2023-08-20 07:05:41
Markets worry regarding growing chaos, with climate change, pandemics and social unrest. “Chaos Kings”: this is how journalist Scott Patterson calls the handful of investors who manage to pull the chestnuts out of the fire in a world marked by catastrophes.
Translating the inevitability of unforeseeable disasters into a profitability model: this is, in short, the ambition of the pioneers of black swan fund. These funds allow professional investors to buy “aggressive insurance” once morest stock market crashes. When the inevitable disaster occurs, the “black swan” fund makes huge gains thanks to its perfect positioning in the face of chaos. These profits should then help client-investors to compensate for the damage in their own portfolios. A bit like fire insurance, but for the financial market in disarray.
This strategy seems attractive but, at the beginning, the diffusion of their idea was not an easy task when the two pioneers – Nassim Taleb and Mark Spitznagel – embarked on this project together in 1999. Taleb later rose to fame as the best-selling author of, among other things, “Fooled by Randomness” and “The Black Swan”, books in which he denounces bad Wall Street risk management and warns once morest the occurrence of unforeseeable extreme eventswhich he baptized “black swans” and which explain the name of the funds.
4.100%
Fund “black swan”
In three months, the “black swan” fund Universa, managed by Spitznagel, has garnered a return of more than 4,100% during the pandemic.
Meanwhile, the world seems increasingly confronted with catastrophic events. The coronavirus pandemic was the archetype of the black swan and had already worried Taleb for years. He had looked at pandemics with mathematical glasses and found similarities to stock market crashes. Exponential – that is, huge and rapid – growth has played a role in how quickly the virus has spread through our hyper-connected world. This is what prompted Taleb to take up the pen once more at the end of January 2020 – in collaboration with the scientist Yaneer Bar-Yam, specialist in complexity – to warn of the systemic risk represented by the coronavirus.
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Two rather worried disciples of the “black swans”
For the “black swan” fund Universa, managed by Spitznagel, himself advised by Taleb, the pandemic has acted as a new catalyst for growth. In three months, the fund has garnered a return of more than 4,100%. Assets entrusted by clients – and to which Universa applies its unique risk management – have grown from just over $4 billion at the outbreak of the pandemic to $16 billion at the end of 2021.
“Crisis Hunters”
The fund had already proven the relevance of its model during the financial crisis of 2008 and had seen the flow of new money. It was also the time when we saw the first imitations appear. The pioneers therefore created a new asset class, which then also proved its worth, among other things during the famous “flash crash” of May 2010 (when the US stock market suddenly crashed) and “volmageddon” and février 2018 (when stock market volatility is suddenly skyrocketing). If we believe the rumors, Universa would have pocketed 1 billion dollars on this occasion in one followingnoon.
Didier Sornette, founder of the Financial Crisis Observatory, is convinced that financial crashes are predictable, most of the time just before the bursting of the speculative bubble that precedes them.
As self-proclaimed “crisis hunters,” Taleb and Spitznagel say they’re ready for a world in which chaos seems ever more likely to reign. In his new book, Wall Street Journal reporter Scott Patterson talks regarding the “Chaos Kings” who are thriving in a “new era of crises”. And potential crises abound. Think of pandemics, cyberattacks, forest fires and floods from climate change, derailments of AI algorithms, social unrest, attacks on democracy, and more. The concept of “polycrisis” goes even further and asserts that one crisis feeds into another, the total being more dangerous than the sum of the parts.
All of this is in line with Taleb’s concern regarding the growing fragility of our world. And it is paradoxically the result of our drive to increasingly control the world through technology, data and hyperefficient supply chains. The result? A growing complexity likely to dig the grave of our societies, also warn Bar-Yam and Didier Sornette, founder of the Financial Crisis Observatory and another protagonist of “Chaos Kings”. Any hypercomplex system is susceptible to design flaws and can implode at the slightest disturbance. In this sense, the pandemic has exposed the fragility of the global supply chain.
