Black Swan Manager Returning 23% Anticipating Bear Market
Mark Spitznagel pushes the throttles on his new twin-engine Chris-Craft Corsair 28, slicing through Grand Traverse Bay in northern Michigan on a warm day in late July. As the speedboat reaches more than 50 miles per hour, Spitznagel’s blond hair flying in the wind, he churns up a big wake.
Turbulence is where Spitznagel, the founder of hedge fund Universa Investments LP, thrives. On Aug. 4, while Spitznagel is still at his lake house, the Standard & Poor’s 500 Index begins to plunge as weak economic data prompt predictions of a double- dip recession. By noon, Spitznagel, a so-called black swan investor, has spoken with his Santa Monica, California-based firm 15 times by phone to capitalize on its positions to make money while other investors lose it, Bloomberg Markets magazine reports in its November issue.
At Universa’s office, between conversations with Spitznagel, two traders frantically buy and sell derivatives, including options on the S&P 500. The index’s 4.8 percent dive on that day is producing a windfall for Universa, says Brandon Yarckin, a Universa associate who handles investor relations. He points to a Japanese print on the wall -- one of Spitznagel’s favorites -- depicting a giant wave about to crash onto a group of hapless fishermen.
“Days like today are what we are here for,” he says.
Investors are pouring into doomsday black swan funds, spurred by the spreading European debt debacle and Standard & Poor’s downgrade of U.S. creditworthiness. The funds entice investors with the possibility of a huge payoff if a crisis hits; Universa returned about 115 percent to investors in 2008, according to a person familiar with the matter.
This year, as markets retreated, Spitznagel’s team collected gains of 20 to 25 percent through August for its 11 sovereign-wealth-fund and institutional clients, whose investments are run in separate partnerships and managed accounts.
“I couldn’t be more bearish on the stock market right now,” Spitznagel, 40, says. “The stock market has gotten stupidly expensive again. Fortunately, with our position, I don’t have to time the next sell-off.”
The downside of black swan investing can be steady pain -- year after year of losses if a market catastrophe doesn’t occur. In both 2009 and 2010, Universa’s clients lost about 4 percent, according to the person. The hedge-fund industry had a 9.2 percent gain in 2009 and an 8.2 percent return in 2010, according to the Bloomberg aggregate hedge-fund index.
Some managers dismiss black swan funds as a costly investment fad. Philippe Jorion, a managing director in the risk management group at Pacific Alternative Asset Management Co., a fund of hedge funds, compares this form of hedging with homeowners’ insurance: The premiums paid by the homeowner usually exceed the benefit over time.
On top of the ongoing losses, black swan hedge funds typically charge a 1.5 percent management fee and take 20 percent of any profit.
“The problem we have is that these hedging strategies tend to do well only when volatility is high,” says Jorion, who’s based in Irvine, California. “But over the long run, there can be stretches over many years where these strategies are expensive to run and bleed money.”
Nassim Nicholas Taleb coined the term black swan as a metaphor for an unforeseen catastrophe, such as the implosion of hedge fund Long-Term Capital Management LP in 1998 or the terrorist attacks of Sept. 11, 2001. The author and New York University professor has helped inspire a cottage industry of disaster funds.
‘The Black Swan’
His most well-known book, “The Black Swan: The Impact of the Highly Improbable” (Random House, 2007), has sold more than 3 million copies. His latest book dispenses wisdom via aphorisms. In “The Bed of Procrustes: Philosophical and Practical Aphorisms” (Random House, 2010), he writes, “In science, you need to understand the world; in business, you need others to misunderstand it.”
Taleb, 51, shut down Empirica LLC, his black swan hedge fund, in 2005 to focus on writing and because he feared he might have a recurrence of throat cancer. Taleb also frequently lectures before business groups, academics and policy makers.
“I’m not interested in money; I’m not interested in finance,” Taleb says. “I’m comfortable enough as it is. I don’t need it. Finance should be a footnote in my bio, not a central component. Why should I waste time in finance when my influence as an intellectual is so high?”
Assets in black swan and tail-risk funds, which hedge against low-probability events and are named for the tapered lines at either end of a bell curve, are ballooning. They jumped to $38 billion in April from $500 million prior to the collapse of Lehman Brothers Holdings Inc. (LEHMQ) in 2008, according to a JPMorgan Chase & Co. (JPM) report.
Pacific Investment Management Co., whose chief executive officer, Mohamed El-Erian, says the U.S. may be headed for a long period of below-average expansion, is the biggest firm yet to jump into the catastrophe-hedging business. Newport Beach, California-based Pimco, which manages about $1.3 trillion, has a tail-risk strategy with almost $30 billion of assets spread across its funds. Pine River Capital Management LP in Minnetonka, Minnesota, runs the $160 million Nisswa Tail Hedge Master Fund Ltd., and 36 South Capital Advisors LLP of London, which oversees $330 million of assets, also manages black swan funds. Jerry Haworth, who co-founded the firm, says his black swan fund returned 234 percent in 2008.
