Universa Investments LP founder, Mark Spitznagel, discusses the lessons learned from the 2008 financial crisis, warning Bloomberg’s Erik Schatzker that the current stock market exuberance is “sandbagging” investors again, just like it did in previous crises, but reminds that while “monetary intervention is a Faustian bargain,” everyone knows you can’t fight the Fed,
“…you mustn’t fight the Fed. What you must try to do is sort of jiu-jitsu the Fed. You need to sort of use the Fed’s force against it.”
Erik Schatzker: What do you think of as the most important lessons of the 2008 financial crisis?
Mark Spitznagel: Well, I think what it taught us ultimately is that interventionism, monetary interventionism, is a Faustian bargain. It gives us short term gains, and with that comes longer term pains. I think we saw that previous to the last crisis, and I think we’re going through the same process now. What we end up having is a market that is just very good at sandbagging us. It makes us feel for a long time like we’re smart, like we all have an edge – which of course is impossible, we can’t all have an edge – and then, once we’ve up our bets, it shows us its real properties.
Erik: Universa, your firm, and you by extension, wouldn’t have a business if there were no financial crises. But as a matter of principle, are corrections, crashes, market meltdowns an inevitable, necessary feature of the modern financial system?
Mark: Certainly the modern financial system, because of the way it is structured, particularly the way it is structured in terms of, again, monetary interventionism. Interest rates are not free-floating. It doesn’t have to be that way. It’s more of a philosophical disagreement between natural free markets. Are they inherently fragile, and need us to protect ourselves from them? It doesn’t need to be that way but unfortunately it is that way.
Erik: Some people say crashes – maybe not necessarily as big as the one that we had in 2008, perhaps more along the lines of what we had in 2000 or what we’ve had since, some of the stuff that was brought on by sovereign debt bubbles and such in Europe – are going to become more frequent. Do you think we’ll see crashes more frequently?
Mark: You know, I don’t have a good feel for the frequency or the timing. It’s something that I’ve always made very sure to stay away from, and the nature of my investing affords me that. I think we are going to continue to see deeper and deeper ones, simply by virtue of the fact that the degree of interventionism is larger and large. It gets incrementally higher every cycle. In some ways we’re still recovering from that great bubble in 2000, and so the economy needs more and more in order to keep us afloat from that.
Erik: Tell me about the next crisis. What do you think it looks like?
Mark: The way I structure risk mitigation, which is what I do certainly, means that I don’t have the luxury of knowing what the next one is going to look like, thinking that I know what the next one is going to look like. I don’t claim to have known what 2008 would look like, even though we traded it the way we did. For me, insurance-type of investing the way I do is really about covering all of your contingencies. You can’t just isolate one contingency. You need to be able to cover many of them.
Erik: What I had in mind was more along the lines of this. People look back at 2008 and say it was a once in seven decades event, we haven’t seen anything like that since 1929 and the great depression. And it’ll be another seventy years before we have another crisis like that. And I’m just trying to find out whether you think there’s any validity to that kind of thinking. If you can’t predict crashes, can anybody else?
Mark: Yeah, there’s validity to that. In many ways I agree with it. But at the same time, everyone knows you can’t fight the Fed. And you mustn’t fight the Fed. What you must try to do is sort of jiu-jitsu the Fed. You need to sort of use the Fed’s force against it.
Erik: I like that. The Fed is going to do what the Fed is going to do, in other words, and you as an investor have to respond?
Mark: Well you need to be able to go with it in all directions. That’s really the point here. There’s a great cliché that says offense wins games and defense wins championships. I hold that very close. It’s one cliché that happens to be very true in the realm of investing. And that’s because of course compound returns – the rate of compounding – is all we care about in investing and it’s the severe losses that crush the rate if compounding. It’s not the small losses. So this is the reason why I focus on the severe losses, the crashes. So what does that mean? I call this a volatitliy tax, where large losses crush your rate of compounding. We need to think about that. Von Clausewitz’s first principle is secure your base. And this is what we all try to do in portfolio management is secure our base. It’s not what we get through Modern Portfolio Theory.
