A tail-risk hedge fund advised by Nassim Taleb, author of “The Black Swan,” returned 3,612% in March, paying off massively for clients who invested in it as protection against a plunge in stock prices.
The fund, Universa Investments, was founded in 2007 by Mark Spitznagel, who is also runs the fund as the Chief Investment Officer.
Nassim Taleb is Universa's Distinguished Scientific Advisor.
From 1999 to 2004, Spitznagel and Taleb ran Empirica, a hedge fund which applied very similar tail hedging strategies to Universa.
Universa made huge gains in 2008 – as the S&P 500 dropped 38.5% by the end of 2008, the fund increased its investors's money tenfold.
Of course, even when a recession hits, Universa's investors won't starve – they have enough money to invest more than $50 million, which is Universa's minimum investment, and this will be a relatively small part of their overall portfolio.
Universa essentially offers a “black swan protection protocol”, telling clients to think of the fund as catastrophe insurance that allows them to pursue returns more aggressively, without the need for more traditional approaches to risk mitigation.
Mark Spitznagel, who runs the fund, is known for the phrase:
“I spend all my time thinking about looming disaster”
In fact, a Forbes profile from 2011 claims that on roughly 95 trades out of 100 they lose money, yet Spitznagel is unruffled as he sits in his office listening to classical music and losing money each day.
To simplify, here's the essence of how it works:
Universa purchased far out-of-the-money “put” options on stocks and broad market indices.
A put option gives the owner the right, but not the obligation, to sell an underlying asset at a set price within a specified time period. It's a bet that a stock or market is going down.
As it is ultimately a bet, it is a very attractive market for degenerate gamblers!
If the market price falls below the agreed-upon price, you make money.
Universa makes a lot of small bets and watches most of them go bad (hence the 95 out of 100 trades they lose money line).
However, when one hits, it hits big…
For example, back in September 2008, when the S&P 500 was trading around 1200, Universa bought S&P 500 Index put options with a strike price of 850, due to expire late October.
They were betting an “unlikely” drop would occur.
They paid around 90 cents for those options. By October 10th, the S&P had dropped 300 points in a month. The options Universa purchased for 90 cents were now trading for $60 each. Universa cashed out of its position around $50, good for a gain of 5455%.
Now, as a reminder, this is a hedge – investors will have a relatively minimal percentage of their portfolio in Universa.
Essentially, the fund is designed to make an absolute killing if the market crashes and therefore ensures that their investors have insurance if the market suddenly nosedives.
Speaking of diving, let's take a dive into the Investor Letter:
In what has been a terrible period for many investors, this is what Universa investors were greeted with on the first page:
Based on your required invested capital at the start of the year, in March 2020 you experienced a 3,612% net return on capital; year-to-date you have experienced a 4,144% net return on capital.
Spitznagel then flexes The Risk Mitigation Scorecard, which showed that a portfolio invested 96.7% in the S&P 500 and just 3.3% in Universa's Tail Hedge fund, would have had a positive return in March, a month when the S&P dropped 12.4%.
The same portfolio – which eliminates the adverse effect on compounding from downside shocks – would have produced a 11.5% CAGR since inception in March 2008 versus 7.9% for the S&P 500.
(CAGR just means Compound Annual Growth Rate)
I mentioned eliminating the adverse effect of compounding from downside shocks, well this is crucial and he makes a great point here:
Due to the mathematics of compounding, the big losses are essentially ALL that matter to your rate of compounding, not the small losses – and not even the big or small gains.
This goes back to Warren Buffett's wise words:
“Rule number one: Never lose money
Rule number two: Never forget rule number one”