world of finance!

Asness generalizes that hedging is too expensive. For all but the protracted downturn, he avers, its drag on performance is not worth the sacrifice. In his view, even scary moments like the most recent quarter will prove to be but transitory losses. According to Bloomberg, it should be noted, AQR, like other systematic firms, has had a tumultuous time of late as various strategies favored by quant investors have floundered. On the other hand, Spitznagel sweepingly counters with “When the market crashes, I want to make a whole lot, and when the market doesn’t crash, I want to lose a teeny, teeny amount. I want that asymmetry … that convexity.”

At Universa, simplicity is bedeviled by the details. According to Forbes, Universa’s alleged management of $4.3 billion is actually somebody else’s money, for which it offers an external hedge. Forbes estimates that Universa’s actual capital at risk is 2% or 3% of that number. The firm’s headline-grabbing 2020 return of 4,144% (41 times), which produced a gain of at least $3 billion for Universa’s nearly two dozen institutional clients, cost less than $100 million in derivatives. As for how well Spitznagel has done since the firm’s blockbuster founding in 2008, during which it returned 115%, there is enough smoke and mirrors that we refer the curious to the Forbes article. On one point, though, we are in general agreement with Spitznagel: “The big losses are so essentially all that matter to your rate of compounding.”

Investing Is Neither Shakespeare Nor Sugarcane

This debate creates an unfortunate binary choice: To hedge or not to hedge, that is the question. We don’t consider that Shakespearean rhetoric a proper query, however, as its conclusion on hedging is context-agnostic. Rather than being a static allocation of some all-weather portfolio, hedging should be engaged relative to tail and valuation risk.

Businesses like to standardize nature—because this practice leads to scalability. One of the earliest experiments in standardization was the sugarcane plantation. Colonists stripped land of its native vegetation to minimize competition for the cane from local flora. Not being native, the cane attracted no local pests and grew vigorously. Cuttings were cloned from one another to quicken reproduction, forming one homogenous commodity that was infinitely scalable as long as land was available.

The cane required massive labor inputs, however. To scale labor despite the brutal regime cane production required, plantation owners turned to enslaved Africans. These workers were uprooted from a foreign land, stripping them of the family and social connections that may have helped to organize resistance. The cloning, cutting, and bundling for the presses that extracted the sugar constituted the first mechanized assembly line. All cane plants and laborers were replaceable and infinitely replicable. Scalability worked. Sugar consumption exploded in Europe, and the sugar barons were some of the first mega-wealthy that capitalism produced.

Nature, though, is not given to standardization. The plantation requires immense effort to maintain, needing both managerial ingenuity and large energy inputs. Ecologies are inherently diverse and complex. They do not scale, as too much homogeneity breeds instability. When populations get too large, they cannot sustain themselves and contract or attract predators that will find them easy prey. Even now, the COVID virus is wreaking havoc on the consolidated and expertly scaled meat packing industry, a collision of capitalism’s efficiency with nature’s unpredictability.

The investment industry, similarly, loves standardization and scalability. The 60/40 portfolio is the most common attempt at a one-size-fits-all product. Scores of investors, suddenly forced to fend for themselves in an era of self-directed retirement accounts, have been herded into this allocation. This is despite a formal claim to tailoring and individualizing investment accounts by advisors, most of whose promises fall short of fiduciary standards.

The problem is that investing is not a business, but an investment firm is. Investing is context-dependent. A static investment product is insufficient, as markets are not mechanistic but natural systems.

This is the fundamental issue with the debate on hedging above between AQR and Universa. There’s no standardized approach to hedging that is infinitely scalable. AQR is correct that constant hedging is a drag on performance, and Universa is right that tail risk deserves attention. But these are not the only two approaches to the issue.

Much Ado About Valuation

The last decade has been difficult for value investors. There was a paucity of opportunities offering anything close to the margin of safety essential to sustaining long-term gains. Nearly all metrics agree. Whether one applies any or all of the three most favored—Shiller’s CAPE, market cap-to-GDP, or Tobin’s Q—the 2019 market in particular was dangerously detached from its underlying fundamentals. In the midst of the 2020 pandemic, even the “fundamentals,” according to Charlie Munger and Warren Buffett, are in a state of unpredictable and unprecedented flux.

