Sam Zell: Invest Some Capital in Black Swan Scenarios

Next up in our notes from Invest For Kids Chicago is Sam Zell of Equity Group Investments.  He gave a sobering talk and recommended putting some money in 'black swan scenarios.'

•    Zell was the most active real estate investor in US in 1974 through 1976 
•    Zell is just glad he “didn’t have to mark to market” 
•    Wrote an article in which he described his activities as a "grave dancer" (GrizzlyRock Note: Thus earning him one of the better moniker’s in the business!) 

•    How does Zell get the confidence or optimism to go forward in face of uncertainty?  
o    What he found was that he had the confidence because it was embedded in the belief that he was buying things inexpensively 

•    Same sort of situation in 1990 and 1991.  Zell was buying office buildings at less than replacement costs with no value being ascribed to the land

•    What does the world look like circa 2012? 
o    Europe with disintegrating currency and cross winds between parties, 
o    Demographic death spiral, attempt to create austerity 
o    Europe going into recession and maybe more than a recession 
o    Emerging markets growth slowing (China, India, etc) 

•    "Why are stocks so high?  Why are re prices sky high?" 
 •    Would seem to Zell that things would be cheaper that they are given the environment 
•    Middle market debt inefficiently priced and thus interesting 
•    There are "sand dunes of uncertainty" in the US. 
•    Solving uncertainty is better than flooding the world with dollars" 


Zell's Idea: Black Swan Scenarios

•    Zell's idea was to invest some capital in true black swan scenarios 
•    Long run certainty is lacking and a fundamental problem in the US.

This is interesting when you consider that Tiger Management's Julian Robertson (who has seeded tons of hedge funds) was recently interviewed where he said many hedge funds are overly hedged and poised for doomsday scenarios.  Robertson also cited this as a reason as to why hedge funds are underperforming.  Zell obviously agrees with those managers as he advocates some tail risk hedges.


For the rest of the hedge fund presentations from the event, head to notes from Invest For Kids Chicago.

Nassim Taleb's Black Swan: Examining Returns

The following is an article by Janet Tavakoli printed with her permission. She has more than 20 years of experience in investment banking and financial products and is the President of Tavakoli Structured Finance. She previously served at the University of Chicago's Graduate School of Business and additionally is the author of Credit Derivatives & Synthetic Structures, as well as Structured Finance & Collateralized Debt Obligations, amongst other titles.

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In my follow-up commentary (below), I referred to a WSJ article that suggested the returns for 2003 and 2004 for Empirica Kurtosis, Taleb’s previous “black swan fund” (the last admin / wind-up meeting was Jan 2005) were positive in the low single digits after two years of negative returns in 2001 and 2002. If so, investors that stayed in from 2000 would have at best around a 5% return (a middling single digit annualized return). Those who “flocked” (according to Bloomberg) in after 9/11 would have lost substantial principal.

Taleb's Stranded Swan?

Before penning my previous commentary, I contacted Nassim Nicholas Taleb to check whether there were any inaccuracies in a Wall Street Journal article about the performance of his previous black swan fund, Empirica Kurtosis Ltd. The article said the fund had a 60% return in 2000 followed by "losses in 2001 and in 2002.” In 2003 and 2004 it had low single-digit gains, a period when hedge funds posted average returns of 20% and 9% respectively. The fund’s size was around $375 million when most of the assets were returned to investors.

In my query to Taleb, I also asked for confirmation that the fund experienced a voluntary wind-up…more on that later.

Taleb did not respond. Considered with his previous coy reply regarding GQ’s mythical $20 billion, I gave up hope of clarification. I enjoy debating philosophy, but debate is no substitute for size of actual gains.

I was particularly interested in Empirica Kurtosis’s reported anemic performance in 2001, because according to Taleb, the 911 terrorist attacks of 2001 were a “black swan” event.¹

How can a black swan fund do so poorly when the black swan finally appears?

Imagine a scenario: When the black swan appears, investors panic. The fund manager wants to cash in gains when volatility soars. Nervous investors want the manager to buy more “insurance,” when it is expensive and ill-considered. But investors should not be blamed for a black swan fund’s anemic performance any more than a pilot would blame nervous passengers for a bumpy plane ride. Management takes credit (and juicy fees) for the gains, so it should take responsibility for overall performance. This scenario may not be relevant for Empirica Kurtosis, but then, what is the explanation?

What about the voluntary wind-up I mentioned earlier?

Taleb’s web site stated EMPIRICA WAS NEVER CLOSED [emphasis in original].² That may be true if one is only referring to Empirica LLC, a risk management operation. But in my opinion, it is incomplete to assert this without mentioning the voluntary wind-up of Empirica Kurtosis Limited.

