How to Hedge a Swan's Tail
Nassim Nicolas Taleb, author of a book about the inevitability of unpredictable events, told Bloomberg Television last spring he gets irritated every time he hears the coronavirus pandemic referred to as a "Black Swan" – an event of enormous impact and consequence that couldn't have been predicted.
For Taleb, the pandemic is more like a "White Swan", long hiding in plain sight and wholly predictable – something he, Bill Gates and others had been pointing at for years.
Whatever color swan it is, the pandemic (and the ensuing global economic lockdown that macro research firm Strategas argues is the true Black Swan) is only one of several potential society-threatening extreme events identified in the book 7 Deadly Scenarios, written by Andrew Krepinevich. (Don't read it at bedtime.) Like a nuclear attack or a naval altercation with China in the South Pacific, the COVID-19 public health crisis is one of innumerable scenarios, seen and unseen, that could easily trigger a precipitous 35% drop in global market values like the one we experienced in March. And, as Taleb argues, in a complex, globally interconnected and increasingly fragile world the likelihood of such extreme events is increasing.
All this has renewed interest from institutional and individual investors alike in hedging against so called "tail risk."
Tail risk is usually defined as the chance of loss due to rare events. It is often quantified as a price movement three standard deviations outside the norm.
The case for protecting against tail risk in portfolio holdings is fairly straightforward and compelling. It's similar to the rationale for buying insurance on your house.
Where it gets interesting is around execution: how best to hedge against downside risk.
The traditional "keep it simple" time-tested advice from financial advisors has been to diversify across asset classes. For example, to allocate your portfolio 60% to stocks, 30% to bonds and 10% to cash. Which historically has worked pretty well. In his book, Wealth, War and Wisdom, the late investment strategist Barton Biggs looked at the performance of different asset classes during World War II, one of the most globally disruptive events in history, and concluded a 60%-40% stock bond allocation maintained value as well as any other allocation. (Though he also recommended buying farmland as extra protection.)
Many institutional investors adopt a similar approach but diversify less to bonds and cash and more to hedge funds or real assets, strategies that are harder to access for smaller investors.
Few would argue traditional diversification smooths out portfolio returns, moderating peaks and troughs in performance. The problem today is that (a) with bonds and cash yielding close to nothing, cash has a bigger impact on what a portfolio can earn than in a higher interest rate environment. (Assuming a 7% nominal long-term return on equities, allocating 40% to bonds and cash would reduce those returns to slightly more than 4%.) Also, (b) with bonds fully valued, their ability to provide non-correlated positive returns in a stock market sell off is diminished.
Enter the "tail risk" specialists. Among them Taleb, who advises the firm Universa's tail risk hedging program, which was famously terminated by the California Public Employees Retirement System (CalPERS) pension last fall and winter, only months before it would have earned the fund an estimated $1 billion in gains during the March drawdown.
Tail risk insurance comes in many flavors. But the idea is to allocate a small portion of a portfolio say to strategies that pay off when the world seems like it's coming to an end, allocating the rest of the portfolio to stocks. Depending on where the insurance kicks in (down 15%, down 20%, etc.), the price of volatility and an investor's willingness to sell off upside, the overall cost of the insurance can be managed to less than .50% annually. At least by institutional investors and/or family offices with the expertise to construct custom hedges.
For individual investors there are a few hedging strategies offered by specialists like Parametric, including various forms of put buying or collaring. A zero cost collar, for example, has no upfront costs but may limit your upside in strong equity markets. Without a budget, buying puts can be costly. Depending on current levels of volatility, investors may have to spend 3%-5% or more annually to receive the downside protection they desire. These strategies aren’t for everyone, as they typically have higher minimums of $1mm or more.
So, what's an individual investor to do?
One of my favorite ideas is to arrange for as much in lines of credit as your bank, wealth management firm or other reputable financial institution will lend you.
