Whitebox on Risk & Risk Management

There must be something in the Whitebox water supply: it's producing an army of investment math nerds with acute self-awareness and sensibilities, led by their fearless leader Andy Redleaf. Those of you who have not yet seen Whitebox's "10 Enduring Principles To Interpret Constant Market Change" are missing out -- it is absolutely worth three minutes of your day. The text below is extracted from a Jan 2015 Andy Redleaf article titled "Getting Past the Romance of Risk":

“The courage to ‘take a chance.’ The fearlessness of being a ‘risk taker.’ Risk as the force of entrepreneurship. These ideas are so ingrained in the American psyche that in the investment industry they have become dogma: to increase returns the investor must be willing to accept more risk. That is the core result of Modern Portfolio Theory, even if it is hedged with theories about how to accept risk systematically on the “efficient frontier.”

Given this persistent quasi-romance with risk, we have to ask: What great investor or entrepreneur ever succeeded by deliberately taking on more risk?

...the entrepreneur’s goal should always be to create asymmetries of risk and reward in which there is far more to be gained than lost. We strongly believe all investment managers should be doing the same, which is why the first of Whitebox’s 10 Investment Principles is: The source of investment return is the efficient reduction of risk.

If risk is not the basis of return, should an investor strive to take no risk at all? No. There is no such thing as a risk-free portfolio. We believe that the right goal is to reduce risk efficiently: reduce the risks of a position more than one reduces its potential return. One can do this in various ways, but it comes down to the investor striving to own only and exactly what he wants to own…

How do we believe an investor can own only and exactly what he wants to own? In practical terms, what does this look like?

In reality, most securities, taken individually, are bundles of both good and bad qualities. Even a stock that presents generally favorable prospects for potentially good returns is likely to contain at least some unfavorable qualities; the same is generally true for bonds. As such, we believe the key – and the whole point of alternative investing – is to be able to identify and isolate the good from the bad, so that you own only and exactly what you want.

How is this achieved? Sometimes this is done at the security level, by buying securities with desirable qualities and canceling out the undesirable qualities through carefully constructed positions in our short book. Sometimes it is done at the portfolio level, by combining investment “themes” in ways that retain the attractive qualities of an investment idea while, hopefully, canceling out the risks.

Sometimes, it can be achieved by striving to identify and implement hedges that are in themselves what we perceive as sound, attractive investments, the goal being to reduce risk through tactics and decisions that are themselves potentially return-generating investments…

Viewing risk-reduction in itself as a source of potential returns is in stark contrast to a more traditional approach, which we believe accepts some measure of loss in exchange for potential payoff.

Exercising sound judgment in investing, we believe, involves choosing the particular over the abstract. This can mean the difference between buying up “lots” of securities in bundles (often to satisfy a predetermined allocation percentage, for example) versus sorting through individual names, looking for nuances lurking beyond-the-obvious that enhance value, and identifying idiosyncratic dislocations – even among securities that are bought and sold in “lots.” It means looking at risk specifically, not from a high level of abstraction, striving to reduce that risk efficiently through a hedge that in itself is an investment with potential payoff.

Put another way, we believe efficient reduction of risk begins with and cannot be separated from the investment process. To us, every investment decision, therefore, should be a decision about risk. We reject the concept of risk management as an “overlay.”

Most of all, we believe this investment principle entails viewing risk and risk mitigation as a matter of judgment. We feel confident in our belief that investors who exercise good judgment are more likely to prosper than investors who do not…

Seen from this perspective, the concept of risk is somewhat reframed. We simply reject the idea that says “the greater the risk, the greater potential for return.” To us, a truly alternative approach to investing involves what we believe to be a fairly straightforward endeavor: efficiently reduce risk so as to own only and exactly what you want to own.”

On efficient markets: “We believe this…approach to investing isn’t safe, mostly because we see it as lazy. On every point listed above, we’re convinced that money managers who go along with these dogmas are saving themselves work, but risking investors’ money.”

Howard Marks' Book: Chapter 18

Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 18 “The Most Important Thing Is…Avoiding Pitfalls” Risk, Volatility

“…trying to avoid losses is more important than striving or great investment successes. The latter can be achieved some of the time, but the occasional failures may be crippling. The former can be done more often and more dependably…and with consequences when it fails that are more tolerable…A portfolio that contains too little risk can make you underperform in a bull market, but no one ever went bust from that; there are far worse fates.”

“You could require your portfolio to do well in a rerun of 2008, but then you’d hold only Treasurys, cash and gold. Is that a viable strategy? Probably not. So the general rule is that it’s important to avoid pitfalls, but there must be a limit. And the limit is different for each investor.”

Volatility, Psychology, Trackrecord, When To Buy, When To Sell, Clients

“…almost nothing performed well in the meltdown of 2008…While it was nigh onto impossible to avoid declines completely, relative outperformance in the form of smaller losses was enough to let you do better in the decline and take grater advantage of the rebound.”

“In periods that are relatively loss free, people tend to think of risk as volatility and become convinced they can live with it. If that were true, they would experience markdowns, invest more at the lows and go on to enjoy the recovery, coming out ahead in the long run. But if the ability to live with volatility and maintain one’s composure has been overestimated—and usually it has—that error tends to come to light when the market is a its nadir. Loss of confidence and resolve can cause investors to sell at the bottom, converting downward fluctuations into permanent losses and preventing them from participating fully in the subsequent recovery. This is the great error in investing—the most unfortunate aspect of pro-cyclical behavior—because of its permanence and because it tends to affect large portions of portfolios.”

“While it’s true that you can’t spend relative outperformance, human nature causes defensive investors and their less traumatized clients to derive comfort in down markets when they lose less than others. This has two very important effects. First, it enables them to maintain their equanimity and resist the psychological pressures that often make people sell at lows. Second, being in a better frame of mind and better financial condition, they are more able to profit from the carnage by buying at lows. Thus, they generally do better in recoveries.”

Volatility is not the true risk; the true risk lies in what investors do / how they behave during volatile periods.

Mistakes, Creativity, Psychology

“One type of analytical error…is what I call ‘failure of imagination’…being unable to conceive of the full range of possible outcomes or not fully understanding the consequences of the more extreme occurrences.”

“Another important pitfall…is the failure to recognize market cycles and manias and move in the opposite direction. Extremes in cycles and trends don’t occur often, and thus they’re not a frequent source of error, but they give rise to the largest errors.”

“…when the future stops being like the past, extrapolation fails and large amounts of money are either lost or not made…the success of your investment actions shouldn’t be highly dependent on normal outcomes prevailing; instead, you must allow for outliers…"

“…the third form of error doesn’t consist of doing the wrong thing, but rather of failing to do the right thing. Average investors are fortunate if they can avoid pitfalls, whereas superior investors look to take advantage of them…a different kind of mistake, an error of omission, but probably one most investors would be willing to live with.”

“The essential first step in avoiding pitfalls consists of being on the lookout for them…learning about pitfalls through painful experience is of only limited help. The key is to try to anticipate them…The markets are a classroom where lesson are taught every day. The keys to investment success lie in observing and learning.”

“The fascinating and challenging thing is that the error moves around. Sometimes prices are too high and sometimes they’re too low. Sometimes the divergence of prices from value affects individual securities or assets and sometimes whole markets – sometimes one market and sometimes another. Sometimes the error lies in doing something and sometimes in not doing it, sometimes in being bullish and sometimes in being bearish…avoiding pitfalls and identifying and acting on error aren’t susceptible to rules, algorithms, or roadmaps. What I would urge is awareness, flexibility, adaptability and a mind-set that is focused on taking cues from the environment.”

Correlation, Diversification, Risk

“There’s another important aspect of failure of imagination. Everyone knows assets have prospective returns and risks, and they’re possible to guess at. But few people understand asset correlation: how one asset will react to a change in another, or that two assets will react similarly to a change in a third. Understanding and anticipating the power of correlation – and thus the limitations of diversification – is a principal aspect of risk control and portfolio management, but it’s very hard to accomplish…Investors often fail to appreciate the common threads that run through portfolios.”

“Hidden fault lines running through portfolios can make the prices of seemingly unrelated assets move in tandem. It’s easier to assess the return and risk of an investment than to understand how it will move relative to others. Correlation is often underestimated, especially because of the degree to which it increases in crisis. A portfolio may appear to be diversified as to asset class, industry and geography, but in tough times, non-fundamental factors such as margin calls, frozen markets and a general risk in risk aversion can become dominant, affecting everything similarly.”

Hedging, Expected Return, Opportunity Cost, Fat Tail

“…a dilemma we have to navigate. How much time and capital should an investor devote to protecting against the improbable disaster? We can insure against every extreme outcome…But doing so will be costly, and the cost will detract form investment returns when that protection turns out not to have been needed…and that’ll be most of the time.”

Montier on Exposures & Bubbles

Below are some wonderful bits on bubbles and portfolio construction from James Montier. Excerpts were extracted from a Feb 2014 interview with Montier by Robert Huebscher of Advisor Perspectives – a worthwhile read. Cash, Expected Returns, Exposure

“The issue is…everything is expensive right now. How do you build a portfolio that recognizes the fact that cash is generating negative returns…you have to recognize that this is the purgatory of low returns. This is the environment within which we operate. As much as we wish it could be different, the reality is it isn’t, so you have to build a portfolio up that tries to make sense. That means owning some equities where you think you’re getting at least some degree of reasonable compensation for owning them, and then basically trying to create a perfect dry-powder asset.

The perfect dry-powder asset would have three characteristics: it would give you liquidity, protect you against inflation and it might generate a little bit of return.

