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Winning `Black Swan' Investor in '08 Says Market Is Fragile

(Bloomberg) -- For funds that thrive on crisis, the volatility jolt that wiped out over $4 trillion of global stock value in February was merely a tremor. A full-blown financial earthquake looms.

They’re known as tail funds, for whom the traditional objective of producing annual returns is replaced by the contrarian task of preparing for events that are more than three standard deviations from the norm, or those that have a 0.3 percent chance of coming to pass.

Those mandated to hedge such maelstroms -- like Richard “Jerry” Haworth, whose 36 South Capital Advisors LLP profited handsomely from the 2008 crisis -- say conditions are now ripe for the next big one.

“The financial system is a lot more fragile than it was in 2007,” said Haworth in an interview in his Mayfair office in London. “Leverage is up on every single metric, in just about every category, and debt has increased. The more you indebt someone, the more fragile they become, especially with variable interest rates.”

Tail-fund investors are predisposed to warning against the next blow-up. Haworth admits that he’s called “10 of the last two recessions.” To steel themselves against financial armaggedon, the funds typically scoop up long-dated out-of-the-money options on multiple asset classes -- and wait.

Assets in tail-risk funds have grown to $4.9 billion from $3.2 billion in 2011, according to Eurekahedge Pte Ltd. In 2011, the year of the Greek crisis, tail-risk funds boasted the top-performing strategy, but as markets rallied in the six following years they suffered the steepest losses of any hedge-fund style tracked by Eurekahedge. This year, they’re up 0.54 percent, according to the data provider.

Leverage Alarm

It’s getting easier to make the case that the probability of outsize losses is rising thanks to an increasingly complex market landscape late in the U.S. business cycle.

Risky securities and investing strategies that have flourished during the decade of easy-money policies -- from autocallable structured products to risk-parity funds -- could accelerate a downturn, Haworth says. The boom in passive investing may intensify the looming deleveraging wave as exchange-traded funds rush to sell the same securities in unison, he added.

Haworth, who co-founded 36 South in 2001, declined to say how much he manages in his tail-risk funds, which hedge extreme scenarios in both bull and bear markets. After returning 204 percent during the global financial crisis in 2008, his Black Swan Fund closed the next year and returned money to investors.

Tail funds make up “barely 0.2 percent of total global hedge fund AUM, pointing to the difficulty of marketing such strategies to investors despite the crisis alpha they are capable of delivering,” said Mohammad Hassan, head of hedge fund analysis and indexation at Eurekahedge. “The inherent bleed in this strategy is a tough sell.”

New Regime

There are few prophets of doom on Wall Street even with elevated valuations across stocks and credit amid the recent global selloff. But the tone is getting more bearish.

Guggenheim Partners and Pacific Investment Management Co. are among those sounding the alarm on corporate debt, saying higher interest rates could pressure the swollen ranks of over-leveraged firms and weigh on growth, with the risks of a recession rising.

Consumers are loading up on credit, too. A measure of U.S. household debt levels has been edging higher relative to income recently after plunging in the years following the crisis, according to Wells Fargo & Co. Delinquent subprime loans are nearing crisis levels at auto-finance companies.

February’s equity selloff doesn’t register as a tail risk, or black swan, event outside of the relatively small group of investors who wager on securities tied to the VIX. But it may presage a new regime of choppy trading across asset classes, increasing the prospect of hard-to-predict events, according to strategists.

“The summer should be hot for U.S. equity and oil volatilities,” Societe Generale SA strategist Olivier Korber wrote in a recent note.

Still, with price swings across bonds and currencies at subdued levels, volatility remains cheap for tail funds. Even equity volatility -- which has almost doubled compared with last year -- isn’t particularly elevated, but merely back to more-normal levels, according to Haworth.

There are plenty of things that comfort bulls. Corporate America, for example, is embarking on another round of earnings announcements expected to beat estimates.

“Among the reassuring criteria are the good health of banks, a favourable macroeconomic situation, economies with lower sensitivity to inflation than before, and central banks still credible, predictable, good communicators,” Philippe Ithurbide, global head of research at Amundi Asset Management, wrote in a recent note. He predicts “not a crisis scenario, but rather more nervousness” for the rest of the year.

For the investor at 36 South Capital Advisors, signs of good health are illusory.

“Fundamentals today are strong, but they’re strong because there’s effectively free money,” Haworth said. “If interest rates normalize, a lot of that goes away.”

©2018 Bloomberg L.P.

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