Financial markets are nothing if not resilient. They have recovered following every major crisis in our lifetimes. But as Warren Buffet, the most famous advocate of a fortress approach to liquidity management, puts it, "to finish first, you must first finish". You must have enough in reserves to stay invested during a crisis, enough to survive without having to sell your assets on the way down, at the bottom, or on the way up, before they have fully recovered their value.
Liquidity is the key to making it to the other side of a market crisis. Credit facilities are an underappreciated way to create liquidity. And unlike cash, many lines of credit don't cost anything... until you draw them down.
Which is (sort of) like not having to pay for insurance before you file a claim.
Past performance is not indicative of future results and diversification does not ensure a profit or protect against loss. All investments carry some level of risk, including loss of principal.
Small Business Capital Lifelines are Fraying
During a time of unprecedented societal disruption, providers for capital of small- and minority-owned businesses are at risk
The COVID-19 pandemic has highlighted more than any event in our lifetimes the importance to the "real" U.S. economy of small businesses, which generate more than half of GDP.
It's highlighted the hanging-by-a-thread fragility of enterprises owned by minorities or located in disadvantaged communities.
And it's also created existential challenges for the mission-oriented financial partners who serve that community.
Even in the best of times, businesses like Karibu Grocery and Deli, located in St. Paul, Minnesota, struggle to get access to capital and to the basic financial services they need to survive and grow.
Opened by the Ali family in summer 2018, Karibu sells groceries and serves Somali food in east St. Paul. The family faced a number of challenges before they were even able to open Karibu's doors. While siblings Abdiwali, Ikram and Mohamed had a promising location, a business plan and some start-up capital lined up, they struggled to secure additional financing for Karibu because of their limited credit histories.
Karibu's story is anything but unique. During the Coronavirus pandemic and social unrest roiling low-income communities, traditional lenders have pulled back from making smaller, more service-intensive loans in what they perceive as high-risk communities.
According to Forbes.com, only 12% of Black and Latino business owners who applied through mainstream banks or credit unions for forgivable loans under the Paycheck Protection Program (PPP) received what they applied for.
Deprived of access to credit, and with an average of less than 30 days of cash on their balance sheets, nearly half of the 500 minority businesses responding to a survey by Global Strategy Group predicted they will be forced to shutter their doors permanently.
If there are financial lifelines of any kind for minority entrepreneurs amidst this confluence of crises, they may be community development financial institutions (known as CDFIs") – not-for-profit capital providers making investments aimed at expanding economic opportunity in low-income communities.
It was through a CDFI that the Ali siblings and Karibu Grocery & Deli found their capital lifeline. In addition to support provided by the City of St. Paul, the African Development Center and other funding sources, the 30-year old, Minneapolis-based Community Reinvestment Fund USA (CRF) granted the Ali's a loan that enabled them to open Karibu.
Recently, CRF was able to network with more than 40 other CDFIs to help originate over $500 million in PPP loans predominantly for Latino-, Black-, women- and Native American-owned businesses.
Nationally, about 300 CDFIs have approved more than $7 billion in PPP loans. That's out of a total of the more than $520 billion approved for PPP loans.
CRF is one of more than 1,100 community development financial institutions certified by the CDFI Fund, a division of the U.S. Department of the Treasury created in 1994. The CDFI Fund makes approximately $200-300 million in capital infusions to CDFIs each year, which organizations like CRF combine with foundation grants and leverage with various types of loans from commercial banks, who then get regulatory credit for their investments under the Community Reinvestment Act.
Collectively, they have $211 billion in total assets and made more than 750,000 loans to small businesses in 2019 totaling $21.5 billion.
Unfortunately, that's a drop in the ocean relative to overall need.
Many CDFIs are being tested by the same factors threatening the survival of the minority-owned businesses they serve, namely COVID-19, the shutdown of whole sectors of the economy and elevated social unrest.