Right now, of course, there is nothing that generates all three of those characteristics. So you have to try and build one in a synthetic fashion, which means holding some cash for its liquidity benefits. It means owning something like TIPS, which are priced considerably more attractively than cash, to generate inflation protection. Then, you must think about the areas to add a little bit of value to generate an above-cash return: selected forms of credit or possibly equity-spread trades, but nothing too risky.”

Dry powder is generally associated with cash. But as Montier describes here, it is possible that in certain scenarios cash is not the optimal dry-powder asset.

His description of creating a perfect dry-powder asset is akin to creating synthetic exposures, something usually reserved for large hedge funds / institutions and their counterparties.

Interestingly, anyone can (try to) create synthetic exposures by isolating characteristics of certain assets / securities to build a desired combination that behaves a certain way in XYZ environment, or if ABC happens.

For more on isolating and creating exposures, see our previous article on this topic. 

Hedging, Fat Tail

“Bubble hunting can be overrated…I’m not sure it’s particularly helpful, in many regards…

Let’s take an equity‐market bubble, like the technology‐media‐telecom (TMT) bubble. Everyone now agrees I think, except maybe two academics, that TMT was actually a bubble. To some extent it didn’t really matter, because you had a valuation that was so extraordinarily high. You didn’t actually have to believe it was a bubble. You just knew you were going to get incredibly low returns from the fact that you were just massively overpaying for those assets.

Knowing it was a bubble as such helped reassure those of us who were arguing that it was a bubble, though we could see the more common signs of mania like massive issuance, IPOs and shifting valuation metrics that eventually were off the income statement altogether.

All of those things are good confirming evidence, but ultimately it didn’t matter because the valuation alone was enough to persuade you to think, ‘Hey, I’m just not going to get any returns in these assets even if it isn’t a bubble.’

Bubblehunting is much more useful when it is with respect to things like credit conditions and the kind of environments we saw in 2007, when it was far less obvious from valuation alone. Valuation was extended, but wasn’t anywhere near the kinds of levels that we saw in 2000. It was extended, but not cripplingly so by 2000 standards. But the ability to actually think about the credit bubble or the potential for a bubble in fundamentals or financial earnings is very useful.

The use of bubble methodology is certainly not to be underestimated, but people can get a little too hung up on it and start to see bubbles everywhere. You hear things about bond bubbles. Do I really care? All I need to know is bonds are going to give me a low return from here. Ultimately, for a buy-and-hold investor, the redemption yield minus expected inflation gives me my total return for bonds. There can’t be anything else in there.

You get the conclusion that, ‘Hey, I don’t really care if it’s a bubble or not.’ I suspect bubble hunting can be useful in some regards. But people use the term too loosely and it can lead to unhelpful assessments.”

Expected Return, Capital Preservation

“You can imagine two polar extreme outcomes: Central banks could end financial repression tomorrow. You would get real‐rate normalization and the only asset that survives unscathed is cash. Bonds suffer, equities suffer and pretty much everything else suffers. Or, the central banks keep their rates incredibly low for a very, very long period.

The portfolios you want to hold under those two different outcomes are extremely different. I have never yet met anyone with a crystal ball who can tell me which of these two outcomes is most likely – or even which one could actually happen. You’re left trying to build a portfolio that will survive both outcomes. It won’t do best under either one of the two outcomes or the most probable outcome, but it will survive. That really is the preeminent occupation of my mind at the moment.”

When To Buy, When To Sell, Psychology

“One of curses of value managers is we’re always too early both to buy and to sell. One of the ways that were trying to deal with that is to deliberately slow our behavior down, so we try to react at least to a moving average of the forecast rather than the spot forecasts.”

Baupost Letters: 2000-2001

This concludes our series on portfolio management and Seth Klarman, with ideas extracted from old Baupost Group letters. Our Readers know that we generally provide excerpts along with commentary for each topic. However, at the request of Baupost, we will not be providing any excerpts, only our interpretive summaries. For those of you wishing to read the actual letters, they are available on the internet. We are not posting them here because we don’t want to tango with the Baupost legal machine.

Volatility, Psychology

Even giants are not immune to volatility. Klarman relays the story of how Julian Robertson’s Tiger Fund closed its doors largely as a result of losses attributed to its tech positions. As consolation, Klarman offers some advice on dealing with market volatility: investors should act on the assumption that any stock or bond can trade, for a time, at any price, and never enable Mr. Market’s mood swings to lead to forced selling. Since it is impossible to predict the timing, direction and degree of price swings, investors would do well to always brace themselves for mark to market losses.

Does mentally preparing for bad outcomes help investors “do the right thing” when bad outcomes occur? 

When To Buy, When To Sell, Selectivity

Klarman outlines a few criteria that must be met in order for undervalued stocks to be of interest to him:

• Undervaluation is substantial
• There’s a catalyst to assist in the realization of that value
• Business value is stable and growing, not eroding
• Management is able and properly incentivized

Have you reviewed your selectivity standards lately? How do they compare with three years ago? For more on this topic, see our previous article on selectivity. 

Psychology, When To Buy, When To Sell

Because investing is a highly competitive activity, Klarman writes that it is not enough to simply buy securities that one considers undervalued – one must seek the reason for why something is undervalued, and why the seller is willing to part with a security/asset at a “bargain” price.

Here’s the rub: since we are human and prone to psychological biases (such as confirmation bias), we can conjure up any number of explanations for why we believe something is undervalued and convince ourselves that we have located the reason for undervaluation. It takes a great degree of cognitive discipline & self awareness to recognize and concede when you are (or could be) the patsy, and to walk away from those situations.

Risk, Expected Return, Cash

Klarman’s risk management process was not after-the-fact, it was woven into the security selection and portfolio construction process.

He sought to reduce risk on a situation by situation basis via

• in-depth fundamental analysis
• strict assessment of risk versus return
• demand for margin of safety in each holding
• event-driven focus
• ongoing monitoring of positions to enable him to react to changing market conditions or fundamental developments
• appropriate diversification by asset class, geography and security type, market hedges & out of the money put options
• willingness to hold cash when there are no compelling opportunities.

Klarman also provides a nice explanation of why undervaluation is so crucial to successful investing, as it relates to risk & expected return: “…undervaluation creates a compelling imbalance between risk and return.”

Benchmark

The investment objective of this particular Baupost Fund was capital appreciation with income was a secondary goal. It sought to achieve its objective by profiting from market inefficiencies and focusing on generating good risk-adjusted investment results over time – not by keeping up with any particular market index or benchmark. Klarman writes, “The point of investing…is not to have a great story to tell; the point of investing is to make money with limited risk.”

Investors should consider their goal or objective for a variety of reasons. Warren Buffett in the early Partnership days dedicated a good portion of one letter to the “yardstick” discussion. Howard Marks has referenced the importance of having a goal because it provides “an idea of what’s enough.”

Cash, Turnover

Klarman presents his portfolio breakdown via “buckets” not individual securities. See our article on Klarman's 1999 letter for more on the importance of this nuance. 

The portfolio allocations changed drastically between April 1999 and April 2001. High turnover is not something that we generally associate with value-oriented or fundamental investors. In fact, turnover has quite a negative connotation. But is turnover truly such a bad thing?

Munger once said that “a majority of life’s errors are caused by forgetting what one is really trying to do.”

Yes, turnover can lead to higher transaction fees and realized tax consequences. On taxes, we defer to Buffett’s wonderfully crafted treatise on his investment tax philosophy from 1964, while the onset of electronic trading has significantly decreased transaction fees (specifically for equities) in recent days.

Which leads us back to our original question: is portfolio turnover truly such a bad thing? We don’t believe so. Turnover is merely the consequence of portfolio movements triggered by any number of reasons, good (such as correcting an investment mistake, or noticing a better opportunity elsewhere) and bad (purposeful churn of the portfolio without reason). We should judge the reason for turnover, not the act of turnover itself.

Hedging, Expected Return

The Fund’s returns in one period were reduced by hedging costs of approximately 2.4%. A portfolio’s expected return is equal to the % sizing weighted average expected return of the sum of its parts (holdings or allocations). Something to keep in mind as you incur the often negative carry cost of hedging, especially in today’s low rate environment.

Elementary Worldly Wisdom – Part 2

The following is Part 2 of portfolio management highlights extracted from a gem of a Munger speech given at USC 20 years ago in 1994. It’s long, but contains insights collected over many years by one of the world’s greatest investment minds. Caustically humorous, purely Munger, it is absolutely worth 20 minutes of your day between browsing ESPN and TMZ. Expected Return, Selectivity, Sizing, When To Buy

“…the one thing that all those winning betters in the whole history of people who've beaten the pari-mutuel system have is quite simple: they bet very seldom… the wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don't. It's just that simple.

…yet, in investment management, practically nobody operates that way…a huge majority of people have some other crazy construct in their heads. And instead of waiting for a near cinch and loading up, they apparently ascribe to the theory that if they work a little harder or hire more business school students, they'll come to know everything about everything all the time.”

“How many insights do you need? Well, I'd argue: that you don't need many in a lifetime. If you look at Berkshire Hathaway and all of its accumulated billions, the top ten insights account for most of it. And that's with a very brilliant man—Warren's a lot more able than I am and very disciplined—devoting his lifetime to it. I don't mean to say that he's only had ten insights. I'm just saying, that most of the money came from ten insights.

