February 2014 - Richard 'Jerry' Haworth: Humans playing dice

What a difference a month makes! The biggest lesson for us this month is simply to restate a simple truism, Black Swans are by nature unknowable. We want to meet the person who called Crimea as the next potential Black Swan a month ago!

The Crimean situation seems to be in abeyance but the situation, like a tall sand-pile, seems particularly fragile. Putin and Obama both seem to be playing “pigeon chess”; they both knock over all the pieces, crap over the board and return to their camp claiming victory! We know very little of politics, but are aware that arrogance is often accompanied by some sort of secular top in asset markets.

However, the prices in asset markets rise and volatility falls in spite of geopolitical “wobbles”. In China the National People’s congress put out the word that they want to grow at 7.5% next year which basically means it intends to double every DECADE. It already consumes 50% of the world’s iron ore, milk, eggs, cement and steel amongst other commodities. This means in 10 years’ time they will consume over 100% of today’s production of these commodities. In 30 years 400% and in 50 years 1600%.  What could possibly go wrong with this growth model?! Time to get a little farm with a cow and some chickens.

One senses that China intends to move the money spigot away from infrastructure spend to consumer spending as reliance on the rest of the world to buy what they produce is proving a risky exercise. It will probably paper over the debt pile left over by the infrastructure building bubble which leads us on to the decades old question; will this result in inflation or will it, like we have seen in the last three decades, result in a muddle through economy which shows more predilection for deflation rather than inflation?

It seems too good to be true, whatever mis-steps sovereigns take, simply print the money to make the problem go away and move on. The periphery countries don’t seem to have this delightful ability as their currency rapidly depreciates and inflation seeps into the country immediately.

Our investing activity is basically that of a trapper, we lay down around 20 traps (options) where we think animals (assets) are likely to walk expecting to catch 2-3 animals a year which will provide a decent positive return even taking into account the fact that the traps are rusting away over time and will need to be replaced. Every now and again a bushfire (2008 GFC) occurs and ALL the animals run into ALL the traps. All our traps get sprung and we have a bumper year.

This kind of investing style turns out serendipitously to be just what most investors need in their portfolio. The GFC highlighted the fact that most uncorrelated “hedge” investments turned out to be the exact opposite. They went down in some cases MORE than the traditional investments! So investors went searching for what we call true diversifiers, investments which are truly uncorrelated with traditional investments when asset prices plunge. We, on the other hand, being driven largely by volatility, tend to snowball profits, not losses in a severe downturn. A super diversifier if you will.

Black Swans are inherently unknowable so it is unlikely we are going to pinpoint them in advance and discuss them earnestly. Volatility can be moribund for long periods and beating the drum about how valuable they are wears thin after a while. In fact, investors are most likely to faint on this strategy just before a period of high volatility and profitability. The different positions in the portfolio are selected because in some way, we believe they represent value relative to the price and their potential realisation requires a trapper’s patience. We lay the traps and wait for volatility.

That in no way belittles the immense role we believe long volatility funds have to play in a traditional portfolio. There are precious few true diversifiers and even fewer which display convexity whilst over time producing a positive return on investment.

This is especially true now that bond rates are nearly at all-time lows. It is entirely conceivable that both bond prices and equity prices will move down together in the next serious downturn thus removing the bulwark portfolio hedge that the low traditional correlation between bonds and equities have provided. Portfolio losses in this scenario will be exacerbated and the need for diversifiers will be greater than before.