Before starting Universa in 2007, Spitznagel was a partner and the head trader at Taleb’s Empirica, and together, they developed their options-trading strategy. Universa, whose clients include the Canada Pension Plan Investment Board, buys out-of-the-money call and put options tied to the S&P 500, commodities and stocks.
In a typical trade, Universa pays a fee for the right to lock in a set price on the S&P 500 for a period of time, such as one year. If the benchmark index declines below this strike price, Universa’s options increase in value.
“I’m a value investor in my bones,” says Spitznagel, who’s also the firm’s president and chief investment officer. “I want to trade on adverse expectations.”
In April 2010, Universa paid about $2 each for S&P 500 put options expiring that May that would pay off if the index fell below 1,100. At the time, the index was around 1,200. The firm sold the puts as they soared to more than $60 each during the one-day crash on May 6, when the S&P fell as low as 1,066, erasing $862 billion in U.S. equity values in 20 minutes.
‘Like an Idiot’
“Most of the time, you look like an idiot,” says Spitznagel, who’s wearing a Brooks Brothers striped polo shirt and boat shoes during lunch at a restaurant across the bay from his summer home. “You’re holding stuff no one else wants.”
After the 2008 market meltdown, when the S&P 500 fell 38.5 percent, the foundation looked into tail-risk hedges and ended up buying U.S. Treasuries as part of a larger investment strategy, Manske said, adding, “Most people would say, ‘Why in the world are you adding long-duration Treasuries when they are trading at 4 percent?’”
She’s betting that long-duration U.S. government securities will provide cheaper portfolio diversification than a strategy using tail-risk protection.
Janet Tavakoli, a former head of mortgage-backed-securities marketing at Merrill Lynch & Co. who now runs Tavakoli Structured Finance Inc., criticized the performance of Empirica, Taleb’s prior firm. In a 2009 commentary posted on her website, Tavakoli attacked Taleb for losing money in 2001 -- the year of the Sept. 11 terrorist attacks in the U.S., one of the biggest black swan events in history.
The firm’s Empirica Kurtosis fund posted a 7 percent gain in September yet declined 8.4 percent for 2001. Spitznagel, who won’t comment on Empirica’s specific returns, says the Kurtosis fund held a small portion of the firm’s assets and wasn’t representative of Empirica’s other results.
“In the year that Taleb called the mother of all black swans, they lost money,” Tavakoli says. “He’s quick to try to discredit others but not so quick to own up to the weaknesses in his own actions.”
Taleb is dismissive of Tavakoli.
“I can’t take her seriously,” he says. “I have other obsessive detractors more worthy of attention.”
Taleb says he no longer trades and instead devotes himself to writing and serving as an unpaid adviser on risk policies to governments. He doesn’t consider the equity market roller coaster that occurred in August, spurred by S&P’s downgrade of U.S. creditworthiness, to be a black swan.
“What we have here is like a white swan,” says Taleb from his suburban New York home, where he has a collection of 10,000 books. “Moves of 5 percent in the stock market are too common. The downgrade of the U.S. is cosmetic. The only black swan that came from the downgrade is that the bond market rallied.”
At Universa, Taleb has the title of distinguished scientific advisor and helps Spitznagel on research projects. Spitznagel’s devotion to black swan ideas partly swayed his choice of location for his firm. He opted for the relative safety of a one-story building in case an earthquake strikes, a classic black swan event.
In the office, with its exposed beams and view of an alley and a loading dock in Santa Monica’s tourist district, Spitznagel hung a reproduction he commissioned of a somber painting of a black swan by Belgian symbolist William Degouve de Nuncques. On his office window, Spitznagel scribbled more decoration: complex mathematical formulas.
The firm’s bets -- it paid 70 cents in July for put options on Citigroup Inc. (C) that soared to $10 after the stock dropped -- have helped make Spitznagel rich. He seeded a family office with $100 million and paid $7.5 million in 2009 for a 7,357-square- foot (683-square-meter) house in Los Angeles’s wealthy Bel Air neighborhood that was previously owned by divorcing celebrity couple Jennifer Lopez and Marc Anthony.
Spitznagel does almost everything with zeal and intensity. He hones his trading discipline with weekly training sessions in Chinese Chen-style taijiquan, a form of tai chi that emphasizes fighting and defense, and he snowboards in the winter. In 2004, he separated a shoulder after falling off a skateboard to avoid an oncoming taxi in New York’s Central Park. He has given up piloting engineless sailplanes over California’s Sierra Nevada mountains.