So you can get very remarkable investment results if you think more like a winning pari-mutuel player. Just think of it as a heavy odds-against game full of craziness with an occasional mispriced something or other. And you're probably not going to be smart enough to find thousands in a lifetime. And when you get a few, you really load up. It's just that simple…

Again, this is a concept that seems perfectly obvious to me. And to Warren it seems perfectly obvious. But this is one of the very few business classes in the U.S. where anybody will be saying so. It just isn't the conventional wisdom.

To me, it's obvious that the winner has to bet very selectively. It's been obvious to me since very early in life. I don't know why it's not obvious to very many other people.”

“…investment management…is a funny business because on a net basis, the whole investment management business together gives no value added to all buyers combined. That's the way it has to work…I think a select few—a small percentage of the investment managers—can deliver value added. But I don't think brilliance alone is enough to do it. I think that you have to have a little of this discipline of calling your shots and loading up—you want to maximize your chances of becoming one who provides above average real returns for clients over the long pull.”

“…huge advantages for an individual to get into a position where you make a few great investments and just sit back and wait: You're paying less to brokers. You're listening to less nonsense. And if it works, the governmental tax system gives you an extra 1, 2 or 3 percentage points per annum compounded.”

Tax, Compounding, When To Sell

“Another very simple effect I very seldom see discussed either by investment managers or anybody else is the effect of taxes. If you're going to buy something which compounds for 30 years at 15% per annum and you pay one 35% tax at the very end, the way that works out is that after taxes, you keep 13.3% per annum.

In contrast, if you bought the same investment, but had to pay taxes every year of 35% out of the 15% that you earned, then your return would be 15% minus 35% of 15%—or only 9.75% per year compounded. So the difference there is over 3.5%. And what 3.5% does to the numbers over long holding periods like 30 years is truly eye-opening. If you sit back for long, long stretches in great companies, you can get a huge edge from nothing but the way that income taxes work.

Even with a 10% per annum investment, paying a 35% tax at the end gives you 8.3% after taxes as an annual compounded result after 30 years. In contrast, if you pay the 35% each year instead of at the end, your annual result goes down to 6.5%. So you add nearly 2% of after-tax return per annum if you only achieve an average return by historical standards from common stock investments in companies with tiny dividend payout ratios.

…business mistakes that I've seen over a long lifetime, I would say that trying to minimize taxes too much is one of the great standard causes of really dumb mistakes. I see terrible mistakes from people being overly motivated by tax considerations.”

Diversification, Hedging

“…one of the greatest economists of the world is a substantial shareholder in Berkshire Hathaway and has been for a long time. His textbook always taught that the stock market was perfectly efficient and that nobody could beat it. But his own money went into Berkshire and made him wealthy…he hedged his bet.”

If you can hedge without negative consequences, do it. It's likely that the economist's investment in Berkshire was not public knowledge.

Wisdom From James Montier

I have a confession to make: I have a huge crush on James Montier. I think the feeling might be mutual (see picture below, from a signed copy of his book Value Investing: Tools and Techniques for Intelligent Investment.) Jokes aside, below are some fantastic bits from his recent essay titled “No Silver Bullets.”

Risk, Correlation

“…private equity looks very much like public equity plus leverage minus a shed load of costs…hedge funds as an ‘asset class’ look like they are doing little more than put selling! In fact, I’d even go as far as to say if you can’t work that out, you probably shouldn’t be investing; you are a danger to yourself and to others!

The trick to understanding risk factors is to realize they are nothing more than a transformation of assets. For instance, what is the ‘equity risk?’ It is defined as long equities/short cash. The ‘value’ risk factor is defined as long cheap stocks/short expensive stocks. Similarly, the ‘momentum’ risk factor is defined as long stocks that have gone up, and short stocks that have done badly. ‘Carry’ is simply long high interest rate currencies/short low rate currencies. Hopefully you have spotted the pattern here: they are all long/short combinations.”

Proper investing requires an understanding of the exact bet(s) that you are making, and correct anticipation of the inherent risks and correlated interactivity of your holdings. This means going beyond the usual asset class categorizations, and historical correlations. For example, is a public REIT investment real estate, equity, or interest rate exposure?

For further reading on this, check out this article by Andy Redleaf of Whitebox in which he discusses the importance of isolating bets so that one does not end up owning stupid things on accident. (Ironic fact: Redleaf and Montier have butted heads in the recent past on the future direction of corporate margins.)

Leverage

“…when dealing with risk factors you are implicitly letting leverage into your investment process (i.e., the long/short nature of the risk factor). This is one of the dangers of modern portfolio theory – in the classic unconstrained mean variance optimisation, leverage is seen as costless (both in implementation and in its impact upon investors)…

…leverage is far from costless from an investor’s point of view. Leverage can never turn a bad investment into a good one, but it can turn a good investment into a bad one by transforming the temporary impairment of capital (price volatility) into the permanent impairment of capital by forcing you to sell at just the wrong time. Effectively, the most dangerous feature of leverage is that it introduces path dependency into your portfolio.

Ben Graham used to talk about two different approaches to investing: the way of pricing and the way of timing. ‘By pricing we mean the endeavour to buy stocks when they are quoted below their fair value and to sell them when they rise above such value… By timing we mean the endeavour to anticipate the action of the stock market…to sell…when the course is downward.’

Of course, when following a long-only approach with a long time horizon you have to worry only about the way of pricing. That is to say, if you buy a cheap asset and it gets cheaper, assuming you have spare capital you can always buy more, and if you don’t have more capital you can simply hold the asset. However, when you start using leverage you have to worry about the way of pricing and the way of timing. You are forced to say something about the path returns will take over time, i.e., can you survive a long/short portfolio that goes against you?”

Volatility, Leverage

“As usual, Keynes was right when he noted ‘An investor who proposes to ignore near-term market fluctuations needs greater resources for safety and must not operate on so large a scale, if at all, with borrowed money.’”

Expected Return, Intrinsic Value

“...the golden rule of investing holds: ‘no asset (or strategy) is so good that it can it be purchased irrespective of the price paid.’”

“Proponents of risk parity often say one of the benefits of their approach is to be indifferent to expected returns, as if this was something to be proud of…From our perspective, nothing could be more irresponsible for an investor to say he knows nothing about expected returns. This is akin to meeting a neurosurgeon who confesses he knows nothing about the way the brain works. Actually, I’m wrong. There is something more irresponsible than not paying attention to expected returns, and that is not paying attention to expected returns and using leverage!”

Hedging, Expected Return

“…whenever you consider insurance I’ve argued you need to ask yourself the five questions below:

1. What risk are you trying to hedge?
2. Why are you hedging?
3. How will you hedge?
• Which instruments will work?
• How much will it cost?
4. From whom will you hedge?
5. How much will you hedge?”

“This is a point I have made before with respect to insurance – it is as much a value proposition as anything else you do in investment. You want insurance when it is cheap, and you don’t want it when it is expensive.”

Trackrecord, Compounding

“…one of the myths perpetuated by our industry is that there are lots of ways to generate good long-run real returns, but we believe there is really only one: buying cheap assets.”

Klarman’s Margin of Safety: Ch.13 – Part 3

This is a continuation in our series of portfolio construction & management highlights extracted from Seth Klarman’s Margin of Safety. In Chapter 13 (Portfolio Management and Trading) - Part 3 below, Klarman shares his thoughts on a number of portfolio construction and management topics such as risk management, hedging, and correlation.

Portfolio Management, Risk

“The challenge of successfully managing an investment portfolio goes beyond making a series of good individual investment decisions. Portfolio management requires paying attention to the portfolio as a whole, taking into account diversification, possible hedging strategies, and the management of portfolio cash flow. In effect, while individual investment decisions should take risk into account, portfolio management is a further means of risk reduction for investors.”

“….good portfolio management and trading are of no use when pursuing an inappropriate investment philosophy; they are of maximum value when employed in conjunction with a value-investment approach.”

Portfolio management is a “further means” of risk management.

Cash, Liquidity, Risk, Expected Return, Opportunity Cost

“When your portfolio is completely in cash, there is no risk of loss. There is also, however, no possibility of earning a high return. The tension between earning a high return, on the one hand, and avoiding risk, on the other, can run high. The appropriate balance between illiquidity and liquidity, between seeking return and limiting risk, is never easy to determine.”

Everything in investing is a double-edged sword. See Howard Marks’ words on this same topic. 

Risk, Diversification

“Even relatively safe investments entail some probability, however small, of downside risk. The deleterious effects of such improbably events can best be mitigated through prudent diversification. The number of securities that should be owned to reduce portfolio risk to an acceptable lever is not great; as few as ten to fifteen different holdings usually suffice.”

“Diversification is potentially a Trojan horse. Junk-bond-market experts have argued vociferously that a diversified portfolio of junk bonds carries little risk. Investors who believed them substituted diversity for analysis and, what’s worse, for judgment…Diversification, after all, is not how many different things you own, but how different the things you do own are in the risks they entail.”

Awhile back, we posed an interesting question to our Readers, would you ever have a 100% NAV position (assuming you cannot lever to buy/sell anything else)? And if not, what is the cutoff amount for “excessive” concentration? 

Risk, Hedging, Expected Return

“An investor’s choice among many possible hedging strategies depends on the nature of his or her underlying holdings.”

“It is not always smart to hedge. When the available return is sufficient, for example, investors should be willing to incur risk and remain unhedged. Hedges can be expensive to buy and time-consuming to maintain, and overpaying for a hedge is as poor an idea as overpaying for an investment. When the cost is reasonable, however, a hedging strategy may allow investors to take advantage of an opportunity that otherwise would be excessively risky. In the best of all worlds, an investment that has valuable hedging properties may also be an attractive investment on its own merits.”

