(Bloomberg) - Mark Spitznagel is a master at generating buzz for his tail risk-protection business. From partnering with the man who coined the very term “Black Swan” to warning this January that we’re in “the greatest tinderbox-timebomb in financial history,” he makes sure Universa Investments is rarely far from the Wall Street spotlight.
But it’s the firm’s returns that really make headlines — and get the blood of some of the hedge-fund world’s biggest names boiling in the process.
This year Universa has done it again, prompting a backlash that hits at the heart of whether Black Swan insurance is worth the cost — just as a simmering bank crisis and gathering economic clouds put portfolio protection at the top of the global investment agenda.
Sure, all hedge funds like to put a positive spin on performance, and that’s well understood by their sophisticated clientele. But critics like Saba Capital Management founder Boaz Weinstein and Citadel’s former global head of fixed income, Derek Kaufman, say Miami-based Universa goes a step too far, cherry-picking data to burnish results.
Put simply: The famous quadruple-digit returns that make headlines when a crisis hits aren’t everything they may seem.
The latest spat broke out on Twitter in the wake of Spitznagel’s January missive to clients. As he touted the virtues of Universa’s style of hedging, he claimed a small allocation to the money manager equated to an “annuity paying 114% a year.”
Considering that when Covid hit in March 2020, the firm said it returned 3,612% in a single month, that didn’t seem like much. But it appears to have been a final straw for naysayers such as Weinstein and Kaufman.
“None of what they are saying makes sense,” tweeted Kaufman, while Weinstein — who runs his own tail-hedge strategy in the credit realm — called the firm out for the way it calculates its figures. “Name another hedge fund or tail hedge fund that talks in returns on premia spent over some interval instead of return on assets,” he tweeted.
For its part, Universa — which counts Nassim Taleb, author of the 2007 bestseller The Black Swan, as its “Distinguished Scientific Adviser” — says the unconventional reporting style is a match for its unconventional business. Meanwhile, the firm’s clients clearly see a valuable investment proposition.
“While we cannot comment on returns, Universa Founder and CIO, Mark Spitznagel’s recent book, Safe Haven, explains in detail that the point of what Universa does is raise a portfolio’s rate of returns as a direct consequence of lowering its systematic risk,” Brandon Yarckin, chief operating officer at Universa, wrote in an email. “Contrary to Modern Portfolio Theory, this is the metric that matters, and it is demonstrably what we have done in Universa’s 15 year life to date.”
But with the likes of AQR Capital Management co-founder Cliff Asness joining the fray — retweeting Weinstein’s gripe to his 110,000 followers — it’s become a fresh flashpoint in a longstanding tussle over whether tail-risk funds truly live up to their billing.
‘Too Good to Be True’
Measuring the performance of most money managers is pretty simple: Income, such as interest or dividends, plus price change divided by assets under management at the start of the period equals a return, usually expressed in percentage terms.
But tail-risk funds have a different mission. They offer a form of insurance against extreme volatility, typically by buying options that can deliver handsome payouts if markets turn ugly. Because such blowups are rare and unpredictable, using the conventional fund performance calculation may not capture the value they deliver.
So Universa uses a different approach.
Take that 3,612% return, which Spitznagel touted in an April 2020 letter to clients — “kudos to you,” he told them — and which subsequently appeared in news stories from outlets including the Wall Street Journal, Forbes and Bloomberg News.
Using standard fund math, a 3,612% return on $6 billion — roughly Universa’s stated assets under management at around that time (more on that later) — would’ve translated into a mind-boggling $217 billion windfall for Universa clients, and that’s how many people read it. In fact, what Spitznagel described was a return on “required invested capital.” Rather than assets, that refers to the capital it takes to put on positions over the period.
That’s not how most people think about insurance. For example, a homeowner might pay into a policy for years before filing a claim for catastrophic fire damage. The objective is avoiding a total loss and having somewhere to live, not adding up the total cost of those premiums and determining if there was a “return” on the policy.
What Universa in effect does is calculate the return on an insurance policy using only one month of premium. Conveniently ignored there is the reality that clients typically pay Universa for protection for years — a process so painful it’s known as the “bleed” — before ever cashing in.
“On average there’s a drag because it’s insurance,” Kaufman, the former Citadel executive, said in a phone interview. “If something seems too good to be true, it probably is.”
