On April 17, Nassim Nicholas Taleb, the famous Black Swan author and provocateur, took to Twitter to call out the then-chief investment officer of the California Public Employees’ Retirement System for “B.S.” In a four-minute video recorded in a sunny room in his Atlanta home, Taleb claimed that CalPERS’ Ben Meng had “offered extremely unrigorous rebuttals about tail-risk hedging.” In its most basic form, tail-risk hedging is designed to protect investors against extremely rare events — or black swans. Taleb is an outside adviser (technically a “distinguished scientific adviser”) to Universa, but doesn’t manage any investments for the firm.
Two days before in a webcast, Meng had defended his now-infamous October 2019 decision to end a tail-risk hedging program, which Universa Investments anchored, shortly before it would have generated about $1 billion in gains in the March market crash. The badly timed move was immortalized in scores of headlines in the financial and local press. Taleb and Universa founder Mark Spitznagel started the first tail-risk hedge fund in 1999.
Meng started unraveling the initiative of his predecessor, Ted Eliopoulos, almost immediately after joining CalPERS in January 2019. He never talked to or emailed anybody at Universa about the inner workings of the strategies or his decision to abandon the hedge. He told people at the pension plan that he decided to fire Universa and another tail-risk manager because they were too costly. Meng, like many finance professionals, also never understood tail hedging, multiple sources claim. He stepped down in August and could not be reached for comment. In an emailed statement, a CalPERS spokesperson said, “The risk-mitigation strategies CalPERS put in place offset $11 billion in losses during the most volatile time period in February and March.”
Meng publicly attributed his decision to kill the tail hedges to their high cost, their lack of scalability, and the availability of better alternatives. He said the pension plan had other hedges in place and relied on traditional diversification.
Taleb countered that with an argument that is essentially the central argument of tail hedging and risk mitigation. Meng didn’t tell viewers of the webcast what the hedging strategy cost the plan in previous years. “I don’t know if you realize that these strategies need to be weighed against what they made or lost before that,” Taleb said. “Effectively, we think, back-of-the-envelope calculation, the so-called mitigating strategy would have lost something like $30 billion the previous year. So you make $11 billion, you lose $30 billion before, not a great trade. It’s definitely not a great trade over long periods of time, when you lose in rallies and make back a little bit in the selloff,” he said.
Taleb believes that the same flawed logic is why investors lose billions of their savings every year. They’re relying on strategies like diversification that the financial industry has long peddled to protect investors’ downside. But adding assets such as bonds, or even gold, costs investors in bull markets, without fully cushioning portfolios in a crisis.
Taleb says, “What Universa is doing is allowing people to stay in the game long enough to gather alpha. It’s not a luxury. It is a necessity,” he says in an interview. “How many people in the United States own a house without insurance on the house? The way they [critics of tail hedging] look at it, you won’t buy a house if the insurance is expensive. No, you would buy a smaller house. Insurance is not an option.”
“I’m not that emotional of a person, contrary to what it appears,” says Taleb, who is famous for social media outbursts. “But when I see some B.S., I get aggressive.”
Pension funds’ first line of defense against crashes is diversification away from stocks into bonds and other assets. Second, they can opt for products or strategies like trend-following commodity trading advisers or gold. Ron Lagnado, who led the implementation of the tail hedge at CalPERS and is now the director of research at Universa, says, “I’ve written on the failure of diversification. With each big drawdown in the stock market, we see less and less protection coming from bonds. One of the reasons that pensions are so poorly funded is they have maintained such large allocations to bonds and other forms of risk mitigation, which are a drag on performance.”
Former CalPERS chief Eliopoulos, who is now at Morgan Stanley, brought in the tail hedge after hearing Taleb speak, according to sources. He did not want a repeat of CalPERS’ experience in 2008-09, when the pension was forced to sell stocks at the bottom. The pension’s funding ratio never recovered.
Eliopoulos and his team at CalPERS started talking to Universa in 2016, around the U.S. election. Everyone, not just CalPERS, was concerned about the risk to stocks, given the long-running bull market. The pension had already sold about $15 billion worth of shares ahead of the November election and was considering one or two more sales to reduce risk.