Correlation, Volatility

“Investors in marketable securities will not have predictable annual results, however, even if they possess shares representing fractional ownership of the same company. Moreover, attractive returns earned by Heinz may not correlate with the returns achieved by investors in Heinz; the price paid for the stock, and not just business results, determines their return.”

Different types of correlation:

• portfolio returns to indices/benchmarks
• portfolio assets/securities with each other
• price performance of assets/securities with the actual underlying operating performance

Baupost Letters: 1999

Continuation in our series on portfolio management and Seth Klarman, with ideas extracted from old Baupost Group letters. Our Readers know that we generally provide excerpts along with commentary for each topic. However, at the request of Baupost, we will not be providing any excerpts, only our interpretive summaries, for this series.

Sizing, Catalyst, Expected Return, Hurdle Rate, Cash, Hedging, Correlation, Diversification

In the 1999 letter, Klarman breaks down the portfolio, which consists of the following components:

1. Cash (~42% of NAV) – dry powder, available to take advantage of bargains if/when available
2. Public & Private Investments (~25% of NAV) – investments with strong catalysts for partial or complete realization of underlying value (bankruptcies, restructurings, liquidations, breakups, asset sales, etc.), purchased with expected return of 15-20%+, likelihood of success dependent upon outcome of each situation and less on the general stock market movement. This category is generally uncorrelated with markets.
3. Deeply Undervalued Securities – investments with no strong catalyst for value realization, purchased at discounts of 30-50% or more below estimated asset value. “No strong catalyst” doesn’t mean “no catalyst.” Many of the investments in this category had ongoing share repurchase programs and/or insider buying, but these only offered modest protection from market volatility. Therefore this category is generally correlated with markets.
4. Hedges (~1% NAV)

Often, investments are moved between category 2 and 3, as catalyst(s) emerge or disappear.

This portfolio construction approach is similar to Buffett’s approach during the Partnership days (see our 1961 Part 3 article for portfolio construction parallels). Perhaps Klarman drew inspiration from the classic Buffett letters. Or perhaps Klarman arrived at this approach independently because the “bucket” method to portfolio construction is quite logical, allowing the portfolio manager to breakdown the attributes (volatility, correlation, catalysts, underlying risks, etc.) and return contribution of each bucket to the overall portfolio.

Klarman also writes that few positions in the portfolio exceed 5% of NAV in the “recent” years around 1999. This may imply that the portfolio is relatively diversified, but does lower sizing as % of NAV truly equate to diversification? (Regular readers know from previous articles that correlation significantly impacts the level of portfolio diversification vs. concentration of a portfolio.) One could make the case that the portfolio buckets outlined above are another form of sizing – a slight twist on the usual sizing of individual ideas and securities – because the investments in each bucket may contain correlated underlying characteristics. 

Duration, Catalyst

Klarman reminds his investors that stocks are perpetuities, and have no maturity dates. However, by investing in stocks with catalysts, he creates some degree of duration in a portfolio that would otherwise have infinite duration. In other words, catalysts change the duration of equity portfolios.

Momentum

Vicious Cycle = protracted underperformance causes disappointed holder to sell, which in turn produces illiquidity and price declines, prompting greater underperformance triggering a  new wave of selling. This was true for small-cap fund managers and their holdings during 1999 as small-cap underperformed, experienced outflows, which triggered more selling and consequent underperformance. The virtuous cycle is the exact opposite of this phenomenon, where capital flows into strongly performing names & sectors.

Klarman’s commentary indirectly hints at the hypothesis that momentum is a by-product of investors’ psychological tendency to chase performance.

Risk, Psychology

Klarman writes that financial markets have been so good for so long that fear of market risk has completely evaporated, and the risk tolerance of average investors has greatly increased. People who used to invest in CDs now hold a portfolio of growth stocks. The explanation of this phenomenon lies in human nature’s inability to comprehend that we may not know everything, and an unwillingness to believe that everything can change on a dime.

This dovetails nicely with Howard Mark’s notion of the ‘perversity of risk’:

“The ultimate irony lies in the fact that the reward for taking incremental risk shrinks as more people move to take it. Thus, the market is not a static arena in which investors operate. It is responsive, shaped by investors’ own behavior. Their increasing confidence creates more that they should worry about, just as their rising fear and risk aversion combine to widen risk premiums at the same time as they reduce risk. I call this the ‘perversity of risk.’”

When To Buy, Psychology

Klarman writes that one should never be “blindly contrarian” and simply buy whatever is out of favor believing it will be restored because often investments are disfavored for good reason. It is also important to gauge the psychology of other investors – e.g., how far along is the current trend, what are the forces driving it, how much further does it have to go? Being early is synonymous to being wrong. Contrarian investors should develop an understanding of the psychology of sellers. Sourcing

When sourcing ideas, Baupost employs no rigid formulas because Klarman believes that flexibility improves one’s prospectus for returns with limited risk.

Baupost Letters: 1998

Continuation in our series on portfolio management and Seth Klarman, with ideas extracted from old Baupost Group letters. Our Readers know that we generally provide excerpts along with commentary for each topic. However, at the request of Baupost, we will not be providing any excerpts, only our interpretive summaries, for this series.

Hedging, Opportunity Cost, Correlation

Mid-fiscal year through 4/30/98, Klarman substantially increased exposure to disaster insurance (mainly out of the money U.S. equity put options + hedges against rising interest rates and currency fluctuations) because of his fear of a severe market correction and economic weakness. To maintain these hedges, Klarman stated he was willing to give up a portion of portfolio upside in return for protection against downside exposure. For fiscal year ended 10/31/98, these hedges accounted for a -2.8% performance drag.

The performance drag and mistake occurred as a result of expensive & imperfect hedges:

• cheapest areas of the market (small-cap) became cheaper (Baupost’s portfolio long positions were mainly small cap)
• most expensive areas of the market (large-cap) went to the moon (Baupost’s portfolio hedges were mostly large cap)

In assessing the performance results, Klarman stated that he did not believe he was wrong to hedge market exposures, his mistake was to use imperfect hedges, which resulted in him losing money on both his long positions and his hedges at the same time. Going forward, he would be searching for more closely correlated hedges.

In many instances, hedging is a return detractor. The trick is determining how much return you are willing to forego (premium spent and opportunity cost of that capital) in order to maintain the hedge, and how well that hedge will actually protect (or provide uncorrelated performance) when you expect it to work.

The only thing worse than foregoing return via premium spent and opportunity cost, is finding out in times of need that your hedges don’t work due to incorrect anticipation of correlation between your hedges and the exposure you are trying to hedge. That’s exactly what happened to Baupost in 1998.

Catalyst, Volatility, Expected Return, Duration

Attempting to reduce Baupost’s dependence on the equity market for future results, and the impact of equity market movement on Baupost’s results, Klarman discusses the increase of catalyst/event-driven positions (liquidations, reorganizations) within the portfolio, which are usually less dependent on the vicissitudes of the stock market for return realization.

Catalysts are a way to control volatility and better predict the expected return of portfolio holdings. Catalysts also create duration for the equity investor, such that once the catalyst occurs and returns are achieved, investors generally must find another place to redeploy the capital (or sit in cash).

Cash

Klarman called cash balances in rising markets “cement overshoes.” At mid-year 4/30/98, Baupost held ~17% of the portfolio in cash because Klarman remained confident that cash becomes more valuable as fewer and fewer investors choose to hold cash. By mid-December 1998, Baupost’s cash balance swelled to ~35% of NAV.

Risk, Opportunity Cost, Clients, Benchmark

In the face a strong bull market, Klarman cites the phenomenon of formerly risk-averse fund managers adopting the Massachusetts State Lottery slogan (“You gotta play to win”) for their investment guidelines because the biggest risk is now client firing the manager, instead of potential loss of capital.

Klarman observes the psychological reason behind this behavior: “Very few professional investors are willing to give up the joy ride of a roaring U.S. bull market to stand virtually alone against the crowd…the comfort of consensus serving as the ultimate life preserver for anyone inclined to worry about the downside. As small comfort as it may be, the fact that almost everyone will get clobbered in a market reversal makes remaining fully invested an easy relative performance decision.”

The moral of the story here: it’s not easy to stand alone against waves of public sentiment. For more on this, see Bob Rodriguez experience on the consequences of contrarian actions & behavior.

When the world is soaring, to hold large amounts of cash and spending performance units on hedges could lead to serious client-rebellion and business risk. I do not mean to imply that it’s wrong to hold cash or hedge the portfolio, merely that fund managers should be aware of possible consequences, and makes decisions accordingly.

Expected Return, Intrinsic Value

Klarman discusses how given today’s high equity market levels, future long-term returns will likely be disappointing because future returns have been accelerated into the present and recent past.

Future returns are a function of asset price vs. intrinsic value. The higher prices rise (even if you already own the asset), the lower future returns will be (assuming price is rising faster than asset intrinsic value growth). For a far more eloquent explanation, see Howard Mark’s discussion of this concept. 

Wisdom from Whitebox's Andy Redleaf

Ever experience those humbling moments when you read something and think: “Wow, this person is way smarter than me” – happens to me every single day, most recently while reading a Feb 2013 Whitebox client letter during which Andy Redleaf & Jonathan Wood devoted a refreshing amount of text to the discussion of portfolio management considerations (excerpts below). Enjoy!

Hedging, Exposure, Mistakes

“The job of the arbitrageur, as we see it, is to isolate the desired element, the desired asset claim, which in turn is usually desirable because it trades at a different price from a similar claim appearing under some other form. The purpose of a hedge in this view is not to lay off the bet but to sharpen it by isolating the desired element in a security from all the other elements in that security.

