Aug 21, 2014

Hellfire and Brimstone – Electromagnetic Swans and Some Thoughts On Hedging


John Knox, the fire and brimstone preacher key to the Protestant Reformation of Scotland

Electromagnetic Swans

Recently I have been re-reading Nassim Taleb’s Fooled By Randomness and The Black Swan. So I was primed when I saw the headline, “Elliot Warns of Greatest Danger in Electromagnetic Pulse”. Understanding my own bias, and the fact that at any given moment there will be at least ten different hedgefund manager’s warning about twenty different unforeseen dangers and/or once in a lifetime opportunities; I took a few minutes to try and guestimate the probability of there being an electromagnetic storm in my lifetime. And of course, I don’t have an exact answer of what the probability is. The best I can say is that I don’t have any reason to think it’s highly probable but I also don’t have any reason to think that it is totally negligible. The little facts I do have are as follows:

There was a near-miss in 2012, when what scientist called a “superstorm” came close to hitting our planet. The article makes it seem pretty scary but what does a near miss really mean? If you almost roll snake-eyes, (double 1’s with two dice), it does not mean that a snake eyes is a probable combination. Similarly the fact that a solar storm almost hit earth doesn’t really reveal much about the probability of us being hit in the future. As Taleb would say, “we cannot see the generator.”

Perhaps more worryingly, Elliot points out in their letter to investors that a large electromagnetic storm occurred in 1859, knocking out telegraph wires but otherwise leaving that much less electricity dependent time largely unscathed. So we know it can happen. Other than these tidbits, I couldn’t find any evidence of a reliable method of estimating the probability of such an event. Therefore all I can really comfortably say is that the probability is greater than zero and less than one.

Given this level of uncertainty, of my ignorance, it is tempting to drop the subject all together. Some “prudent” people will argue it’s not worth worrying about “once in a lifetime events”. On its face this attitude can seem reasonable, practical, even intelligent; why waste time worrying about something whose probability you can’t reliably estimate?

The flaw in this mode of thought is that it’s not just the probability of a given event – it’s the impact of the “rare” event weighted by its probability that should guide our decisions. Thus to the contrary, our ignorance about a given events probability makes the truly prudent course to be extra concerned, especially if the event would have a severely negative impact. This logic should seem particularly congruent to self-avowed value investors whose modus operendi is to protect against the downside, and let the upside take care of itself.

If such a storm were to happen tomorrow, scientists and Elliot management estimate that we would fare far worse than our ancestors. They predict that much of the developed world would be without power for potentially months, as the hard to replace electronics that enable our power grid would be destroyed by the storm. It does not require a highly developed imagination to see that this would have a profoundly negative impact on economic activity, and more disturbingly, day-to-day life itself.

Financial markets would not likely fare much better than the electrical grid, and probably worse. Hypothesizing for a moment, and assuming you could even find prices for any of these instruments without power; one safe bet is that equities would plummet. The credits markets would freeze and at least the front-end of really high-grade sovereign curves would rally. The U.S. dollar and gold would catch a bid along with a few other safe haven currencies, and from there it gets a little tricky. The long end of the Treasury bond curve might actually sell-off as investors worried about inflation from expected government policies to shore-up the economy. Commodities markets would likely suffer massive declines and the viability of the exchanges might come into question, as many people sought to either default on contracts or take delivery of more precious metals than could be physically settled. Suffice to say, it would be a shit-show.

You may think such statements hyperbole, and if you are confident that the probability of such an event is indeed very low then perhaps it is. But the point I am trying to make isn’t just about electromagnetic storms. It’s about how we should think about what we don’t know, and what that might mean for portfolio construction.

 Principles & Panacea

The most common method of guarding against the markets gyrations is to create a portfolio that is diversified among asset classes. To its credit, many versions of this strategy have served to reduce the volatility of a portfolio over course of the past century (in America). In fact, if you go into any private wealth manager in the United States, they will probably show you a chart like the one below and explain that it demonstrates you are better off investing in a mix of asset classes.


A less common approach to achieving a portfolio that will protect against downside risk is to practice the art of value investing. The thinking being, that owning a portfolio of undervalued assets should create a margin of safety that can serve as a cushion against adverse developments.

I mention these strategies both because they are somewhat well known and contain elements of truth. Furthermore, either of them, if applied with skill, has the ability to achieve superior relative risk adjusted returns over the long-term. The danger to investors lies in mistaking the sound principles that underlie them, and the relative results that can be achieved by them, for an investing panacea.

Returning for a moment to the subject of our fallibility, consider that it does not require a catastrophe for markets to take dramatic and unforeseen directions. Consider the case of one Benjamin Graham, as Murray Stahl relates it in this excerpt from his wonderful essay Benjamin Graham: Investor and Person. There is perhaps no better example of how a fundamentally sound strategy can fail even the brightest star during a severe market dislocation.

