“If you are irritated by every rub, how will you be polished?” -Rumi
This quote from Rumi offers one of the most crucial life sentiments: embracing the challenges (“the rubs”) that allow us to learn, grow, and become better people. It’s the “exercise of life,” if you will. In investment terms, the quote is also highly applicable to the volatility that comes with being a disciplined long-term investor.
On the other hand, when it comes to hedge-fund blow-ups, our goal is first to avoid them altogether and then secondarily limit their impact on a portfolio if this situation unexpectedly occurs. It is not a matter of embracing normal volatility because it is not normal volatility; instead, blow-ups are one-off, unrecoverable situations that can essentially only be mitigated via portfolio construction. But we can learn valuable lessons from them, and so we forge ahead with this topic.
As I write this morning, we may be witnessing a future blow-up case study in real-time. In recent days, Archegos Capital Management has reportedly been forced by creditors (banks) to liquidate tens of billions of dollars’ worth of holdings. Some media stocks that the firm held have declined over 50%, while the stocks of Archegos’s lenders are taking a hit in the pre-market today. Looking at my screens, a couple of American banks have fallen nearly 5%, a European bank has declined over 13%, and a Japanese bank is down almost 15% on the news of anticipated losses.
We’ll have to wait to confirm the specifics of the situation, but at this initial stage, it sounds like this is yet another case of too much leverage, a trade gone wrong, and the downward spiral of resulting margin calls. There is little transparency in the situation thus far, but I gather that total return swaps probably allowed Archegos to gain levered exposure to the stocks in question. Hopefully, the situation is contained, but one potentially broader adverse impact is the tightening of credit (i.e., less lending) by the impacted banks because of the problem at hand. Now back to our historical examples…
The Carlyle Capital Corp, which traded under the ticker CCC, was a closed-end fund launched in 2007. CCC was a separate legal entity affiliated with The Carlyle Group, which was designed to help diversify Carlyle’s footprint and create an access point for retail investors (not historically Carlyle’s typical investors, which were more institutional). As a concise bio, the Carlyle Group has been “one of the most successful alternative asset firms in the world, managing as of 2014 more than $200 billion in assets,” according to CAIA (Source: CAIA Level I, 3rd Edition).
CCC sold for $20/share in a mid-2007 IPO, but by March of 2008, it traded at 30 cents per share. As the timeframe was coincidental with the onset of the 2007 real-estate crisis (then leading into the 2008 Financial Crisis), you may have already guessed that CCC was a fund focused on the now-infamous AAA-rated residential mortgage-backed securities (RMBS). When subprime borrowers defaulted on their mortgages, the RMBS structures collapsed, and so did CCC…and eventually many other RMBS holders (nothing major – just 95-year-old Bear Stearns, 160-year-old Lehman Brothers, etc.).
At a more granular level, the CCC strategy was to borrow at low short-term interest rates and then use the money to purchase the AAA RMBS (again, “highly rated”), which paid a slightly higher yield. By jacking the leverage up to about 31 times (yikes!), CCC could pay investors a 10% yield. That’s right. CCC invested $31 for each $1 that was contributed to the fund.
Is an investment good if you need to magnify it by 31 times to achieve an acceptable rate of return? That’s a rhetorical question, but if you know of an application where this is a good idea, please send me a note. At this stage, you know the rest of the story: RMBS prices started to decline, which led to the margin-call death spiral that alt.Blend readers are (hopefully) now all-too-familiar with. The demise left the shareholders – 15% of which were Carlyle partners – with nothing. It also “led to more than $50 billion in losses at major investment banks” (Source: CAIA Level I, 3rd Edition).
To be fair, the RMBS held by CCC were assumed to be safe, with no credit risk because of being backed by the US government; thus, on the surface, the strategy employed by CCC was a sound one. One can certainly make “safe” underlying holdings into an unsafe investment by adding too much leverage. In this case, however, the underlying RMBS holdings of the fund would have collapsed regardless of the degree of leverage employed. Leverage just exacerbated the situation and caused losses to the lenders.
On February 5th, 2018, the VIX index (aka CBOE Volatility Index) registered its largest one-day spike in history in an event now affectionately known as “Volmageddon.” This can be seen visually below:
It may be an event that most investors don’t even remember – as it was ultimately a reasonably quick disruption – but this volatility spike had real casualties. I had a front-row seat to one of them.
I met with the LJM team multiple times in 2017, primarily to focus on their “Preservation & Growth Strategy.” I knew of a few other advisors using their mutual fund, and it seemed worth a closer look. Now going through my files, I still have a full LJM presentation and fact sheets on their funds that were updated through December of 2017. In fact, here’s the fact-sheet header, designed to convey the strategy I mentioned above:
I also have nearly two pages of meeting notes from when I last met with them on January 29th, 2018. Here are some excerpts (bullets and emphasis added):
- Preservation and Growth. Started 12 years ago, but has been in MF for 5 years.