The question is how to cohabit with this threatening chaos and, to begin with, if Taleb’s black swans are indeed unpredictable. Heated debates rage on the latter point, which comes as no surprise given Taleb’s reputation for arrogance.
“Come here. See that man over there? His name is Ed and he made $7 million in seven years. He lost it all in seven seconds. Now you can go.”
Sornette is convinced that financial crashes are predictable, usually just before the bursting of the speculative bubble that precedes them. They are the counterparts of the Black Swans and Sornette calls them “Dragon Kings”. For Taleb, these are just “gray swans”, i.e. somewhat predictable disasters, such as the 2008 financial crisis. From a risk management point of view, there is not much to do because it is very difficult to predict the timing of these events., explains Taleb. For investors, it is therefore better to follow a strategy that does not make forecasts but is always ready to face disasters.
Discipline to do
Taleb put all this into practice with his investment fund Empirica Capital, which he founded in 1999 with Spitznagel. They met following working for years as options traders, a job that made them aware of the risks of sudden disasters. Options give the buyer the right to buy (call) or sell (put) the underlying asset, such as a stock or a commodity at a predetermined price. Conversely, the seller of the option must supply or buy back the asset when the price has moved sufficiently and the buyer exercises his option right.
“Come here. See that man over there? His name is Ed and he made $7 million in seven years. He lost it all in seven seconds. Now you can go.” That’s the message Taleb received from an experienced trader on his first day on the Chicago Mercantile Exchange options exchange.
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The disciple of Taleb and his “black swan”
Spitznagel was given a comparable mantra by his mentor at the Chicago Board of Trade, another major options exchange in Chicago. “Love to lose” or immediately sell your position at the first loss instead of hanging on to it hoping for a rebound. It takes iron discipline to take those painful losses every time, but it avoids blowing yourself up in the event of a catastrophic loss.
97%
Almost everything in action
Instead of the classic 60/40 portfolios (60% stocks and 40% bonds), Taleb & Co proposes to invest in stocks up to 97%, the balance of 3% being invested in the “swan” fund. black” as insurance once morest chaos.
This discipline proved useful at Empirica, which recorded slight losses almost constantly and reaped phenomenal profits for a few days. The fund is indeed betting on chaos by buying “put” options daily on, for example, the US S&P500 equity index, but with a strike price far from the current index quotation. Concretely, the latter should fall by 20% for the option to gain value. Most options therefore expire having lost their value – the stock market does not crash very often – which means that Empirica loses the premium paid. This premium is minimal, however, given that the underlying risk – a 20% crash – is considered unlikely. But when calamity strikes, options are suddenly worth gold.
Swept diversification rule
Thanks to this strategy, the fund is permanently positioned to face unforeseen catastrophes. Disasters which, according to Taleb and his contrarian approach, are much more likely to occur than ordinary investors think of Wall Street, because his experience and research in statistics taught him that “unlikely” crashes occur more often than risk models and their normal distribution predict. If Taleb and other critics are to be believed, the normal distribution – known for its bell shape – would underestimate the risks lurking in the tails, the extremes of the graphs. In addition, crashes can cause immense damage to portfolios, so the priority should be to avoid them.
Empirica has thus completely reversed the traditional approach to investing. Typically, fund managers expect to make profits – even modest ones – as often as possible and take the risk of an exceptional crash. Empirica takes losses – equally modest – most of the time, but can never be wiped out by a crash. On the contrary, a crash will be equivalent to winning the jackpot.
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Invest defensively in times of crisis
Taleb & Co also brush aside the golden rule of portfolio diversification. Instead of the classic 60/40 portfolios (60% stocks and 40% bonds), they propose to drop bonds and invest in equities for 97%, the remaining 3% being invested in the “black swan” fund as insurance once morest chaos. This way, investors get the most out of equity rallies – without the dead weight represented by the 40% bond – and remain protected in the event of a stock market crash.
Doesn’t massive adherence to the “black swan” strategy not threaten to fuel the catastrophic bubble once morest which the fund precisely claims to protect?