Chapter 13 of the Graham memoirs relates his experience as an investor during the Great Depression. The chapter begins by comparing these experiences to Dante’s version of hell. As is well known, Graham was a conservative investor. He makes mention of selected long positions such as Plymouth Cordage. The shares were trading at a price of $70 with in excess of $100 of working capital. Such investments are classic value stocks. Graham mentions others such as Pepperell Manufacturing and Heywood and Wakefield.

The Graham Fund, then known as the Benjamin Graham Join Account, had the following positions in the middle of 1929, just prior to the stock market collapse. The fund had $2.5 million of capital. It owned $2.5 million of convertible preferred shares offset by an equal amount of equivalent common stock short sales. This arbitrage position is fairly common today. In 1929, such undertakings were considered to be very conservative and required very little margin. This was the case in the Graham Account.3 There were also $4.5 million of genuine long positions and $2 million of borrowings against these positions. According to Graham’s then computations this amounted to 125% margin (i.e., 4.5 long on 2 of borrowings, or exposure of 2.25x, for 125% leverage).

In the modern era the exposure would be calculated as follows:

$2.5M long convertible preferred

2.5M short common stock

4.5M long common stock

2.5M portfolio equity

$9.5M total exposure

$2.5M portfolio equity

380% total exposure

The investment performance results as reported by Graham were as follows.

1929 (20)%

1930 (50.5)%

1931 (16.0)%

1932 (3.0)%

1929 – 1932 (67.7)%

Of course, as is known, Graham managed, subsequent to the Great Depression, to rebuild his fortune and ultimately achieve a level of wealth that he probably could not have imagined in 1929. One factor in the recovery was that in January 1934 his investors generously consented to remove the high water mark and re-instate performance fees.5

However, another important factor is that the application of the principles of value

investing once again generated results in accord with the historical standard subsequent to the summer of 1932.

This brief summary of investment experience invites two questions. First, should

Benjamin Graham have anticipated the investment calamity of the Great Depression? Second, does there exist an inherent flaw in the philosophy of value investing such that the application of margin of safety principles does not always produce a margin of safety?

In answer to the first question, it would have been necessary for Benjamin Graham to have conceived in 1929 that the next four years would witness a circumstance in which production of goods and services for which there was evident demand in 1929 would become remarkably diminished in the ensuing years. Scholars still debate the causes of this phenomenon nearly 80 years after its occurrence. If Benjamin Graham failed to foresee the Great Depression, one cannot find many contemporaries who managed to foresee the calamity. Indeed, luminaries such as John Maynard Keynes or Irving Fisher fared no better than Graham.

In answer to the second question, it is perhaps sufficient to say that value investing is a technique that merely seeks to assess the worth of a given enterprise against its trading price at a given moment. It makes no claim to see the diminutions of value that are caused by economic crises….

Wow. One of the greatest investment minds of all time, the founder and master of his craft operating in conditions of market efficiency that would leave any of todays investment managers salivating uncontrollably, was brought to his knees by the great depression. The lesson, if there is one, is that if it can happen to him, it can happen to you (or me).

So what should investors do? If diversification and a margin of safety are insufficient for protecting against the vagaries of fate, what remedy is there? I don’t have an easy answer but I do have some thoughts:

Limit the use of Leverage

Obviously I’m not breaking new ground with this one. But I lead off with it because it is probably the most important, especially for young investors. I believe Warren Buffett has said he would never leverage himself by more than a quarter of his equity. I am certain he is familiar with the record of his teacher Benjamin Graham during the great depression, and has drawn a similar that very lesson from it. As usual, the admonition is easier proscribe than execute. Leverage has a way of creeping up on you. It is the temptation of scalability – the idea that more can be achieved with less. You have to consistently resist the little voice in your head that says this time is different, to allow that, this situation is unique and deserves to be exploited to its maximum.

Great investors are able to see past this temptation. They understand the dark side of leverage. That it erodes at whatever margin of safety you’ve accumulated, and leaves you exposed to the markets irrationality; the very thing that as an investor you are paid to exploit becomes a potentially fatal liability.

Beware Of Overestimating Your Diversification

Just as we should have humility about the outcomes that will affect our portfolios, the Black Swan concept (the limits of induction), teaches us to have humility about how our portfolio components will perform. For instance, people like to think that owning bonds is an effective hedge against deflation but what kind of bonds exactly? In a real economic catastrophe any bonds with credit risk exposure, not matter how strong, might actually decline in value. A truly devastating economic scenario could actually be viewed as stagflationary and thus one would expect a decline in the value of high duration bonds as well. The point is to think deeply about your positions; they may behave nicely under normal conditions and fail you when you need them most.

