Investor who returned 4,000% in Q1 2020 explains what people get wrong about risk mitigation

·Former Correspondent
·6 min read

Hedge fund manager Mark Spitznagel, the founder of $11 billion "Black Swan" hedge fund Universa Investments, says investors have been getting risk mitigation wrong from the start.

"Our goals are even wrong. And really, we have Modern Portfolio Theory to thank us for this. But it's just kind of a heuristic of investing that you need to take more risk in order to get higher returns, in order to get more wealth at the end of the day. And as you take less risk, your returns are going to go down," Spitznagel told Yahoo Finance Presents in a rare interview to discuss his second book, "Safe Haven: Investing for Financial Storms," which he describes as his firm's "manifesto."

The 50-year-old professional safe-haven investor said, "The goal of risk mitigation, like the goal of investing, should be to raise our rate of compounding over time," which he adds "flies in the face of everything we know from modern finance."

It's what Spitznagel has dubbed the "great dilemma of risk," where if an investor doesn't take enough risks, it will likely cost them their wealth over time, and if they take too much risk, it will also likely cost them their wealth over time.

While many have this idea that risk mitigation is often a trade-off against wealth creation, Spitznagel demonstrates that "there really is another way" to cost-effectively lower a portfolio's risk and be additive over time, raising a portfolio's CAGR.

Spitznagel is among the best performing investment managers of the last decade-plus, reaping massive gains from market crashes. During the depths of the COVID-19 pandemic last year, Universa delivered a stunning 4,144% return during the first quarter when markets sharply sold off.

Businessman checking stock market data. He using a mobile phone. Analysis economy data on forex earn graph.
Businessman checking stock market data. He using a mobile phone. Analysis economy data on forex earn graph.

According to documents reviewed by Yahoo Finance, the life-to-date average annual return on invested capital from the fund's inception 11 years ago through the end of 2019 is north of 105%, making Universa one of the top-performing hedge funds during that time. Today, Universa manages close to $11 billion in assets under management, almost triple what it had at the end of 2020, documents show.

As Spitznagel notes in the book, the performance of Universa's risk-mitigated portfolios is "a direct consequence of having far less risk."

Universa Investments specializes in risk mitigation, deploying a tail-risk hedging strategy to limit losses from an outsized market event, like a "Black Swan." Nassim Nicholas Taleb, author of "The Black Swan," is the "Distinguished Scientific Advisor" to Universa Investments.

"[The] way Universa invests is really probably the most bearish expression that one could have as an investor. And yet, at the same time, my clients want the markets to go up," Spitznagel said.

To put it simply, the tail hedge acts like insurance with asymmetric and explosive downside protection. Spitznagel is known for stomaching small expected losses over time and making large profits in a crash.

Spitznagel, who grew up a "scrappy, poor kid," in the Chicago commodities trading pits, said that's where he learned from a mentor that "a small loss is a good loss."

"And as a pit trader, this is kind of what I was taught, really starting as a teenager, that this is what trading is —Trading is taking very small losses and taking very large profits," Spitznagel said, pointing out that it's "diametrically opposed to the way pretty much all hedge funds operate."

While Universa's returns, like the 4,000% return in the first quarter of 2020, often garner media attention during crashes and sell-offs, Spitznagel said he "always like to de-emphasize that."

"[Because] really, at the end of the day, any punter can devise a trade that does well in a crash. The key is how do you do in a crash an insurance-like payoff like Universa's. How do you do in a crash relative to the rest of the time? So that's really what matters, are these long swaths of time that really matter," the investor added.

When it comes to the state of the markets, Spitznagel is of the view that the Federal Reserve "manipulating the most important information parameter in the economy, and that's the interest rates," which thereby "rips apart" the homeostatic system of the financial markets, which he notes is a "corrective feedback mechanism."

"But I would argue it doesn't remove it. It basically just sort of delays it and concentrates it in time. So I think a good way to think about this is when you're driving, driving is very much this sort of feedback mechanism where you make these minor corrections. And I think that's a good way to think about what the market does, the price system does. But think when you drive on ice, all of a sudden you have this delayed feedback so that when you do something, nothing happens until all of a sudden it does," Spitznagel added.

He points out that history shows that the homeostatic corrective feedback mechanism "rears its angry head, and that's really what a crash is."

"But it's made worse, and it's delayed through this central bank interventionism," he added.

To be sure, Spitznagel says he remains "very much agnostic to all of this."

"[I] think it's important to invest in a way that you don't rely on this sort of grandiose forecast. I think it's a misnomer when people think that investing is about forecasting. I think that generally, everybody agrees that. But it really shouldn't be about forecasting," he added.

Spitznagel emphasized that the range of outcomes is massive, and you only get one path to trade.

"We don't get an average across all possible paths in the multiverse. We get just one. So it's a little bit crazy to invest based on that one," he added.

While Spitznagel has an exception of "some destruction in the future in the financial markets, that doesn't necessarily mean that someone should just hide away because that in and of itself may not be the best strategy, either."

"That's kind of like the dogma of diversification, thinking that just by lowering your risk, it's going to be better for you. People need to think that through more carefully," he added.

Julia La Roche is a Correspondent at Yahoo Finance. Follow her on Twitter.

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