Erik: Now, when you describe yourself as a portfolio manager many people might be confused. They think of a portfolio manager as somebody who is trying to make money by taking positions that are going to increase in value or generate return over time. You’re doing something different.
Mark: Yes, certainly. To think about it simply, Universa is a safe haven, but it’s a particularly explosive, insurance-like safe haven. And it’s there specifically so that the more explosive it is the more systematic risk my clients are able to take.
Erik: Many investors who hedged or who diversified gave up much of the upside in equities since the financial crisis and we need only look at hedge fund returns for example to see that. Now, hedge funds don’t necessarily need to beat the S&P 500, but they do have to deliver value to their customers, and many of their customers or clients don’t think that they have been doing that. What did these investors who hedged or diversified do wrong?
Mark: Modern Portfolio Theory sold us a bill of goods. And that bill of goods is that if you lower your volatility through diversification – it’s this dogma of diversification – if you lower your volatility yes you’re also going to lower your arithmetic return, but if you get that ratio going up all is well. And then you can take some leverage – which is kind of crazy in itself that good risk mitigation requires leverage – and all is well. You’ll raise your long-run return. But it just hasn’t worked out that way. As we diversify, de-worsification is really what we’re doing when we diversify. Diversification, of course, in this environment too where all correlations spike to one when you least can afford them to, it’s a fundamental problem, and its’ so contrary to the way I think about it, it’s a completely different way of constructing portfolios, which for me is about focusing on the downside and mitigating the volatility tax.
Erik: So, if people want to understand a bit better what you do, and more and more, with some $10 billion under management now people are beginning to see the value in what you do, help us appreciate the nature of a tail risk hedge. What kinds of things are in the Universa portfolio?
Mark: Well without getting into specifics, as I said it’s an explosive, insurance-like payoff, but specifically explosive insurance-like convex payoff to what you have in your portfolio. So that’s the important thing. We can’t get too fancy, in my view, about knowing exactly what that next crash is going to look like. We need to get all of the contingencies right. What that means is whatever your exposures are you need to have very specific downside crash-convexity to those exposures.
Erik: But you find that where, in out-of-the-money options?
Mark: Well yeah there’s a range of places where we can find this in derivatives markets.
Erik: Principally derivatives we’re talking about.
Mark: In order to get the type of asymmetry that I’m talking about it really requires the use of derivatives, yes. So that’s a good simple way to think about it.
Erik: We learned in 2008 that derivatives contracts themselves can blow up. Are the derivatives that you’re trafficking in now safer instruments than they were in 2008?
Mark: I’m not sure. Again, this is a contingency I don’t want to have to think about. I don’t feel like I have an edge in that. I don’t feel like anybody has an edge in that. We all suffer from this hindsight bias where we think we had that last crash, for instance, figured out, we think we understood the cause and effect. I don’t have the luxury of cause and effect. I don’t have the luxury of thinking everything though exactly the way it’s going to pan out, because I will absolutely be wrong. So my simple solution to that is I don’t take single-entity counterparty risk. I face the exchanges. The saying goes it’s kind of like buying Titanic insurance from someone who’s on the Titanic. It’s just not a great idea.
Erik: The cost of protection, at least as measured by the VIX, and I know that’s an imperfect measure, has mostly been low, mostly, over the past ten years. What if insurance gets more expensive?
Mark: What if it does? It’s likely to be associated with an event. That tends to be how it works. We saw it happen very briefly last February. The interesting thing in this age is when we see these flare-ups how quickly it all comes back to cheapness again. I expect we’ll continue to see that and the reason is selling insurance is just sort of the most obvious and most straightforward way to earn this extra yield. We are in this yield-starved, yield-chasing environment, and again it goes back to central banks.
Erik: But how is it that those guys who were, if you will, selling insurance, got destroyed in February, and you didn’t?
Mark: Because I’m on the other side of that trade. I’m not selling insurance, I’m fundamentally on the other side of that trade. I’m purchasing insurance from the market, insurance-like payoffs, so there’s really a pretty steady drumb-beat of supply on the other side because it feels so good. It feels good structurally as a professional trader, it feels good cognitively to make this little premium most of the time.