Consider Holding Cash

I was already writing this post when I started reading some of Seth Klarmans investor letters. So it struck me when I noticed that he was consistently referencing some of the ideas I had been kicking around with regard to value investing and hedging. One of Klarman’s claims to fame is achieving his amazing investing record whilst maintaining a substantial allocation to cash.

Cash, as an asset, has something of a reputation problem. Most of which can be attributed to its obvious lack of relative yield. To its further shame, many widely cited studies of asset returns have shown cash to be among the poorest performing asset classes in the modern era. The perception of cash as unattractive is so pervasive that even lay people are loath to see cash sitting their account, “not working for them”. And I must confess, at times I too find myself having thoughts along these lines.

As usual, the accepted wisdom is far from wise or at least incomplete. More enlightened investors such as Klarman see cash something akin to an option whose value will be realized when the next opportunity or cycle presents itself. Where the student sees the empty hand as weak without a weapon in it, the master sees the potential in a limb free of constraint.

Somewhat paradoxically, cash aversion is also common among professional managers and institutional investors. Klarman suggests the reason for this phenomenon is the institutional focus on relative performance. Managers think of themselves as investors and therefore feel it is their obligation to be invested, in something, anything. The institutional imperative to be doing something is too powerful for most to resist. As usual, Klarman said it better than I could. Here he is on adopting an absolute performance orientation. I find it very zen:

Most institutional and many individual investors have adopted a relative-performance orientation…They invest with the goal of outperforming either the market, other investors, or both and are apparently indifferent as to whether the results achieved represent an absolute gain or loss. Good relative performance, especially short-term relative performance, is commonly sought either by imitating what others are doing or by attempting to outguess what others will do. Value investors, by contrast, are absolute-performance oriented; they are interested in returns only insofar as they relate to the achievement of their own investment goals, not how they compare with the way the overall market or other investors are faring. Good absolute performance is obtained by purchasing undervalued securities while selling holdings that become more fully valued. For most investors absolute returns are the only ones that really matter; you cannot, after all, spend relative performance.

Absolute-performance-oriented investors usually take a longer-term perspective than relative-performance-oriented investors. A relative-performance-oriented investor is generally unwilling or unable to tolerate long periods of underperformance and therefore invests in whatever is currently popular. To do otherwise would jeopardize near-term results. Relative-performance-oriented investors may actually shun situations that clearly offer attractive absolute returns over the long run if making them would risk near-term underperformance. By contrast, absolute-performance-oriented investors are likely to prefer out-of-favor holdings that may take longer to come to fruition but also carry less risk of loss.

One significant difference between an absolute- and relative- performance-orientation is evident in the different strategies for investing available cash. Relative-performance-oriented investors will typically choose to be fully invested at all times, since cash balances would likely cause them to lag behind a rising market. Since the goal is at least to match and optimally beat the market, any cash that is not promptly spent on specific investments must nevertheless be invested in a market-related index.

Absolute-performance-oriented investors, by contrast, are willing to hold cash reserves when no bargains are available. Cash is liquid and provides a modest, sometimes attractive nominal return, usually above the rate of inflation. The liquidity of cash affords flexibility, for it can quickly be channeled into other investment outlets with minimal transaction costs. Finally, unlike any other holding, cash does not involve any risk of incurring opportunity cost (losses from the inability to take advantage of future bargains) since it does not drop in value during market declines.

Hold Antifragile Assets

Nassim Taleb defines something as antifragile if it gains from disorder. The most obvious incarnation of antifragile in the world of investments is an option. There is a good deal of debate over whether options are too expensive or worthwhile, and as with everything in investing, there will be exceptions to whatever generalization you arrive at according to the price being asked.

In an attempt at generalization, some have framed the question of options as akin to the age-old question of whether insurance is worth buying. In this context, my only observation is that market catastrophe insurance, though it may be expensive in most retrospective periods, has a unique value proposition because unlike most insurance outcomes that are designed to protect against a localized event – say your house burning down or car being stolen; market catastrophe hedges are virtually certain to provide you with cash during a systemic event. I.E. when everyone else’s house is on fire and they are begging to sell it to you.