Because a significant percentage of the businesses they lend to tend to be in the service, hospitality and restaurant sectors – parts of the economy that have been disproportionately affected by the pandemic – the credit quality of CDFI's loan portfolios is even more stressed than that of regulated financial institutions.
"This is definitely a situation where we have to 'put our own masks on first' before we can help others," says CRF's founder and CEO Frank Altman.
The lifeline for CDFIs could be a provision in the HEROES Act – a coronavirus relief bill passed by the U.S. House of Representatives in May. The bill would appropriate $1 billion to make capital injections into CDFIs – four to five times the annual amount the CDFI Fund normally makes available each year. As of late August, the fate of that appropriation was stalled negotiations with the U.S. Senate.
Long term, however, other non-governmental solutions are needed if CDFIs are to continue to serve as the provider of capital for minority businesses.
The growing popularity of impact investing may hold some promise. Over 25 years, Calvert Impact Capital has raised over $2 billion by offering Community Investment Notes to investors in denominations of as little as $20, making the proceeds available to CDFIs and other mission-driven intermediaries. Online technology company CNote's flagship also offers the opportunity to invest directly in CDFIs.
The Ali family and Karibu Grocery & Deli are only one proof point of how critical the access to capital CDFIs provide is to small- and minority-owned businesses and, by extension, to the U.S. economy.
Building a Structure for Digital Success
The pandemic environment has created no shortage of challenges for individuals and businesses in the United States. But not all of those challenges have resulted in negative outcomes. Take the wealth management industry, for example. While quarantine conditions and social distancing guidelines meant changing the way many financial advisors were accustomed to serving their clients, some – like Baird – were able to roll with that change, using technology to adapt without sacrificing the important personal nature of those relationships.
I recently co-authored an article for Investment News with Ryan Burwell, Director of Technology Strategy for Baird’s Private Wealth Management business, reflecting on the digital transformation of our industry and what financial advisors will expect from firms in the future.
You can read that article below.
Innovating the U.S. National Debt: "Trills" to the Rescue?
This year alone, in response to the coronavirus pandemic, Congress has authorized more than $2 trillion in fiscal stimulus spending with no revenue sources identified to pay for it – this on top of a previously estimated $1 trillion budget deficit in 2020. Another $1 trillion in stimulus could be on the way.
Most if not all of this $4 trillion will be financed with newly issued debt – 10 years after the National Commission on Fiscal Responsibility and Reform, also known as Simpson-Bowles, warned about the long-term effects of what were already (even then) ballooning levels of public indebtedness.
Projections by the Committee for a Responsible Federal Budget say that by 2023, U.S. debt held by the public will surpass previous high-water marks set following World War II. They estimate the budget deficit could grow to 117% of GDP by 2025, well above the level economists usually point to as the threshold for a malignant debt spiral.
How will we ever keep this overhang of public indebtedness from giving us a square root recovery – down, up, then slow, anemic growth as far as the eye can see? Or a "zombie economy," like the one Japan has been contending with for decades?
Optimists point to two factors:
- The lowest interest rates in our lifetimes, which make all types of debt more affordable.
- The U.S. dollar's status as the world's only reserve currency, which proponents of Modern Monetary Theory (MMT) argue allows the United States to issue new dollars to pay for new debt without the consequences less fortunate countries would have to contend with.
Pessimists cite two problems with the optimists' arguments:
- Monetizing mountains of new debt could lead to resurgent inflation, which would inevitably raise interest rates and increase the cost of debt service.
- The very profligacy justified by MMT would eventually debase the world's only reserve currency.
For now, we may be in the Land of Oz. But to echo an observation in a recent Financial Times piece, "erosion of the dollar's value in a world awash with central bank money" means the laws of fiscal gravity would once again apply to the U.S.