If we think about it this way, then alternative investing can be defined as owning precisely what the investor wants to own, in the purest possible form. Sadly, owning just what one wants to own is no guarantee that one will own good things rather than bad. But at least a true alternative investor has eliminated one whole set of mistakes – owning stupid things by accident. If the alternative investor owns stupid things at least he owns them on purpose.

The really bad place to be is where all too many investors find themselves much of the time, owning the wrong things by accident. They do want to own something in particular; often they want to own something quite sensible. They end up owning something else instead.”

Volatility

“Consider, for instance, the stocks of consumer staples companies. Because no one can do without staples, these stocks are often assumed to be insensitive to the economy. And because they are, on the whole, boring companies without much of a story they generally fall on the value side of the great glamour/value divide. Precisely these characteristics, however, recently have caused them to be heavily bought by safety-conscious investors so that as a group they are now priced to perfection…

Throughout markets today the most powerful recurrent theme is the inversion of risk and stability; almost universally securities traditionally regarded as safe and stable are neither. We are less confident in opining that securities traditionally regarded as speculative have now become safe. Still the thought is worth following out… Tech is traditionally thought of as speculative, but Big Tech today is not the Tech of the go-go years. These days Big Tech is mostly just another sub-sector of industrials.”

A great example for why historical volatility is not indicative of future volatility (as so many models across the finance world assume).

Volatility is driven by fundamentals and the behavioral actions of market participants – all subject to the ebb and flow of changing seasons. If fundamentals and the reasons driving behavioral actions change, then the volatility profile of securities will also change.

Diversification, Risk

“Speaking of looking for safety in all the wrong places, diversification is widely regarded as a defensive measure. This is a misunderstanding. Diversification in itself is neither defensive nor aggressive. It is a substitute for knowledge; the less one knows the more one diversifies…In our credit strategies, diversification was the watchword for 2009. We bought essentially every performing bond priced below 40 cents (an extraordinary number of such being available in that extraordinary time). We did this because collective the expected payoff on such bonds was enormous…It made no sense to pick and choose. Making fine distinctions about value in an inherently irrational situation more likely would have led us astray. In that situation diversification, rather than blunting the investment thesis, actually helped us focus on the best on the interesting factor: the market-wide loss of faith in the bankruptcy process.”

I think it's an interesting nuance that diversification itself doesn't necessarily "blunt" the potency of ideas. In certain instances, such as the one outlined above, diversification lends courage to investors to size up ideas without committing to one or two specific firms or assets.

In his 1996 letter, Seth Klarman has discussed something similar, using diversification to mitigate unfamiliarity risk by purchasing a basket of securities exposed to the same underlying thesis and opportunity set.

Diversification, Volatility, Expected Return

“The downside of a concentrated portfolio is that returns tend to be lumpy and dependent on events.”

Baupost Letters: 1997

Continuation in our series on portfolio management and Seth Klarman, with ideas extracted from old Baupost Group letters. Our Readers know that we generally provide excerpts along with commentary for each topic. However, at the request of Baupost, we will not be providing any excerpts, only our interpretive summaries, for this series.

Mandate, Trackrecord, Expected Return

For the past several years, Klarman had invested heavily into Baupost’s international efforts/infrastructure because he believed that opportunities in the U.S. marketplace were less attractive than those found abroad, due to increased competition and higher market valuations.

Did Baupost’s flexible investment mandate give it an advantage in trackrecord creation and return generation?

For example, a healthcare fund cannot start investing in utilities because the latter provides better risk-reward, whereas Baupost can invest wherever risk-reward is most attractive.

The trackrecord creation and return generation possibilities for those with more restrictive mandates are bound by the opportunities available within the mandate scope. Baupost, on the other hand, has the freedom to roam to wherever pastures are greenest.

Cash, Expected Return, Risk Free Rate

In the category of largest gains, there was a $2.2MM gain for “Yield on Cash and Cash Equivalents” which at the end of Fiscal Year 1997 (October 31, 1997) consisted of $39MM or 25.5% of NAV.

In 1997, cash earned 5-6% ($2.2MM divided by $39MM) annually, in drastic contrast to virtually nothing today. I point this out as a reminder that historically, and perhaps one day in the future, cash does not always yield zero. In fact, cash interest rates are often highest during bull markets when it’s most prudent to keep a higher cash balance as asset values increase.

For those who fear the performance drag from portfolio cash balances, or those who feel the pressure to “chase” yield in order to boost portfolio returns, this serves as a reminder that cash returns are not static throughout the course of a market cycle.

Hedging, Cash

At 10/31/97, value of “Market Hedges” was $2.0MM, or 1.4% of NAV. Hedges were also the source of his second largest loss that year, declining $2.1MM in value.

That’s a whole lot of premium bleed worth $2.0MM or ~1.5% of NAV! Interestingly, this is almost the exact gain from portfolio cash yields (see above). Coincidence?

If you believe that the phenomenon of the last 20 years will continue to hold – that interest rates will increase as the underlying economy recovers and equity markets move higher, then one can roughly use interest rates (and consequently portfolio cash yields) as a proxy to determine how much hedging premium to spend.

Theoretically, this should be a self-rebalancing process: higher cash yields in bull equity markets = more hedging premium to spend (when you need it most) vs. lower cash yields in bear equity markets = less hedging premium to spend (when you need it least).

Cash, Opportunity Cost

Klarman comments that cash provides protection in turbulent times and ammunition to take advantage of newly created opportunities, but the act of holding cash involves considerable opportunity cost in the form of foregoing attractive investments in the interim – but investors must keep in mind they cannot earn investment returns without actually investing.

After a temporary hiccup in the markets, Klarman discusses portfolio repositioning: adding to some positions while reducing or deleting others, to take advantage of the shifts in the market landscape.

It’s a delicate balance determining when to deploy capital, and when to hold it in the form of cash. You can’t run an investment management business holding cash forever – that would make you a checking account with extremely high fees.

The second point serves as an excellent reminder that the “opportunity cost” calculation involves not only the comparison between cash and a potential investment, but also between a potential investment and current portfolio holdings.

Derivatives, Leverage

Klarman held a wide variety of options and swaps in his portfolio, such as SK Telecom equity & swaps, Kookmin Bank equity and swaps, etc.

In Klarman’s writings, you’ll generally find warnings against using leverage, and equity swaps definitely constitute leverage. I wonder if the derivative swaps were a product of his interest in emerging markets. For example, perhaps Baupost was not able to trade directly in certain markets, and therefore utilized swaps to gain exposure through a counterparty authorized to trade in those countries.

When To Buy

In a market downturn, momentum investors cannot find momentum, growth investors worry about a slowdown, and technical analysts don’t like their charts.

In extreme market downside events, patterns & trends in liquidity, trading volume, sales growth, etc. – that may have existed for years – disintegrate. Therefore, investors who rely on those patterns and trends become disoriented, which then fuels and reinforces more market chaos. This is what we witnessed in 2008-2009, and the time for fundamental investors, and those with intuition and foresight, to shine.

Capital Preservation, Compounding,

Over time, by again and again avoiding loss, you have taken the first step toward achieving healthy gains.

Volatility

Toward the end of the December 1997 letter, Klarman praises his team of analysts and traders who, like himself, hate to lose money, even temporarily, for any reason at any time.

So let it be written! Klarman acknowledges that he doesn’t like to lose money, even temporarily in the form of volatility. 

36South: Profiting from the Tails

Many have read about Cornwall Capital (I wrote about them awhile back), a firm that successfully profited from shorting subprime CDS. Those who enjoyed the Cornwall Capital piece are in for a treat. Below are highlights extracted from an Eurekahedge interview with Richard Hollington of 36South, a hedge fund that also specializes in profiting from volatility and tail risk. This piece is a little longer than our usual articles. There is a lot of good commentary below on how to source, execute, size, and manage portfolio hedges. However, reading this article does not a hedging expert make. In other words, I don’t recommend trying this at home.

Hedging, Derivatives, Fat Tail, Barbell, Sizing, Expected Return, Volatility

“The underlying philosophy is that markets are rational most of the time but 5% of the time rationality gets thrown out of the window, whether because people have made money too easily and become complacent or have lost money too quickly and are so distressed that they are off-loading assets below their intrinsic worth. The emphasis of this approach is market psychology. We search for fear, greed, hysteria and mania. We sell into a bubble about to burst and buy into a post-crash recovery. Bubbles as we know, can take time to play themselves out over an extended period of time and their turning points are normally associated with high volatility. This makes the method of investing in an opportunity critical. Normally it is better to wait until the bubble is bursting as the markets tend to go a lot higher or lower than one thinks. The downside to this is that the move might be over in a short period of time.”

“Our investment methodology is to BUY ONLY long dated “out-of-the-money” options. This methodology has some excellent features…these options can return multiples of the original investment. We look for options that have the potential to return between 5 and 10 times the original investment. Because of their high reward characteristics, only 10-20% of the fund need be invested in these options to achieve our target returns of 15-25%. Our worst case loss is thus known, being the amount invested in options…Our rationale here is that one can never get killed jumping out of a basement window!”

