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Why does everyone hate tail-risk hedgers?
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.”
Spitznagel wasn’t surprised when Meng ended CalPERS’ tail-risk hedging program. He had seen such decisions many times before. As the founder and president of Universa, he knows his products require investors to go up against modern portfolio theory and the other orthodoxy they learn in business school and starter finance jobs.
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.
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.”
Spitznagel wasn’t surprised when Meng ended CalPERS’ tail-risk hedging program. He had seen such decisions many times before. As the founder and president of Universa, he knows his products require investors to go up against modern portfolio theory and the other orthodoxy they learn in business school and starter finance jobs.
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.