Clearly, now is the time for the kind of financial innovation Yale economist Robert Shiller had in mind when he wrote his book Finance and the Good Society:
"Ironically, better financial instruments, not less activity in finance, is what we need to reduce the probability of financial crises in the future. ... Innovations could include the implementation of new and better safeguards against economic depression. ... We could also see innovative measures developed to curtail the rising plague of economic inequality that threatens to create serious social problems in society."
As an example of this kind of financial innovation in the service of social goals, Shiller called a couple of years ago for the U.S. government to issue bonds linked to our country's GDP. He described his idea in an article in The New York Times titled, "The Next New Thing in Finance – Bonds Linked Directly to the Economy."
GDP-linked bonds, wrote Shiller, "would be helpful in a financial crisis, when economic growth, inflation and tax revenue fall, making conventional debt burdensome."
"In expansions, however, investors would benefit."
In other words, debt service costs would be low in periods when the U.S. couldn't afford to pony up, but would increase in periods when economic growth rebounded and increased tax revenues enabled us to service our debt without compromising other types of public spending. Other countries have experimented with this unconventional approach. In fact, the Italian government recently launched such a bond to help fund the country's coronavirus response and recovery.
Shiller took this idea one step further in describing the possibility of the U.S. government raising money by issuing what he calls "Trills" – perpetual securities (with no maturity date) that would pay a dividend equal to one-trillionth of U.S. GDP. The stronger the economic growth, the higher the dividend.
Trills would also give investors, who could conceivably include a significant portion of productive workers in the U.S., an incentive to contribute to future economic growth. (Think of the popularity of Treasury Inflation Protected Securities, or TIPS, an idea Shiller also proposed in 1996.)
COVID-19 relief is only one of several proposed multi-trillion dollar initiatives on the plates of policymakers these days. There is Medicare for All (also known as universal healthcare). The Green New Deal. Not to mention investments needed to rebuild America's crumbling infrastructure.
There is simply no way traditional debt can finance even a fraction of all those spending and investments proposals – never mind how low interest rates are or how strong the U.S. dollar is today.
Whether Trills are the answer or not, there is no question Shiller-esque financial innovation will be necessary to help get us out of the jam we've gotten ourselves into and provide the investments necessary for the future vitality of our country.
Would You Hire This Man Today?
Pete Mahurin is a legend.
One of the longest-tenured, and for many years the largest, producers at the former Hilliard Lyons, he is renowned not only for his client relationships and his investment acumen, but for the letter he wrote over 50 years ago requesting employment as a broker trainee. It is a classic:
I am writing concerning job openings in the Finance field. My name is Pete Mahurin, age 29. I am in excellent health, having not missed a day of work in five years. I neither smoke nor drink. I am a High School science teacher. I also am in the wholesale egg business.
My college years were wilder than most. I worked as a steeplejack (painting water towers) and played poker for a living. However, I quit poker and have not played in six years.
I will give you some of my assets and liabilities. First the assets: I am quick to learn. I can sell. I expect to work and I like to work. I am dependable. I will be at work on time and not half asleep.
Now my liabilities. I have no rich friends or relatives and can bring your firm no business in that manner. My background is rural and I am not in the Country Club set and have no interest in being in it. I have never owned a share of stock in my life.
Selling eggs, teaching, painting water towers and playing poker. A non-traditional resume, to say the least. But it might just be one of the very things that made possible Mahurin's extremely successful career in wealth management.
"Pete might be considered 'old school' by today's standards," says Baird Vice Chairman Jim Allen, one of Mahurin's closest friends, "but don't suggest that to his clients or to those who he has mentored over the years."
"Because of who he is and where he has come from, they have all benefited from the wisdom and guidance of an individual who is not just gifted, but tirelessly hardworking and authentic, with values that can provide valuable lessons for generations to come."
As the senior-most generation of financial advisors begins to transition out of our business and (hopefully) hand their practices and their clients off to next-generation successors, I worry that we risk losing one of the things I've always loved about the wealth management business – the diversity of backgrounds advisors have brought to our industry and the multiplicity of paths they followed to get here.