“We zero in on…situations by using our in-house developed ‘Quadrivium’ Methodology. Quadrivium literally means where four rivers meet and a strategy which conforms to criteria required in each of the four circles in our approach will be selected to form a portion of our risk portfolio. The four criteria are used in conjunction with each other in order to ‘ensure that one reality respects all other realities’ as Charlie Munger put it so well. These criteria are:

• Volatility has already been covered. We ensure the option (using volatility as a proxy) is cheap enough to provide the leverage we require for the level of risk.
• The next criterion is to look at the technical picture of the market to seek confirmation that there is potential for market movement to the extent and in the direction that we require to attain a multiple return on the option price.
• The next criterion is fundamentals in that market/asset/option to corroborate our view. We have developed a framework of economic indicators that we monitor in each of the markets we have selected to trade. We are specifically looking for flaws in the structure of markets which are caused by government policy and supply demand imbalances.
• The next step in the process is based on the sentiment prevailing in the market that we wish to trade. Sentiment often becomes deeply entrenched at market tops and bottoms to the extent that supporters of the status quo can become aggressive in defense of their beliefs. In order to gauge the prevailing sentiment in the market we use Internet searches for key words and couple this with feedback obtained from diverse media coverage. These media opinions can reflect ‘irrational exuberance’ or deep-seated pessimism on a particular stock, index, commodity or currency. These quotations from seasoned professionals in the financial markets encapsulate the essence of this driver of our trading philosophy.”

“Since we know exactly what the current option portfolio is worth we can safely say that this is the absolute worst-case meltdown in the fund based on market risk. This would be an extremely unlikely scenario because long dated options always have some time value and it would mean all positions have moved against us in all asset markets and volatilities have collapsed at the same time. We manage each option on a stop-loss methodology. The stop-loss is based on the number of times the initial option premium multiplies. The first stop is instituted when the option premium has increased three fold. At this level a 60% stop on the option price is registered. As it moves to four times, the stop is tightened to 50% and so on until a maximum of eight times when the stop will be 10%. At this point in time the option has earned the right to discretionary stop-loss status as long as it does not hit the 10% in place. A profit target is then calculated which is based on a three standard deviation move above the 200-day moving average. We will also sell options which have only a year to run if they have not achieved the minimum 3-fold increase and are still worth something.”

Howard Marks' Book: Chapter 7

Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 7 “The Most Important Thing Is…Recognizing Risk” Risk, Capital Preservation, Compounding

“…Warren Buffett, Peter Lynch, Bill Miller and Julian Robertson. In general their records are remarkable because of their decades of consistency and absence of disasters, not just their high returns.”

“How do you enjoy the full gain in up markets while simultaneously being positioned to achieve superior performance in down markets? By capturing the up-market gain while bearing below-market risk…no mean feat.”

“The road to long-term investment success runs through risk control more than through aggressiveness. Over a full career, most investors’ results will be determined more by how many losers they have, and how bad they are, than by the greatness of their winners.”

The resilient yet participatory portfolio (this term was stolen from a very smart man named Ted Lucas at Lattice Strategies in San Francisco) – a rare creature not easily found. We know it exists because a legendary few, such as those listed above, have found it before. How to find it for ourselves remains the ever perplexing question.

Our regular Readers know that we’re obsessed with the complementary relationship between capital preservation and compounding. For more on this, be sure to check out commentary from Stanley Druckenmiller and Warren Buffett – yes, two very different investors.

Conservatism, Hedging

“Since usually there are more good years in the markets than bad years, and since it takes bad years for the value of risk control to become evident in reduced losses, the cost of risk control – in the form of return foregone – can seem excessive. In good years in the market, risk-conscious investors must content themselves with the knowledge that they benefited from its presence in the portfolio, even though it wasn’t needed…the fruits…come only in the form of losses that don’t happen.”

People talk a lot about mitigating risk in the form of hedging. But what about remaining conservatively positioned (such as having more cash) and incurring the cost of lower portfolio returns? Isn’t the “return foregone” in this case akin to hedging premium?

Conservatism, Fat Tail

“It’s easy to say that they should have made more conservative assumptions. But how conservative? You can’t run a business on the basis of worst-case assumptions. You won’t be able to do anything. And anyway, a ‘worst-case assumption’ is really a misnomer; there’s no such thing, short of a total loss…once you grant that such a decline can happen – for the first time – what extent should you prepare for? Two percent? Ten? Fifty?”

“Even if we realize that unusual, unlikely things can happen, in order to act we make reasoned decisions and knowingly accept that risk when well paid to do so. Once in a while, a ‘black swan’ will materialize. But if in the future we always said, ‘We can’t do such-and-such, because the outcome could be worse than we’ve ever seen before,” we’d be frozen in inaction.

So in most things, you can’t prepare for the worst case. It should suffice to be prepared for once-in-a-generation events. But a generation isn’t forever, and there will be times when that standard is exceeded. What do you do about that? I’ve mused in the past about how much one should devote to preparing for the unlikely disaster. Among other things, the events of 2007-2008 prove there’s no easy answer.”

Risk, Making Mistakes, Process Over Outcome

“High absolute return is much more recognizable and titillating than superior risk-adjusted performance. That’s why it’s high-returning investors who get their pictures in the papers. Since it’s hard to gauge risk and risk-adjusted performance (even after the fact), and since the importance of managing risk is widely underappreciated, investors rarely gain recognition for having done a great job in this regard. That’s especially true in good times.”

“Risk – the possibility of loss – is not observable. What is observable is loss, and generally happens only when risk collides with negative events…loss is what happens when risk meets adversity. Risk is the potential for loss if things go wrong. As long as things go well, loss does not arise. Risk gives rise to loss only when negative events occur in the environment.”

“…the absence of loss does not necessarily mean the portfolio was safely constructed…A good builder is able to avoid construction flaws, while a poor builder incorporates construction flaws. When there are no earthquakes, you can’t tell the difference…That’s what’s behind Warren Buffett’s observation that other than when the tide goes out, we can’t tell which swimmers are clothed and which are naked.”

Good risk management = implementing prevention measures.

Once planted, the seeds of risk can remain dormant for years. Whether or not they sprout into loss depends on the environment and its conditions.

In other words, mistakes that result in losses are often made long before losses occur. Although loss was not the ultimate outcome does not mean mistakes were not made.

Baupost Letters: 1996

Continuation in our series on portfolio management and Seth Klarman, with ideas extracted from old Baupost Group letters. Our Readers know that we generally provide excerpts along with commentary for each topic. However, at the request of Baupost, we will not be providing any excerpts, only our interpretive summaries, for this series.

Risk, Sizing, Diversification, Psychology

In 1996, Baupost had a number of investments in the former Soviet Union. Klarman managed the higher level of risk of these investments by limiting position sizing such that if the total investment went to zero, it would not have a materially adverse impact on the future of the fund.

“Unfamiliarity” is a risk for any new investment. Klarman approaches new investments timidly to ensure that there isn’t anything that he’s missing. He does so by controlling sizing and sometimes diversifying across a number of securities within the same opportunity set.

Baupost mitigates risk (partially) by:

• Sizing slowly and diversifying with basket approach (at least initially)
• Balancing arrogance with humility. Always be aware of why an investment is available at a bargain price, and your opinion vs. the market. Investing is a zero-sum game, and each time you make a purchase, you’re effectively saying the seller is wrong.

Reading in between the lines, the Russian investments must have held incredibly high payoff potential (in order to justify the amount of time and effort spent on diligence). Smaller position sizing may decrease risk but it also decreases the potential return contribution to the overall portfolio.

Interestingly, this method of balancing risk and return through position sizing and diversification is more akin to venture capital than the traditional value school. For example, recently, investors have been buzzing about a number of Klarman’s biotech equity positions (found on his 13F filing). I’ve heard through the grapevine that these investments were structured like a venture portfolio – the expectation is that some may crash to zero, while some may return many multiples the original investment. Therefore, those copying Klarman’s purchases should proceed with caution, especially given Klarman’s history of making private investments not disclosed on 13F filings.

Diversification

Klarman believes in sufficient but not excessive diversification.

This may explain the rationale behind why Klarman has been known to purchase baskets of individual securities for the same underlying bet – see venture portfolio discussion above.

Correlation, Risk

Always cognizant of whether seemingly different investments are actually the same bet to avoid risk of concentrated exposures.

Mandate, Trackrecord

Baupost has a flexible investment mandate, to go anywhere across asset classes, capital structure, geographies, etc., which allows it to differentiate from the investment fund masses. Opportunities in different markets happen at different times, key is to remain adaptive and ready for opportunity sets when they become available.

The flexible mandate is helpful in smoothing the return stream of the portfolio, and consequently, the trackrecord. Baupost can deploy capital to where opportunities are available in the marketplace, therefore ensuring a (theoretically) steadier stream of future return potential. This is in contrast to funds that cannot take advantage of opportunities outside of their limited mandate zones.

Liquidity

Klarman is willing to accept illiquidity for incremental return.

This makes total sense, but the tricky part is matching portfolio sources (client time horizon, level of patience, and fund redemption terms) with uses (liquidity profile of investments). Illiquidity should not be accept lightly, and has been known to cause problems for even the most savvy of investors (for example: see 2003 NYTimes article on how illiquidity almost destroyed Bill Ackman & David Berkowitz in the early stages of their careers).

Patience

For international exposure [Russia], Baupost spent 7 years immersed in research, studying markets, meeting with managements, making toe-hold investments to observe, hired additional members of investment team (sent a few analysts to former Soviet Union, on the ground, for several months) to network & build foreign sell-side & counterparty relationships.

Selectivity, Cash

Buy securities if available at attractive prices. Sell when securities no longer cheap. Go to cash when no opportunities are available.

We’ve discussed the concept of selectivity standards in the past, and whether these standards shift in different market environments. For Klarman, it would seem his selectivity standards remained absolute regardless of market environment.