But the investment strategy group also started researching tail hedging to protect against a stock crash. By August 2017, CalPERS had implemented a pilot program, with Universa, LongTail Alpha, and some internal tail-hedge investments. The pension was the largest ever to deploy a tail hedge. The hedge was initially designed to protect about $5 billion in equities, with several planned increases that would have ultimately shielded about 10 percent of the stock portfolio.
When markets are up, a pension fund would pay a small fee to Universa and the other managers, just like insurance. But most CIOs — including Eliopoulos — aren’t in the job long enough to see a tail hedge through, and few want to defend any excess costs to their boards.
Lagnado gets upset thinking about Meng’s defense of conventional diversification as less costly than Universa’s options-based risk mitigation.
In an internal Universa document that ended up getting leaked to the press in April, Lagnado argued that CalPERS was essentially using a conventional 60-40 portfolio for risk mitigation, with 60 percent of the assets invested in the S&P 500 and 40 percent invested in the Barclays U.S. Aggregate Bond Index. Universa calculated that over the 12-year period, the compound annual growth rate trailed an all-stock portfolio by 1 percent per year and 11.3 percent cumulatively. That’s not risk mitigation, he explained.
From his home in northern Michigan, Spitznagel says the misunderstanding about tail hedging — a name he says he has come to hate because it’s been co-opted by marketers — comes down to simple concepts.
Tail-risk hedging, or risk mitigation, as Spitznagel prefers to call it, should raise an investor’s wealth. “That seems obvious. You would think the name of the game is to raise wealth,” he says. I first met Spitznagel and Brandon Yarckin, Universa’s chief operating officer, at the Plaza Hotel in Manhattan in January, before Covid-19 shut down the city. On the phone, Spitznagel starts talking faster and louder as he rattles off his points about conventional wisdom in the industry.
Modern finance offers up strategies like diversification, which lowers people’s wealth, he says. “And it does that very, very well. That’s a definitive statement. Even the most successful proponents of diversification, like Ray Dalio, openly say that it lowers your returns. But the argument is that it smooths your ride, even if it makes you poorer at the end of the day.” A portfolio made up of many different types of investments will weather different markets. One investment — say, real estate — will do well, even as another asset declines in value.
But it’s the big losses that matter when it comes to compounding. “That’s not my opinion; it’s not even an empirical observation. This is a mathematical fact,” Spitznagel says. “That is tail hedging. People don’t understand any of that. It flies in the face of everything we’ve been taught.”
A former hedge fund manager who declined to be named agrees with Universa’s founder. “Yep, the entire hedge fund industry is predicated on lowering the volatility of investors’ portfolios. No one will say this out loud, but what’s the point of that? It lowers the psychological pain during a crash, but it doesn’t maximize wealth. It’s a crude solution.” The hedge fund manager says all risk-mitigation strategies rely on some kind of diversification, negative risk correlations, or market timing.
Spitznagel gets wound up and almost shouts into the phone when talking about hedge funds. “Risk mitigation should raise your returns. But no one will come up with that.”
Spitznagel won’t talk about performance because of compliance reasons, but he says Universa has proved itself through two crises and multiple mini-downturns since 2007. Although Universa generated a 4,144 percent return in the first quarter of 2020, it’s the overall portfolio effect that matters more, according to a client letter obtained by II. The portfolio effect is the impact it has on the compound annual growth rate (CAGR) of an investor’s entire portfolio.
In March 2020, a hypothetical portfolio with 3.33 percent in the Universa tail-risk strategy and 96.67 percent in the Standard & Poor’s 500 stock index had a CAGR of 0.4 percent. The S&P 500 is a proxy the firm uses for the systematic risk the investor is mitigating.
The S&P 500 had declined 12.4 percent as of the end of March. Since the end of 2019, Universa’s hypothetical portfolio has returned 16.2 percent, compared with the S&P’s 4.5 percent. Most telling, the portfolio has gained 11.5 percent per year since inception in March 2008. The S&P has returned 7.9 percent per year over the same period. According to an audited performance statement from a source close to the firm, Universa’s life-to-date average annual return on invested capital across all Black Swan Protection Protocol funds from January 1, 2008, to December 31, 2019, was 105.2 percent.
But tail-hedging products remain devilishly difficult to sell.