Taleb never responded to my query about the wind-up. The Bermuda-based trustee was more helpful and confirmed that Empirica Kurtosis Limited was indeed wound up in 2004/2005.

Winners’ Swan Dive

Big wins and big losses always occur after any market move. Winners are eager to claim they were smart—not lucky.

The big picture should be big enough to provide perspective. A black swan fund may have a good year followed by losses and mediocre returns. Empirica Kurtosis Limited may have become an example of a black swan fund with clipped wings.

(See also: “Taleb Kills $20 Billion Mythical Swan,” June 1, 2009)

¹ Excerpted Transcript May 8, 2007 – The Colbert Report (Stephen Colbert interviews Taleb)

Taleb: Take Google, September 911, the rise of the internet, Harry Potter…They were unexpected and no one saw them coming, and after they happened, oh yah, it was so explainable by historians, scholars and academics, but before they happened, they were so unexpected.

[Later]

Colbert: So you say…911 could not be predicted.

Taleb: It is very very hard to predict these events.

[Apparently Taleb never heard of the August 2001 presidential briefing: “Bin Laden Determined To Strike in U.S. based on a July 2001 intelligence report.]

Colbert: …I’m glad to hear that, because that means the 911 Commission was a waste of time. Because we shouldn’t have investigated why it happened, right?

Taleb: You need you need [sic] to investigate to see if it is predictable or not…

Colbert: But why? Why investigate something that can’t be predicted, because there is nothing to learn from it.

Taleb: No, after the fact, Okay, you have to look at…uh…first of all you can learn something from the event, it’s not like you can’t learn at all.

Colbert: Okay

Taleb: But 911, 911, what I’m saying is that its there is so many events like 911 that could have taken place, you see, so, its just to see if there’s responsibility, is there any vigilance or no vigilance. This is why we investigated 911.

Colbert: ..Is Iraq a Black Swan? We couldn’t have ever foreseen it would go poorly, we would never have known that was not going to go well…

Taleb: No, wars, wars, yah, listen, wars since Napoleon…we learned that wars…wars are more and more unpredictable, more and more complex, the link between action and consequence becoming fuzzier, and I think that the war in Iraq was a mistake…we should have seen that it could have led to these dire consequences. [Only since Napoleon?]

Colbert: We should have but we didn’t, therefore we couldn’t.

[Later]

Colbert: It seems like you’re essentially saying the future is unpredictable.

Taleb: No, I’m saying, yes, my idea in the book is to show two things: number one that the future is rather unpredictable, it is dominated by Black Swans and these black swans are not predictable, and the second point that is quite central, is that we humans…all right?...try to concoct stories to convince ourselves that the future is more predictable than it actually is…[Like Taleb’s Napoleon story?]

Colbert: The future is essentially not predictable.

Taleb: Yes, it’s not.

Colbert: By that logic, doesn’t it mean that in the future you will be able to predict things, because you are predicting that you cannot predict things?

² The only mention of Empirica on Taleb’s web site was as follows: “Owned Empirica LLC a trading/hedging/protection operation (currently the business became the Black Swan Protection Protocol managed by the traders at Universa –I am an advisor). Note that EMPIRICA WAS NEVER CLOSED. Current Corporate Boards: a few hedge funds. A prophetic novel by Viken Berberian about Empiricus Kapital.” There was no mention of Empirica Kurtosis Limited (Emprica Kurtosis), a fund, or of its returns even though it seems it may have been part of this operation at one time. The fund’s returns are not mentioned in Taleb’s Wikipedia profile (as of this writing). The returns for Empirica Kurtosis Limited are mentioned in Mark Spitznagel’s Wikipedia profile, but in an incomplete way. Spitznagel was a partner with Taleb in this venture: “Empirica was reported to have made a 60% return in 2000 and lower (though unconfirmed) returns from 2001 to 2004.”

Thanks again to Janet for letting us post up her work. Check out her firm Tavakoli Structured Finance and her books Credit Derivatives & Synthetic Structures, as well as Structured Finance & Collateralized Debt Obligations,

Nassim Taleb Explains the Black Swan

If you've never heard of Nassim Taleb, he is known for his Black Swan theory and overall doom focus. This video focuses on Taleb explaining the Black Swan in detail. Even if you don't agree with it, it's an interesting video.



Obviously, much more is detailed in his book, The Black Swan: The Impact of the Highly Improbable. We've actually highlighted Taleb's other book in our most recent Recommended Reading List as well.


[hat tip to WallStNation for flagging this]