Hedging

Baupost will always hedge against catastrophic or sustained downward movement in the market. This can be expensive over time, but will persist and remains part of investment strategy.

Klarman embedded hedging as an integrated “process” that’s part of the overall investment strategy. This way, Baupost is more likely to continue buying hedges even after years of premium bleed. This also avoids “giving up” just as disaster is about to hit. For more on this topic, be sure to check out the AQR tail risk hedging piece we showcased a few months ago.

Buffett Partnership Letters: 1964 Part 3

Continuation of our series on portfolio management and the Buffett Partnership Letters, please see our previous articles for more details. Historical Performance Analysis, Process Over Outcome, Psychology

“…the workouts (along with controls) saved the day in 1962, and if we had been light in this category that year, our final results would have been much poorer, although still quite respectable considering market conditions during the year…In 1963 we had one sensational workout which greatly influenced results, and generals gave a good account of themselves, resulting in a banner year. If workouts had been normal, (say, more like 1962) we would have looked much poorer compared to the Dow…Finally, in 1964 workouts were a big drag on performance.”

There is a chart in the January 18, 1965 partnership letter, in which Buffett breaks down the performance of Generals vs. Workouts for 1962-1964, and discusses the return attribution of each category in different market environments.

Most investors conduct some form of historical performance review, on a quarterly or annual basis. It’s an important exercise for a variety of reasons:

• To better understand your sources of historical return – performance analysis forces you to examine the relationship between your process vs. the outcome. Was the outcome as expected? If not, do changes need to be made to the process?
• To help you and your team become more self-aware – what you do well, badly, and perhaps reveal patterns of behavioral strength and weakness (here's an article about an interesting firm that offers this analysis)
• Team Compensation
• Highlight necessary adjustment to the portfolio and business
• Etc.

The investment management world spends a lot of time scrutinizing the operations of other businesses. Shouldn’t we apply the same magnifying glass to our own?

Sizing, Catalyst, Hedging, Activism, Control

“What we really like to see in situations like the three mentioned above is a condition where the company is making substantial progress in terms of improving earnings, increasing asset values, etc., but where the market price of the stock is doing very little while we continue to acquire it…Such activity should usually result in either appreciation of market prices from external factors or the acquisition by us of a controlling position in a business at a bargain price. Either alternative suits me.”

“Many times…we have the desirable ‘two strings to our box’ situation where we should either achieve appreciation of market prices from external factors or from the acquisition of control positions in a business at a bargain price. While the former happens in the overwhelming majority of cases, the latter represents an insurance policy most investment operations don’t have.”

Buffett discusses the phenomenon known as the “two strings” on his bow which allowed for heavy concentration in a few positions. The potential to (eventually) acquire a controlling stake in the underlying company served has an “insurance policy” via the creation of a catalyst after asserting control. (Some may argue that activism is applicable here as well. However, we tread cautiously on this train of thought because activism by no means entails a 100% success rate.)

It’s important to understand that control is not an option available to all investors. Therefore, when sizing positions, one should reconsider the exact emulation of Buffett’s enthusiastic buying as price continues to decline, and concentrated approach.

Interestingly, if a controlling stake in a company serves as an insurance policy (as Buffett describes it), is ‘control’ a type of portfolio hedge?

Activism, Control

“We have continued to enlarge the positions in the three companies described in our 1964 midyear report where we are the largest stockholders…It is unlikely that we will ever take a really active part in policy-making in any of these three companies…”

Control ≠ Activism

Conservatism

“To too many people conventionality is indistinguishable from conservatism. In my view, this represents erroneous thinking. Neither a conventional or an unconventional approach, per se, is conservative.”

“Truly conservative actions arise from intelligent hypotheses, correct facts and sound reasoning. These qualities may lead to conventional acts, but there have been many times when they have led to unorthodoxy. In some corner of the world they are probably still holding regular meetings of the Flat Earth Society.”

“We derive no comfort because important people, vocal people, or great numbers of people agree with us. Nor do we derive comfort if they don’t. A public opinion poll is no substitute for thought. When we really sit back with a smile on our face is when we run into a situation we can understand, where the facts are ascertainable and clear, and the course of action obvious. In that case – whether conventional or unconventional – whether others agree or disagree – we feel we are progressing in a conservative manner.”

More Baupost Wisdom

Before my November vacation, I will leave you with a juicy Baupost piece compiled through various sources that shall remain confidential. Instead of the usual excerpts or quotes, below are summaries of ideas and concepts. Creativity, Making Mistakes

• False precision is dangerous. Klarman doesn’t believe that a computer can be programmed to invest the way Baupost does. (Does this mean their research, portfolio monitoring, and risk management process does not involve computers? Come to think of it, that would be pretty cool. Although it would make some administrative tasks more difficult, are computers truly necessary for the value-oriented fundamental investor?)
• Investing is a highly creative process, that’s constantly changing and requiring adaptations
• One must maintain flexibility and intellectual honesty in order to realize when a mistake has been made, and calibrate accordingly
• Mistakes are also when you’re not aware of possible investment opportunities because this means the sourcing/prioritization process is not optimal

When To Buy, Conservatism, Barbell

• Crisis reflection – they invested too conservatively, mainly safer lower return assets (that would have been money good in extremely draconian scenarios). Instead, should have taken a barbell approach and invested at least a small portion of the portfolio into assets with extremely asymmetric payoffs (zero vs. many multiples)

When To Buy, Portfolio Review

• They are re-buying the portfolio each day – an expression that you’ve undoubtedly heard from others as well. It’s a helpful concept that is sometimes forgotten. Forces you to objectively re-evaluate the existing portfolio with a fresh perspective, and detachment from any existing biases, etc.

Risk

• They try to figure out how “risk is priced”
• Risk is always viewed on an absolute basis, never relative basis
• Best risk control is finding good investments

Hedging

• Hedges can be expensive. From previous firm letters, we know that Baupost has historically sought cheap, asymmetric hedges when available. The takeaway from this is that Baupost is price sensitive when it comes to hedging and will only hedge selectively, not perpetually
• Prefer to own investments that don’t require hedges, there is no such thing as a perfect hedge
• Bad hedges could make you lose more than notional of original investment

Hedging, Sizing

• In certain environments, there are no cheap hedges, other solution is just to limit position sizing

Cash, AUM

• Ability to hold cash is a competitive advantage. Baupost is willing to hold up to 50% cash when attractive opportunities are not available
• The cash balance is calculated net of future commitments, liabilities, and other claims. This is the most conservative way.
• Reference to “right-sizing” the business in terms of AUM. They think actively about the relationship between Cash, AUM, and potentially returning capital to investors.

Returning Capital, Sizing

• Returning capital sounds simplistic enough, but in reality it’s quite a delicate dance. For example, if return cash worth 25% of portfolio, then capital base just shrank and all existing positions inadvertently become larger % of NAV.

Leverage

• Will take on leverage for real estate, especially if it is cheap and non-recourse

Selectivity

• Only 1-2% of deals/ideas looked at ultimately purchased for portfolio (note: not sure if this figure is real estate specific)

Time Management, Sizing

• Intelligent allocation of time and resources is important. It doesn’t make sense to spend a majority of your (or team’s) time on positions that end up only occupying 30-50bps of the portfolio
• Negative PR battles impact not only reputation, they also take up a lot of time – better to avoid those types of deals
• Klarman makes a distinction between marketing operations (on which he spends very little time) and investment operations (on which he spend more time).

Team Management

• There is a weekly meeting between the public and private group to share intelligence and resources – an asset is an asset, can be accessed via or public or private markets – doesn’t make sense to put up wall between public vs. private.
• Every investment professional is a generalist and assigned to best opportunity – no specialization or group barriers.
• Culture! Culture! Culture! Focus on mutual respect, upward promotion available to those who are talented, and alignment of interest
• Baupost has employees who were there for years before finally making a large investment – key is they don’t mind cost of keeping talented people with long-term payoff focus
• Succession planning is very important (especially in light of recent Herb Wagner departure announcement)
• The most conservative avenue is adopted when there is a decision disagreement
• They have a team of people focused on transaction structuring

Trackrecord

• Baupost invests focusing on superior long-term returns, not the goal of ending each year with a positive return. We have talked about this before, in relation to Bill Miller’s trackrecord – despite having little logical rationale, an investor’s performance aptitude is often measured by calendar year end return periods. Here, Klarman has drawn a line in the sand, effective saying he refuses to play the calendar year game

Sourcing

• Differentiated sourcing creates opportunities via better pricing, less competition, etc. Learned from Michael Price (or perhaps Max Heine’s playbook) – focused on differentiated sourcing, something that public investors generally don’t think about.

Wisdom from Steve Romick: Part 2

Continuation of content extracted from an interview with Steve Romick of First Pacific Advisors (Newsletter Fall 2010) published by Columbia Business School. Please see Part 1 for more details on this series.  

Capital Preservation, Conservatism

“Most of our financial exposure is on the debt side. We were able to buy loans with very strong collateral, which we thought we understood reasonably well, and we stress tested the portfolios to determine what our asset coverage would be in a worst case scenario. We ended up buying things like Ford Credit of Europe, CIT, American General Finance, and International Lease Finance. We discounted the underlying assets tremendously, and in every case we didn‘t think we could lose money so we just kept buying.”

“The biggest lesson I ever learned from Bob is to prepare for the worst and hope for the best.”

Underwriting to an extremely conservative, worst case scenario helps minimize loss while increasingly likelihood of upside. This is similar to advice given by Seth Klarman in a previous interview with Jason Zweig.