- Goal: capture spread between implied and realized vol on the S&P. Get 80-100bps of return each month (in MF strategy).
- Low Vol regimes persist when markets/economies are healing.
- Selling upside calls and downside puts. Never long Vega. Theta falls off a cliff between 60 and 15 days.
- Layer in call spreads and put spreads to hedge. DCA into volatility, adding to the position every day that should provide 4-5bps per day (20 trading days = 100bps). Adjust risk based on market conditions.
- While they were challenged in 2013, they believe the outcome would be much better now.
- When it didn’t work, and how they have addressed it:
- 2 risks: market and vol risk. Their goal is to expose us to as much VIX as possible with least market risk possible.
- : Down 6.8% in Aug 2015, and so was the S&P…appears correlated. VIX spiked the fastest in history. Next month, the S&P was down 2.5%, but LJM was up 5.66%. They consider that if 80% of losses are related to vol, then they did their job.
- What about a drastic down move?
- No purchased catastrophe hedge (out of the money puts).
I had no idea at the time, but the Preservation & Growth fund would lose half of its value one week later and a total of 82% over two trading days. Within about two months, LJM would be shuttered entirely and faced with an onslaught of lawsuits. According to my notes, the team believed it had improved their approach based on lessons learned from previous volatility spikes. History now tells a different story. In essence, LJM was short vol, as we’ve seen in other blow-ups. The VIX had an unprecedented spike, the trades moved against them, and it became an impossible environment to navigate successfully.
Ultimately, the last two bullet points from my notes (in bold text) were why I didn’t use the fund for clients. I needed an alternative that could help protect a portfolio in a significant market selloff, and LJM seemingly had no recourse for that situation. In layman’s terms, they had no emergency brake. In Alts terms, there was no catastrophe hedge. No out-of-the-money put, just in case. Fortunately, the fund simply wasn’t a good fit for my portfolio construction objectives because of that one missing component.
Where Does That Leave Us?
As we’ve seen in this two-part series, some investments can be outright failures, where nearly all of the investors’ capital quickly evaporates. If such outcomes were expected, no one would invest in the associated funds in the first place. Also, a strategy can often work very well until it doesn’t. A thorough due diligence (DD) process can uncover some red flags – like excessive leverage or overly concentrated bets – only if those risks are present at the time of the review.
While avoidance of all risks would be ideal, it is not practically possible. In their recent article, What Hedge Fund Risk Systems Don’t See, Linus Nilsson and Rikard Lundgren also outline several factors that can lead to unexpected losses, including some that we’ve touched on. They also point out the risks of “unknown unknowns,” where the only hope of identifying the evolving risks relies upon experience and creativity.
Investors should be as granular as possible in understanding how a given investment process works, its shortcomings, and how it can be sustained in various challenging environments. Allocations can also be sized purposely to help mitigate risk. Then, even if a fund is wholly decimated, an investment portfolio’s overall well-being and recovery potential can remain fully intact despite the blow-up. I often suggest sizing Alternatives in 5% increments (for more diversified funds) relative to total portfolio assets. The goal is to make the allocation large enough to have a meaningful impact, yet small enough such that a single investment should not undermine the portfolio’s long-term health.
Texas Flood…and RIP SRV
Taking us back to where we started in the previous post (The Rub: Part 1), hopefully, all those affected in Texas are well on their way to recovery by now. But the cleanup will take a long time, as many frozen pipes burst, flooding homes and collapsing ceilings – some of which were only recently restored after the devastation of 2017’s Hurricane Harvey – and the destruction is potentially the most costly in the state’s history. Looking to the future, and as with our hedge-fund blow-up examples, I expect there will be critical lessons garnered from this ongoing situation that can prevent it from being repeated.
The late, great Stevie Ray Vaughan didn’t need to contemplate future disasters of his home state when he and Double Trouble delivered this epic rendition of Texas Flood on Austin City Limits back in ’83. He only needed to pour his heart and soul into the music. Still, had SRV been in the business of forecasting disasters instead of flooring audiences with the blues, he still couldn’t have known the relevance “Texas Flood” would have over three decades later. Some things are just unknowable. And, as we’ve now explored with the Texas power grid, Long Term Capital Management, Amaranth, Carlyle, and LJM, even those closest to the situations often do not see the blow-ups coming.
These situations also reinforce the notion of there being no free lunch in investing and that – if something seems too good to be true – it probably is. It matters not only that a given fill-in-the-blank (stock, fund, bond, etc.) investment pays a 10% yield, but equally importantly, how that yield is generated. If it’s not constructed on something sustainable and robust, then neither is your investment plan. That’s the rub.
Until next time, this is the end of alt.Blend.
Thanks for reading,