They may even be better protected, because the idea that bonds go up when stocks go down has come under pressure in recent years. Moreover, in the event of a strong correction, everything can collapse. However, there is one downside. Jan Loeys, a strategist at JPMorgan, suggested in early 2021 that investors who dumped bonds from their 60/40 portfolios in exchange for additional stocks (to improve their yield) were actually fueling a speculative bubble. Doesn’t massive adherence to the “black swan” strategy not threaten to fuel the catastrophic bubble once morest which the fund precisely claims to protect investors?
Pari via the CDS
Furthermore, Spitznagel, a libertarian and skateboard fanatic, is firmly convinced that the massive interventions of the American central bank will sooner or later result in a gigantic explosion of the market. Each intervention aimed at calming the economy and the markets is, according to him, additional fuel. In the meantime, he is continuing his trading strategy – the Black Swan Protection Protocol – in the new Universa fund which he created in 2007 following Taleb closed the door at Empirica. The daily losses – “as if you are losing part of your skin every day” – weigh on him, as do the calls from angry customers who continue to suffer drip losses while equity markets rise – sometimes rapidly and for many years. Discipline is not necessarily an investor’s forte.
Taleb – who presents himself more readily as a writer, philosopher and scientist – remains involved in Universa, however. Including via contests on Twitter, like the one with Cliff Asness, the founder of the famous hedge fund AQR. Asness does not believe in “tail-hedging” – betting on the extremes of the distribution – practiced by Universa. Over the long term, buying insurance once morest financial catastrophes through options does not produce significant gains, Asness wrote. Taleb then blamed Asness for his disappointing results – “crap” – with AQR. To which the latter replied that while Taleb was “sometimes brilliant”, he might also be “sneaky and a particularly terrible person”.
At Universa, the results speak for themselves. Between 2008 and 2019, the fund recorded a average return of 105% per year. And the excellent year 2020 had not yet come to an end. The counterpart of this particularly high return? A management fee of 1.5% of assets under management plus 20% of profits, which allowed Spitznagel to afford Jennifer Lopez’s villa in Bel Air for 7.5 million dollars.
Bar-Yam claims to have found an algorithm capable of predicting a crash: the simultaneous rise or fall of a group of stocks would represent an alarm signal.
Bill Ackman, the hedge fund manager, also pocketed a fortune from the pandemic by ‘freaking out early’, the principle which, according to Patterson, characterizes the “Chaos Kings”. Ackman understood earlier that the markets that we were on the eve of a wave of global contamination and speculated via “credit default swaps” (the infamous CDS) on the decline in corporate bonds, especially American and European Unions, for a total value of 71 billion dollars. The swaps which, like options, are a derivative allowing risk to be negotiated, had cost him $26 million. They brought him the trifle of 2.6 billion dollars.
Risk of systemic crisis
But for Patterson, it is a unique and circumstantial jackpot, like the one pocketed by John Paulson and Michael Burry during the American mortgage crisis. Paulson also suffered heavy losses in the years that followed. On the other hand, a “black swan” fund is sustainable insurance once morest vulnerabilities in the financial system.
Today, Taleb worries regarding a much more existential vulnerability: that of humanity. In a hyperconnected and complex world, humanity risks being swept away sooner or later by a systemic crisis. Like someone who keeps playing Russian roulette. Taleb therefore advocates the precautionary principle in the event of uncertainty as to the measures likely to cause serious and irreparable damage. The burden of proof then rests with those who wish to act.
Some critics blame this attitude for its ability to create paralyzing paranoia. For this reason, Sornette also believes that black swans are a dangerous concept. If the future is unpredictable, then why should we care? This gives policymakers and bankers an excuse to do nothing to avert disaster, Sornette believes.
Like Bar-Yam who, with his New England Complex Systems Institute (NECSI), tries to predict extreme events such as famines, pandemics and, yes, financial crashes, he continues to believe in the predictability of these disasters in the hope of stopping them. Bar-Yam claims to have found an algorithm capable of predicting a crash: the simultaneous rise or fall of a group of stocks would represent an alarm signal. But don’t talk regarding it to his friend Taleb: it might upset him.
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