Part of that has to do with the way retail brokerage evolved over the years into investment management, which evolved into wealth management. It's shifted from sales to advice. From transactions to relationships. From a business to a profession, with different standards and hurdles to entry.
There's also no question our industry values different types of diversity than in the past – specifically, gender and ethnic diversity – and firms like Baird are working to ensure their associates more closely reflect the diversity of the clients we serve.
But younger advisors are less likely to have done the things Pete Mahurin did in his youth. We're not likely to have the same eclectic breadth of experience in our advisor ranks a decade from now that we do today.
If and when that happens, I for one am afraid our industry will have lost something unique and special, even for all we have gained.
Where Will the Next Generation of Financial Advisors Come From?
This month, as communities across the country begin to look for a safe path back to some semblance of normal life, college students are graduating in what must seem a surreal fashion. With no ceremonies or celebrations to attend in person, some are doubtless thinking hard about the current environment and what it might mean for their plans.
One thing seems certain: Unless their time in quarantine has radically changed their outlook, many of them won't be going into the wealth management business.
Earlier this year I wrote an article for Investment News about what was then perhaps the biggest crisis facing our industry – an impending wave of financial advisor retirements anticipated in the next decade with nowhere near enough interested young talent in the recruiting pipeline to replace them. The implications of this are serious not just for wealth management firms but for their current and prospective future clients.
In the months since the article was published, other priorities have obviously shifted to the front burner due to the COVID-19 pandemic and its impact on both the economy and people's financial lives. But the next-gen talent shortage continues to simmer in the background.
Before shelter-in-place orders turned college seniors' last semester into an extended virtual reality exercise, I sat down with Baird's Next Generation Talent Manager Katie Jackson to talk about what Baird is doing to bridge the looming generation gap in our industry. You can watch that interview in the video below.
Learn more about Baird’s Foundations program at BairdCareers.com.
Image Taken Before the Pandemic: Foundations Associates Anita Volk and Michael Krecek take steps toward their futures as Financial Advisors.
This Time Is Different
It seems like each new market and economic crisis is inevitably compared to the most painful one that immediately preceded it, and the chaos that came with the global spread of COVID-19 has been no exception. Shortly after the first major U.S. sell-off, it was already drawing comparisons to The Global Financial Crisis that began in 2008 and birthed The Great Recession. But, as I note in an article recently published by On Wall Street, there are some important differences between that environment and the one we find ourselves in now. You can read about them in the reprint below:
This Is It
The Most Important Lesson for Future Leaders of Finance
If I could offer one piece of advice to millennial professionals in the finance industry who have never been through a bear market, much less an unfolding societal crisis like that caused by the COVID-19 virus, it would be this: Pay attention.
Extreme times reveal core values. Crises reveal character. This may be one of the single most important moments you will ever experience in your development as future leaders of our industry. Decades from now you will talk about this with your children and grandchildren, with the employees who will then be reporting to you, with the companies and businesses you will be running. The pandemic of 2020 will be one of the things that formed you as a professional and a person.
Now is a time for heightened mindfulness. Pay attention to what you are feeling and how you're reacting to situations. At work. At home. In the communities you are a part of. What matters most to you amid the profound unfamiliarity and uncertainty and anxiety we are living with on a daily basis?
Watch the people you admire and respect. How are they behaving? My bet is that those rising to this occasion are radiating an outward-focused commitment to attending to and serving others, while at the same time, they seem centered and grounded.
This is the secret to leading effectively in a crisis. You need to find the solid ground on which you can stand – stable, centered, strong. But that solid, stable ground has to be the conviction that your purpose, at times like these, isn't to worry about yourself – it is to help others. To help real people in the real world with real problems.
As I wrote in the middle of the financial crisis of 2008 – 2009, "The best way to make it through a crisis is to stop focusing on your own problems and start helping others with theirs."