Exposure, Intrinsic Value

“A lot of that has been culled back. The yield on our debt book was 23% last year and now it‘s less than 8%.”

The relationship between exposure and intrinsic value has been something we’ve previous discussed, nevertheless it remains an intriguingly difficult topic. Even Buffett ruminated over this in 1958 without providing a clear answer to what he would do.

For example:

Day 1 Asset 1 purchase for $100 Asset 1 is sized at 10% of total portfolio NAV Expected Upside is $200 (+100% from Day 1 price) Expected Downside is $80 (-20% from Day 1 price) Everything else in the portfolio is held as Cash which returns 0%

Day 2 Asset 1’s price increases to $175 Asset 1 is now worth 16.2% of total portfolio NAV (remember, everything else is held as Cash) Expected Upside is now +14.2% ($175 vs. $200) Expected Downside is now -54.2% ($175 vs. $80)

What would you do?

Not only has the risk/reward on Asset 1 changed (+14.2% to -54.2% on Day 2 vs. +100% to -20% on Day 1), it is now also worth a larger percentage of portfolio NAV (16.2% on Day 2 vs. 10.0% on Day 1)

Do you trim the exposure despite the price of Asset 1 not having reached its full expected intrinsic value of $200?

Steve Romick’s words seem to imply that he trimmed his exposure as the positions increased in value.

Risk, Hedging

“You can protect against certain types of risk, not just by hedging your portfolio, but by choosing to buy certain types of companies versus others.”

Practice risk “prevention” by choosing not to buy certain exposures, versus neutralizing risks that have already leaked into the portfolio via hedges (which require additional attention, not to mention option premium).

Baupost Letters: 1995

Here is the first installment of a series on portfolio management and Seth Klarman, with ideas extracted from old Baupost Group letters. Our Readers know that we generally provide excerpts along with commentary for each topic. However, at the request of Baupost, we will not be providing any excerpts for this series.

When To Buy, Risk

In a previous article on The Pensioner in Steve Drobny’s book Invisible Hands, we discussed how most people analyze risk as an afterthought once a portfolio has been constructed (whether by identifying factors, or by analyzing the resulting return stream), and not usually as an input at the beginning of the portfolio construction process.

Klarman’s discusses how risk can slip into the portfolio through the buying process, for example, when investors purchase securities too soon and that security continues to decline in price.

This would support the idea of controlling risk at the start, not just the end. To take this notion further, if risk can sneak in through the buying process, can it also do so during the diligence process, the fundraising process (certain types of client, firm liquidity risk), etc.?

Benchmark, Conservatism, Clients

Baupost is focused on absolute, not relative performance against the S&P 500.

Similar to what Buffett says about conservatism, Klarman believes that the true test for investors occurs during severe down markets. Unfortunately, the cost of this conservatism necessary to avoid losses during these difficult times is underperformance during market rallies.

Klarman also deftly sets the ground rules and client expectations, such that if they did not agree with his philosophy of conservatism and underperformance during bull markets, they were more than welcomed to take their money and put it with index funds.

Selectivity, Cash

We’ve discussed in the past the concept of selectivity– a mental process that occurs within the mind of each investor, and that our selectivity criteria could creep in either direction (more strict or lax) with market movements.

Klarman is known for his comfort with holding cash when he cannot find good enough ideas. This would imply that his level of selectivity does not shift much with market movements.

The question then follows: how does one ensure that selectivity stays constant? This is easily said in theory, but actual implementation is far more difficult, especially when one is working with a large team.

Catalyst, Volatility, Special Situations

Following in the tradition of Max Heine and Michael Price, Klarman invested in special situations / catalyst driven positions, such as bankruptcies, liquidations, restructurings, tender offers, spinoffs, etc.

He recognized the impact of these securities on portfolio volatility, both the good (cushioning portfolio returns during market declines by decoupling portfolio returns from overall market direction) and the bad (relative underperformance in bull markets).

Hedging

Many people made money hedging in 2008. In the true spirit of performance chasing, hedging remains ever popular today, 4 years removed from the heart of financial crisis.

Hopefully, our Readers have read our previous article on hedging, and the warnings from other well-known investors (such as AQR and GMO) to approach with caution. I believe that hedging holds an important place in the portfolio management process, but investors should hold no illusion that hedging is ever profitable.

For example, even the great Seth Klarman has lost money on portfolio hedges. However, he continues to hedges with out-of-the-money put options to protect himself from market declines.

The moral of the story: be sure to carefully consider the purpose of hedges and the eventual implementation process, especially in the context of the entire portfolio as a whole.

Wisdom from David E. Shaw: Part 2

Here is Part 2 of our summary (focused on portfolio management tid bits, of course) of an interview with David E. Shaw in Peter J. Tanous’ book Investment Gurus. For additional background and context, please see Part 1.  

Risk, Hedging

“The purpose of a portfolio optimizer is to trade off risk and return in some predefined way, and to try to come up with a portfolio that’s close as possible to optimal in terms of those risk/return criteria…The optimizer knows things like transaction costs, the hedging of various risk factors…So it constructs a portfolio that is nearly optimal with respect to some risk/reward criterion, and then it modifies it continuously as new data come in…As an example of what such a program might do, the optimizer might find that one security looks under-priced relative to all these other different instruments, but if I actually bought that security, then I would have to much exposure to automobile stocks, and I would also tend to be short interest rates. I might also be making an implicit bet on economic cyclicality, and if the economy started to go bad, I might lose money that way.”

“…in practice you never really look at an isolated trade. You have to look at the whole universe. We use an optimizer that takes into consideration all the factors we know about…both for predicting profit and also for minimizing various sorts of risk. That doesn’t mean eliminating them. It’s the sort of thing you were describing, where you analyze the influences on a given stock, get information on all of the related stocks, bonds, options and so forth, and then construct a portfolio that tries to get as many of those risk factors as possible to cancel out. But it doesn’t happen in a simple way. Everything relates to everything else.”

The Optimizer is a computer software/algorithm programmed to understand the relationship between risk and return. How those terms and that relationship is defined, remains a mystery. Shaw is very secretive about their process. Nevertheless, the computer constructs the portfolio based on certain risk/reward factors – an idea akin to how fundamental human investors approach portfolio construction.

No (wo)man is an island. Similarly, no risk is an island. In the integrated world of today’s market economy, all risks are related in some way, which makes identification and hedging of risk factors an extremely difficult and delicate task. To “simplify” this process, Shaw talks about getting “as many of those risk factors as possible to cancel out” thus hopefully decreasing the number of transactions necessary to implement a hedging program and thus lowering associated costs as well.

Discount Rate, Opportunity Cost

“…the optimizer also knows about the cost of capital, and it’s not likely to get very excited about something that would tie up a lot of capital for a long period of time.”

What exactly constitutes the discount rate or cost of capital? For companies, it’s the weighted average cost of capital (WACC). One could argue that the calculation of this figure is quite fuzzy, especially with the presence of equity in the capital base. And moving further along the complexity scale, what is the cost of capital for (unlevered) investors?

If we removed from our minds the WACC formula carved deep from years of textbook finance training, the concept of cost of capital becomes quite interesting to think about.

Shaw references how The Optimizer associates the cost of capital with time. Based on traditional finance theory, this is because investors have a time preference of receiving cash today vs. tomorrow, and thus need to be compensated for the time delay. Traditionally, the risk-free-rate is used as the compensation figure. However, if we use the risk-free-rate, how then do you calculate the cost of capital for a portfolio of various international assets (where the risk-free-rate of the underlying holdings varies by country)? Do you take into account the effect of currency fluctuations for each country?

I have also heard some people reference the cost of capital as an opportunity cost figure. If so, does it change based on available returns provided by other opportunities? But if the cost of capital is a relative figure, how then do we calculate the cost of capital for those other investments? It becomes a rather recursive process…

However intangible, and regardless of differing definitions and calculation methodologies for the cost of capital, it is still a very real and necessary consideration in the investment, and portfolio management process. Stay tuned for some juicy bits on discount rate / cost of capital from Seth Klarman.

James Montier on Tail Risk Hedging

James Montier always provides a wonderful blend of value and behavioral principles, as well as humor in his written work. His books (I'm the proud owner of a signed copy of Value Investing) and articles are always worthwhile reads (and available for free on the GMO website once you create an account). Here is a tail risk hedging article Montier wrote in June 2011 (around the same time AQR published another piece on tail risk hedging – see our previous post on the AQR piece).

A year later, tail risk hedging remains popular. As Montier astutely points out, “The very popularity of the tail risk protection alone should spell caution for investors.” Nevertheless, he gives some practical advice on how to approach with caution, including:

1. “Define your term.” – what exactly are you trying to hedge?
2. Once defined, consider locating alternatives to “hedging” that could help achieve the same result. Montier gives a few examples of how to “hedge” the illiquidity/drawdown risk we experienced in 2008 without actually buying hedges.
3. If buying insurance is the best course of action, be sure to calculate the expected return vs. the cost of insurance. This may require forward looking predictions on how certain existing securities/assets in portfolio will do in a tail event.
4. Last but not least, the most difficult part: getting the timing right.

I will add the following remark skimmed from a previous PIMCO discussion. Be sure to consider your benchmark before indulging in tail risk hedging products. In certain instances, the annual premium of these insurance contracts may be greater than what you can afford. For example, in today’s environment, foundations aiming to achieve CPI + 500 via relatively senior fixed income securities may find it difficult to sacrifice a couple hundred basis points of performance to hedging premium.