Hendry, Taleb & Faber: How To Invest $100 Million In 2010

At the recent Russia 2010 conference, an interesting question was posed: how would you invest $100 million for 12 months? The panel included hedge fund manager Hugh Hendry, black swan-er Nassim Taleb, and Marc Faber, among others.

Taleb presented a few ideas that he would allocate to the 'risky' portion of the portfolio. He likes a short of the S&P 500 and a long of precious metals (gold, silver, platinum) in a fixed ratio of around 1.5 to 1. He also suggests to buy an out of the money option on hyperinflation through a basket of instruments on gold, treasuries, etc. He doesn't care about inflation, he wants to possibly game the slim chance of hyperinflation. He says you will probably lose money on the play, but if you're right and hyperinflation hits, you can win huge. Lastly, he also says that you should be shorting US treasuries, something we've seen numerous prominent hedge fund managers recommend.

Hendry then took the mic and was his usual entertaining self. He focused on how everyone at the conference had a different opinion and he was sick of opinions, saying "Who cares about that opinion? You pay people for what they do with that opinion." And he brings up a very good point. It's one thing to have a trade idea or research, but it is quite another thing to execute it. We've postulated that this could potentially be the problem over at Peter Thiel's global macro hedge fund Clarium Capital as they've had a rough past two years.

Hendry says that he doesn't even need to spend all the $100 million to invest, but rather just a tiny amount of it. He simply underwrites the risk that the Bank of England will cut rates further. He takes the proceeds from this and uses it to cheapen an option that bets against the English central bank raising interest rates over the next four months. If they raise rates, all he loses is his premium, which is not a lot. However, if nothing happns, he can make five times his money. It's all about the risk/reward skew. He also mentioned that he had a John Paulson-esque play where you could make 75 times your money and only risk a tiny amount, but he teased the audience and said he'd save that for another time. We've previously covered some of Hendry's hedge fund commentary on the site as he's been the resident deflationist.

Some of the answers from other panelists were also intriguing as they favored emerging market consumer plays. They also recommended avoiding: credit, real estate (especially commercial) in the western world, as well as western financial institutions.

We highly recommend watching the video of the hour-long panel here.

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,

Hedge Fund News Summary (Soros, Och Ziff, Taleb, & More)

We've found a bunch of various hedge fund tidbits that aren't long enough to merit their own article, so we decided to collectively assemble them into this melting pot of a post. Without further ado, we present some of the news that has surfaced out of hedge fund land over the recent days:

- George Soros has called credit default swaps "instruments of destruction" and thinks they should be banned. Shorting via credit default swaps allows limited risk and unlimited profit potential in a sense. Soros argues that those selling CDS receive limited profit potential and unlimited risk, yielding a clear imbalance. Soros said, "People buy a CDS not because they expect an eventual default but because they expect them to appreciate in response to the adverse developments." He cites AIG as a major loser in this regard as they were a large seller of CDS and were on the receiving end of the negative reward spectrum. Lastly, in a separate conversation, Soros has said that the market, "may have further to go because there is a lot of liquidity, a lot of investors are on the sidelines. If the market keeps on going up, more of them may decide to join in. You never know how far the rally goes." His old colleague at the Quantum Fund, Jim Rogers, agrees with him, as we noted when we recently covered Rogers' portfolio & thoughts. Speaking on the topic of China, Soros also thinks that they have benefited from being isolated from the world and they are in better shape than the international banking system. He thinks that China's influence will grow faster than most people think. We just yesterday covered Soros' hedge fund portfolio.

- Hedge Fund Och Ziff had almost 35% of their assets in cash as of the first quarter as they expect markets to fall again. Currently, they manage around $20 billion in hedge fund assets, so you do the math. They believe the economic recovery will be a long drawn out process and it will not just bounce back immediately. Their main fund lose 15.5% last year and is up 6.3% for 2009 as of the end of April.

- David Einhorn's Greenlight Capital noted in his May investor letter that he has returned to financial and REIT shorts after those sectors have rallied heartily. We also learned that he has put on an options bet wagering that interest rates will rise. (We also recently covered a somewhat similar play: Julian Robertson's steepener play). Additionally, Einhorn still retains a large gold position, which we noted when we covered Greenlight's portfolio.

- Nassim Taleb associated Universa Investments is starting a fund based on the thesis of hyperinflation. Universa has ties to Nassim Taleb, the author of the (in)famous book, The Black Swan, which talks about how extreme events can impact the markets. And, it is also a part of our recommended reading list series. Universa was up more than 100% in 2008 due to their bearish stance. They started with $300 million in 2007 and now run around $6 billion. The new fund will be run by Mark Spitznagel and wagers on rising interest rates, among other inflation based plays (such as commodities and options). While Taleb himself does not run the firm, he has significant investments with them and is often associated with them. In the past, we've covered Taleb's explanation of the Black Swan.

- Boaz Weinstein will be starting a new hedge fund, Saba Capital Management. They plan to start trading in August and have raised around $160 million since the end of April. Weinstein has made headlines for the fact that he lost more than $1 billion last year at Deutsche Bank trading bonds. The fund is named Saba after the Hebrew word for grandfather. It is also the name of the credit unit Weinstein started while at DB. His bad performance last year is his only losing year out of 11 years. He felt pain from misteps in Ford (F) bonds and various credit default swaps. His DB unit last year was down around 18% and managed around $10 billion. We'll have to see if he can get back to his past winning ways with his new venture.

- Hedge Fund Balyasny Asset Management was using leverage of 20 cents for every dollar they had in net assets for their stock funds. Their long/short split is roughly 50/50 these days as well. Dmitry Balyasny said, "Economic numbers, housing data, earnings, risk appetite and credit have all gotten less bad. The question is, for how long?" Their main fund was up 0.5% for 2008 and is up 2% thus far in 2009. They are leaning towards the belief that stocks will drop in the second half of the year. Balyasny goes on to say, "The situation is quite fluid and we have to respect the probability that the market is going to continue discounting bad news and embracing every slight improvement, causing shorts to eventually capitulate." We will be covering Balyasny in our hedge fund portfolio tracking series here soon, so stay tuned.

- A pair of ex-Touradji Capital portfolio managers have launched a new commodities fund. Instead of playing directly in commodities market as Touradji typically does, their new venture will make relative value based bets via the equity markets. This new fund sounds like an excellent candidate for our hedge fund series as it will allow us to track commodity and macro experts via equities positions, which are very easy to track courtesy of SEC filings. We haven't covered Touradji yet in our Q1 2009 portfolio tracking series, but we'll be getting to them very soon, so stay tuned.

And with that, we conclude our quick wrap up of some various hedge fund news tidbits.

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]