As far as I can tell, Klarman held out of the money options to protect against market declines. Or at least he did in the years between 1995 and 2000 (which is all the letters I’ve been able to find – feel free to send me more Klarman also famously profited from buying put options on Japanese equities in the late 1980’s and subprime CDS preceding the housing collapse (nice work if you can get it). The below excerpt from his 1995 letter makes it pretty clear that, at lest in those days, he thought it was worthwhile to hold such antifragile assets:


And here he says it again:


And again:


And again, with some more remarks on holding cash:


It is worth mentioning is that the Market Hedges portion of the Baoupost (Klarman’s) portfolio usually ranged between 0.5-2% of assets, with Cash & Cash Equivalents of 15 – 35% of assets. I’d love to know how far out of the money Klarman was looking, and in what tenor, and why. Unfortunately that level of detail is likely beyond my reach. Even so, it’s interesting to see that he thought it worthwhile to invest up to 2% of his portfolio in what is commonly derided as an “expensive” or “wasting” asset. I wonder if he still does…..

Klarman Table2

Think Carefully About Short-Selling

As I understand it, short-selling put the hedge into hedge fund and thus it should come as no surprise that short selling is an integral part of many sophisticated investors approach to markets. The general expectation being that short-selling will be utilized as a method of generating alpha through a reduction of market risk and individual security selection. On the other hand, the potential for unlimited losses (asymmetric risk), the general proclivity for the markets to rise, and the overall difficulty of finding attractive positions, has lead many investors to shun the enterprise completely. Suffice to say, there is no shortage of opinions on the subject.

Having mixed feelings about it myself, I was keen to see what Klarman had said and done in this arena. Though, knowing he is an avowed value investor, it didn’t come as complete surprise when he voiced disinclination towards the practice:

We have ruled out short selling for a number of reasons, including the unlimited downside risk that short selling poses. With puts, at least, your cost is limited to the up-front premium. Such a hedge, however, is historically quite expensive and, as we learned last year, far from perfect.

I should point out, Klarman is discussing short selling in regards to the specific market positioning of 1999. So while I do believe the quote reveals something about his attitude towards short-selling generally, it should not be read as Klarman forswearing short-selling totally. Klarman’s passage reminded me of a less famous but equally a credentialed Baoupost alumnus who has his made his opinion on short selling public. In the depths of the financial crisis, David Abrams made the following remarks at a conference on value investing hosted by Columbia Business School:

And the final thing too, within the whole industry is the long / short side. People have to, whether your managing a fund like that or investing in a fund like that, you have to be doing some fairly deep soul searching now because the government’s after you, politicians are after you, there’s no way to do it without taking counter-party risk, and how do you feel safe with counter-party risk? Maybe it will subside and it will be fine but you know, you’ve got to be doing some deep soul searching now.

To clarify that a bit, Mr. Abrams is making the point that short selling has two weaknesses. The first is what we might term regulatory risk; the risk that the government or relevant regulatory body will suspend the rights of institutions to sell short. This happened during 2008 when U.S. and U.K. regulators banned short selling on approximately ~800 financial firms. Thus Mr. Abrams seems justified in imploring investors to think deeply about the value of a strategy that has the possibility of being prohibited just when it is most desirable. His second point about “counterparty risk” is more technical. It refers to the fact that when you short securities you must necessarily borrow them from someone else – that someone else is your counterparty. Almost always this someone else has the right to demand the shares back on any given day and thus, you keep your short position at the pleasure of your counterparties.

Honestly, I don’t know what conclusions to draw from his points. They are tempting to dismiss as unlikely events, the kinds of things that happen to other people. Most likely he is correct in taking a middle ground by recommending one think very carefully about relying solely on short selling as a method of protecting against adverse market events. As usual, the risks of the method must be balanced against the potential rewards of the specific situation. It is not supposed to be easy.

Social Perspective & Conclusion

I once did a post on John Maynard Keynes and value investing. So I was delighted to find that Murray Stahl had achieved a superior treatment of the subject in one of his market commentaries. One quotation by Keynes stuck a chord with me when I read it. Here it is:


Howard Marks talks about how second order thinking is required to be a great investor; that ability to look beyond the immediate, to consider the consequences of consequences. How few investors consider the affect of their actions on the broader functioning of the economy (except to say that it is positive), and less still of their potential impact on the psychology of their fellow investors? I think Mr. Marks would agree that Keynes had the right stuff.

Keynes’ observation is about more than just stoicism in the face of a market decline. It alludes to a hard reality that in the age of Alpha obsession people would often rather forget. That reality, as it pertains to hedging, is that as much as people can and should try to protect themselves from adverse market outcomes, it would be extremely difficult to maintain, let alone build wealth, in the face of a catastrophic event. No less especially because the vast majority of financial instruments are in one form or another, promissory notes against future economic activity; as much as we all want to be Ubermensch, and self sustaining scallop farmers, the truth is that what we call our economy is really just a social system, and to a much grater extent then many would care to admit, our wealth in any period of meaningful duration is more likely to be a function of Beta than Alpha. I think Dr. Franklin said it best when he proclaimed, “We must all hang together, or assuredly we shall all hang separately.”