To compound the confusion, Universa’s AUM — now $16.4 billion — is actually defined in a regulatory filing as the “amount of equity market risk that a client seeks to protect.” That means the assets at the firm’s disposal are in practice far smaller.
Of eight former or current tail-risk fund managers interviewed by Bloomberg News, seven said they use a more conventional method of reporting returns — though several agreed it wasn’t necessarily suitable for tail-risk strategies. Six said “return on required invested capital” was not a standard metric in the industry. One said they report something similar, but alongside the return of their program on the overall hedged portfolio.
Unconventional
The 52-year-old Spitznagel first met Taleb when he was a master’s student at New York University’s Courant Institute of Mathematical Sciences and the latter an adjunct professor there.
The two started the tail-risk hedge fund Empirica in 1999, which lasted for about six years. In 2007, Spitznagel launched Universa, right before the worst financial crisis since the Great Depression. (Not too long after, he bought a farm near Lake Michigan that makes award-winning goat cheese.)
To be clear, Universa’s numbers aren’t technically incorrect, and calculating the firm’s performance is a complicated business.
Because they mostly trade derivatives, tail-risk funds need far less capital, since options can be bought on margin. That’s even more true for Universa, which both buys and sells contracts. The firm estimates its insurance costs on average about 1.7% of a protected portfolio annually, according to a person who has heard the firm’s pitch and who declined to be identified as the discussion was private.
As that balance depletes in a smooth-sailing market, the firm might ask you to top up. And the expectation is that, in the event of a crash, you’ll be cashing out rather than reinvesting your gains.
“I basically say to folks you’ll hopefully have the opportunity to pop the champagne every five or seven years,” said Alex Dancy, managing director of Lionscrest Advisors Ltd., which invests solely with Universa.
Universa’s Yarckin gave a hypothetical example.
“If a client hedged $1 billion with $5 million in capital in January of 2020, a 4,000% return in March leaves them with $205 million. After wiring out $200 million at the end of March, $5 million remains. During the subsequent rally, they lost that $5 million but still made $195 million in profit for 2020. Accounting methodologies assuming intra-year compounding would say they net lost $5 million on the year, rather than profited $195 million.”
According to its January letter, an investor with 98% in the S&P 500 and 2% in Universa would have seen their money grow an average 11.8% annually in the firm’s 15-year history, compared with 9.6% for the index alone.
That is “mathematically equivalent to what a 2% allocation to an annuity paying 114% per year would have added,” Spitznagel wrote in the letter seen by Bloomberg News.
Yet that adds another layer of complexity, since the calculation assumes the portfolio rebalances every quarter — meaning that the client tops up their investment after the strategy loses money and reallocates to the S&P 500 after it makes money. That makes the 114% gain decidedly different from any fund return.
The firm’s hedging programs are also tailored to each client, so its return figures may not represent every investor. In another letter seen by Bloomberg News, the annuity figure was 79% instead of 114%.
Tough Sell
The confusing performance of a firm like Universa is just one of several reasons tail-risk funds draw fierce criticism from rivals who claim there are superior ways to protect a portfolio.
Many of these skeptics, like Asness at AQR, argue that the ongoing costs of maintaining this insurance — the continual rolling of options — ultimately ends up being too expensive for the long term.
The protection also doesn’t work in every kind of downturn. When stocks ground lower last year as central bankers raised rates, there wasn’t enough volatility for most tail-risk strategies to pay out and alternative approaches to diversification offered more profitable ways to offset the declines.
To Universa, that’s only by design. It aims to score a huge payout only in the worst stock selloffs so clients can avoid forced liquidations and potentially profit from a rebound.
It’s such a tough sell that in a foreword to Spitznagel’s 2021 book, Taleb evoked a saint who lived her life as a man and was falsely accused of impregnating a local woman until she was vindicated after death. The book, he wrote, was a “monumental f*** you to the investment industry.”
After 22 years hedging tail risks, Jerry Haworth at 36 South Capital Advisors knows just how hard it is to explain and defend the business. But he says managers should avoid over-selling a single month’s performance.
“I don’t think any fund, tail risk or not, should market investment returns by cherry picking by time or asset class or product,” he said. “It’s a difficult pitch, but it shouldn’t be.”
By Justina Lee