Learn that. Experience that. Live that. And you will have the most important thing you need to lead our industry through peak and valley cycles and crises in years to come.
Lessons Learned From Investing in Volatile Times
Even for those of us who've seen them before, times like these can be incredibly challenging to navigate for investors.
Right now I worry about people who are trying to do that on top of their day jobs, especially with everything else the Covid-19 pandemic has given them to deal with.
I recently corresponded with fellow Baird blogger Mike Antonelli about our experiences investing through volatile times. I hope people thinking about their next trade can benefit from what we've learned... or at least avoid the most common mistakes.
Character and Culture: The Legacy of Paul Purcell
Several years ago, I sat in a midtown Manhattan restaurant telling my lunch guest, former UBS Wealth Management Americas CEO Marten Hoekstra that I would soon be joining Baird, a Milwaukee-based global financial services firm as Vice Chairman.
"Are you kidding?" Hoekstra said. "That's fabulous! You rarely get the chance to work with a true leader like Paul Purcell."
Purcell, longtime Chairman and former CEO of Baird, passed away at the age of 73. Since then, leaders from across the financial services industry have echoed Hoekstra's comments, offering an outpouring of praise for a fallen colleague and lamenting that our industry has lost one of its best.
"Paul Purcell was the epitome of the way we think of best in class: hardworking (a non-stop worker), intuitive, of the highest integrity, passionate, boldly humble, committed, loyal, an unparalleled relationship builder," said Kim Fleming, Chairman and CEO of Pittsburgh-based Hefren-Tillotson.
Jim Allen, former Chairman and CEO of Hilliard Lyons, trusted Purcell enough to sell his business to Baird last year and signed on to continue serving as Vice Chairman of Baird.
"For many years, I have enjoyed the privilege of knowing Paul as the highly regarded leader of a strong competitor," Allen shared. "More recently, I was honored to call him a colleague. He was always genuine, caring and insightful. While he was analytically gifted, he was constantly guided by his keen instincts and intuition."
"He was a great man and an incredible leader," said D.A. Davidson CEO Jim Kerr. "He was always known for doing the right thing." Kerr's former colleague longtime D.A. Davidson Chairman Bill Johnstone added, "He proved that you could be both enormously successful and do so with integrity, grace, kindness and humility."
For more than a decade, at CEO roundtables and board meetings for the Securities Industry and Financial Markets Association (SIFMA), and during my last two years at Baird, I myself had the privilege of watching Paul Purcell in action.
I admired his integrity and unflinching honesty, which could sometimes come off as uncomfortable bluntness, like when he told me in an interview for my 2012 book Stewardship: Lessons Learned from the Lost Culture of Wall Street, "There's no question our industry lost its way [during the financial crisis]. It was greed, glorious greed."
I admired the culture he built at Baird, which may be his most enduring legacy. He believed passionately in employee ownership, and not only had the courage to repurchase Baird from its then corporate owner, but the foresight to share that ownership with approximately two-thirds of the firm's 4,600 employees, who are known as associates, akin to partners in a broadly-held partnership.
He believed to his core in treating everyone with the dignity and respect they deserved. No email – from anyone, on any topic – was too unimportant for him not to answer. If my mobile phone buzzed at 9:30 pm on a Saturday, it was inevitably Paul, responding to something I had sent him. Under his leadership, every year, for the last 17 years of his career, Baird was recognized as one of the top companies to work for in America.
Culture is the organizational equivalent of character. Culture is driven from the top and reflects the character of a firm's leaders. Character and culture matter. Get them right and anything is possible. Without them, nothing else matters.
Paul Purcell was a true leader because he got them right. Exquisitely right. That is the example he set for all of us and the legacy he bequeaths to our industry.
This tribute originally appeared in Barron's on March 9, 2020.
John Taft is Vice Chairman of Baird. He is a past chairman of the Securities Industry and Financial Markets Association (SIFMA), where he advocated for responsible financial reform.