“He’s never had a casual interest in anything,” says older brother Eric Spitznagel, a freelance journalist and author. “If he cares about something, he’ll immerse himself in it totally.”
A native of Michigan, Spitznagel got hooked on trading in middle school when he visited the Chicago Board of Trade. “The energy was incredible,” he says. He hung a point and figure chart of the soybean futures markets on his bedroom wall.
With the help of Everett Klipp, a family friend and trader, Spitznagel clerked at the CBOT during summers while he was a student in high school and at Kalamazoo College in Michigan. Spitznagel joined Klipp’s firm after graduating with a political science degree in 1993 and soon began trading in the bond futures pit for his own account. Spitznagel says Klipp taught him the value of taking small losses while waiting for the big score.
“A small loss is a good loss,” Spitznagel remembers the now deceased Klipp telling him.
In 1999, Spitznagel entered a master’s program at New York University’s Courant Institute of Mathematical Sciences, where he met and began to cement his relationship with Taleb. At the institute, former Morgan Stanley and Goldman Sachs Group Inc. (GS) quant trader Neil A. Chriss had built a program in applied financial math.
Chriss hired Taleb, then known for a wonky 1997 tome, “Dynamic Hedging: Managing Vanilla and Exotic Options,” as an adjunct professor. Chriss put Spitznagel in touch with Taleb after the student mentioned he had read Dynamic Hedging and said that the book was his bible as a trader.
The two men talked on the phone, and Taleb, who was preparing to start Empirica, says he was impressed that an experienced floor trader was training in quant theory.
“I hired him without seeing him,” Taleb says. “I told him to take a train to Greenwich.”
The pair opened Empirica together in 1999 in Greenwich, Connecticut, staked with $50 million from Donald Sussman’s Paloma Partners LLC hedge fund. Taleb says Spitznagel brought his pit-trader aggressiveness to the firm in an effort to get a good price on transactions.
“Mark would get into shouting matches with brokers,” Taleb says. “He used to turn red with anger.”
When the Internet bubble burst in 2000, the Empirica Kurtosis fund posted a 57 percent return that year, according to company documents summarizing its results. In contrast, the S&P 500 fell 10.1 percent in 2000. The fund went into a tailspin starting with the 2001 decline, followed by drops of 13 percent in 2002 and 3.9 percent during the first two months of 2003. That’s when the partners closed the fund.
In February 2007, after about a year on Morgan Stanley (MS)’s proprietary-trading desk, Spitznagel left to open his own firm. He says the frothy market conditions early that year inspired his decision to start a black swan fund but that he had no idea that the credit crisis would soon plunge the world into recession.
“The market was -- and still is -- very overvalued,” he says, referring to the price of stocks. “The risk-reward made particularly good sense. It certainly lit a fire for me.”
Spitznagel manages his investors’ money in unconventional ways. An investor specifies a notional amount to protect and then gives Universa the money to buy the options. Universa requires clients to deposit cash equaling the required exchange margin to support the position, which is only 1 to 5 percent of the face value of the options when market volatility is low.
Most futures and commodity-trading advisers, who counsel clients on futures and options contracts, require at least a 50 percent deposit, says James Bibbings, president of Chicago-based Turnkey Trading Partners, a consultant to commodity and currency traders. A fraction of that 50 percent will be invested in actual contracts, with the remainder parked in cash or cash-like securities that can easily be sold if the firm needs to post additional margin on the customer position.
So while Universa hedged a notional $6 billion for investors, it managed only $68.3 million, according to a March Securities and Exchange Commission filing. Yarckin says the amount fluctuates as the market’s implied volatility rises and falls, and the firm’s capital in September was about four to five times higher than in March.
Spitznagel says investors appreciate not having to tie up so much of their capital with his firm. He says he can operate with small deposits because he structures his investments to minimize the size of losses. Spitznagel is now seeking $1 billion for a new fund that will try to capitalize on mispriced options on benchmarks as well as individual commodities, currencies, stocks and other financial instruments.
“There is no other vehicle out there that I know of where you will see this extreme underfunding, because I doubt there is any other vehicle out there that has the conservative risk controls we do,” he says.
Last year, Spitznagel bought a 200-acre (80-hectare) cherry orchard and farm near his summer home in Northport Point, Michigan, that he’s converting into a goat dairy. Driving through the orchard, he lowers a window in his Mercedes-Benz G 55 AMG sport utility vehicle, plucks a fresh cherry off one of his trees and pops it in his mouth.
“This is my idea of farming,” he says.
With the S&P 500 down about 16 percent in early October from its 2011 high, Spitznagel finds making money almost as easy as picking cherries. And he argues that there’s a high probability that the S&P 500 will continue its decline, plunging an additional 40 percent in the next few years. That would spur even more investors to flock to black swan funds -- hoping for a big payday while risking a bust.
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