Before this latest swan landed, volatility of the S&P 500—both historic and the VIX—had been so calm for such a prolonged period of time, despite the demonstrably more chaotic political, financial and environmental climates, you could be forgiven for thinking the world was now segmented into distinctly disconnected parallel universes. In a climate of onward and upward, however, most investors behaved as though they were utterly unaware that the stock market is actually a market in stocks. And the price of those tradable fractional interests does not exist in an arbitrary vacuum, but are ultimately tied to the underlying value of the businesses themselves.

Economic times are not always rosy, and markets do not march ever skyward. When investors suspend disbelief and extrapolate the onward-and-upward scenario, it’s time to worry about the deadly duo of tail and valuation risk. Universa benefited in spades from the tail risk of a pandemic. Its rather static approach to the dangers of tail risks, however, doesn’t consider valuation.

We also have advocated a portfolio of deep, out-of-the-money put options, but, unlike Universa, not to hedge equity exposure. Our clients essentially have none. That’s because we are value investors and stocks are so expensive that history has only rarely and briefly seen similar interludes. Further, in seeking out historically underpriced assets, it didn’t escape us that volatility was extremely cheap leading into 2020. Stocks were expensive, fundamentals weak, and insurance bargain-priced.

What about tail risk in June 1932? Or December 1974? Or even March 2009? A static portfolio that hedges tail risk must be constantly vigilant. In reality, though, once the swan has landed, risk has decreased substantially (and, not coincidentally, the price of protection against further damage becomes prohibitive).

In investing, prediction is the parent of misfortune. Markets writhe in response to any number of irrational stimuli. Guessing its levels in the near term is folly. But preparedness for economic eventualities is wise. Thus, holding hedges when stocks are at record valuations and volatility is exceptionally cheap is a context dependent judgment that takes advantage of the historical patterns of market cycles.

When stocks are at uncommonly low valuations, as was the case in 1932 and 1974 (somewhat less in 2009), further downside risk is minimal. During the 1918–19 Spanish flu pandemic, markets fell only about 11%, depending on when one dates the pandemic’s start. The COVID crisis has seen much greater declines, with more quite possibly to come. Valuation accounts for the divergence. The 1918 market began with a CAPE of about 8. The 2020 market had a CAPE over 30. Hedging in the context of a low CAPE in fact is a direct, and we would argue an unnecessary, drag on performance. It is in those rare moments when valuations are absurdly cheap that Warren Buffett says it rains gold, and we most go outside with buckets to collect it. That’s why Buffett was selling puts in 2008.

This can only be achieved if there is cash on hand to put to work. Of course, that is the intention of hedges. They provide cash as equity values decline. As strict value investors, though, we cannot hold equities when their forward rates of return are rationally expected to be poor. Instead, we hold short-term U.S. Treasury securities. This is a barbell portfolio: safe, low-yielding assets on one end and small, nonlinear, asymmetrical bets on the other that may appreciate 10-fold—and often much more.

Long-Term Return Optimization

Hedging tail risk with respect to valuation optimizes returns, preparing for economic calamity when justified but avoiding a constant drag on portfolio growth. Instead of treading water on the downturn, the barbell portfolio leaps ahead. We must remember Charlie Munger’s admonition that great investing mostly consists of waiting patiently—colloquially, “sitting on your ass.” When the right moment arrives, go all in. This is a further distinction from AQR and Universa. Both presume that a portfolio ought to be fully invested all the time. Again, that is best for investment firms but not necessarily best for their clients.

Unlike most allocations, the key consideration of the barbell portfolio is not between earning nothing in cash or earning something in bonds or stocks. Instead, it is how much the cash can earn if available when assets have become cheap versus the upfront cost of holding them for the current moment.

Such a portfolio, popularly promulgated by Nassim Taleb, is not routinely adopted by investment managers because it’s especially bad for business. It’s difficult indeed telling impatient clients that they should sit out seemingly certain present gains for the sake of uncertain future ones. The requisite restraint often has such a short shelf life that it threatens the sustainability of almost any manager’s business model. The fiduciary duty, however, is to do what is best for clients, not investment firms, even if conviction leads to client attrition.

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