Karyn Williams, founder of consultant Hightree Advisors and former CIO of Farmers Insurance, says, “What do people see with a tail hedge? They see a line item, and that line item looks like a drag on performance for most of its productive life. You don’t always see a return, but you do see this cost associated with it. If you’re the CIO, you want more returns, not less.”
Williams adds that some tail-hedge managers have even changed their underlying processes to reduce this cost or even show returns in up markets. “It’s because of the pressure of being a line item that sticks out every quarter like sore thumb.”
That’s how he describes his experience with his mentor, Everett Klipp, as a teenager in the Chicago trading pits. Spitznagel’s father brought him down to the floor in the 1980s to meet Klipp, a family friend. “I was mesmerized. I was 16 and I wanted to be a pit trader. I wanted to be specifically in the corn pit.”
As a clerk, Spitznagel would bring U.S. Department of Agriculture crop reports to Klipp. He’d tell Spitznagel that nothing he could read would tell him what the price of corn would be. You can’t forecast. “All that matters is you have to be able to take a lot of small losses,” Klipp told Spitznagel. “He was brainwashing me that you have to be positively skewed,” he laughs.
Getting serious, Spitznagel contrasts that with people coming out of Harvard Business School, who graduate and join Goldman Sachs’s proprietary trading desk. “They’re taught the reverse. That a good trade is one that prints a small amount of money all the time. That’s a good strategy until you lose it all and then some. I was taught the opposite. You have to look like an ass and feel like an ass to be a good trader.”
After Spitznagel graduated, Klipp backed him and he became the youngest trader in the U.S. Treasury bond pit at 21. He then went on to become a prop trader at Nippon Credit Bank.
In 1999, he took a sabbatical and went to New York University’s Courant Institute of Mathematical Sciences, where he met Taleb. They decided to start Empirica Capital, the first formal tail-hedging fund. Spitznagel was the trader and Taleb raised the assets. Four years later, Taleb faced health issues, and the two shut the firm down. Spitznagel briefly joined Morgan Stanley’s proprietary process-driven trading group, PDT Partners, before starting Universa in 2007.
COO Yarckin was a derivatives broker at D.E. Shaw subsidiary KBC Financial Products, which covered Empirica, and helped Spitznagel start Universa. Selling hedges, he says, has always been an uphill battle. Investors may say they want protection, but they don’t want to stray too far from what they can easily explain to their boards. “If you’re providing masks during a pandemic, it’s probably very easy. However, think of us as having to explain why you’d need a mask in the first place,” Yarckin says.
The structure of the financial industry, including incentives and the “agent” problem, also weighs on tail hedging. CIOs are rewarded based on beating benchmarks, not averting disaster. Plus, it’s not their money; they’re only the agent. That’s why the majority of Universa’s investors are family offices and high-net-worth individuals, he believes. These people feel the pain personally when crisis strikes.
The pain at a pension fund is indirect, hitting beneficiaries, and perhaps taxpayers, who need to make up any shortfalls.
Taleb likewise believes he’s spent his life being misunderstood. “But it doesn’t matter much. It forces you to be robust in your arguments. When you’re robust, you don’t really care,” he says.
“What I’m saying is not controversial for the people who practice decision-making; it’s only controversial for analysts or people who get paid but don’t have skin in the game,” says Taleb.
Clients tend to devote only a fraction of their portfolio to the hedging product. This means they can allocate more to stocks — getting more systematic exposure — because their risk is hedged. “Maybe that’s part of the problem,” Spitznagel says. “You’ve got to believe that something really bad is happening. We’ll get an asteroid strike or something. It’s a bet on doom. But nothing is further from the truth.”
Universa’s strategy should be the next risk parity, he believes. “But we never will be. We should be the dominant new paradigm in risk mitigation.” The risk-parity comment is barely out of Spitznagel’s mouth before he says, “Universa’s success comes because people don’t believe it works. If they did, we wouldn’t have a business.”
CalPERS — Universa’s most infamous doubter — will forever be part of the company’s story, Lagnado believes.
The pension fund’s decision came down to behavioral mistakes, says Spitznagel. There’s an explicit annual “insurance cost” to tail hedging, just as any other risk-mitigation measure has a price. For example, CalPERS lost out on four years of gains after the fund sold about $15 billion in equities in 2016.
But that number wasn’t written down in a balance sheet.
