MARK SPITZNAGEL

President & Chief Investment Officer

Universa Investments L.P.

Mark founded Universa Investments L.P. in

January 2007 and has developed its
unique focus on risk mitigation in the
context of achieving long-term
improvements to portfolio construction. His
SAFE HAVEN INVESTING - PART ONE investment career has spanned over 20
years as a derivatives trader, during which

NOT ALL RISK MITIGATION he has cultivated his approach to safe

haven strategies, specifically bespoke tail
IS CREATED EQUAL hedging.

October 2017

There is a movement today among pension funds toward systemic risk

mitigation—or “safe haven”—strategies. This makes great sense as a
potential solution to the widespread underfunding problem. Many pensions
still haven’t fully recovered from the crash of 2008, and can’t afford another.
Moreover, truly effective risk mitigation must lead to an incrementally higher
long-run geometric return, or compound annual growth rate (CAGR); and a
higher CAGR is the way to raise a pension’s funding level over time.

Just how does risk mitigation raise the CAGR? Modern Portfolio Theory tells
us that diversification and rebalancing can lower a portfolio’s risk and raise
its geometric return, and with the right covariance structure it is
counterintuitively possible for its geometric return to exceed that of any of its
components.

This is investing’s own theory of relativity: There is no one value that

we can assign to an investment, specifically a risk mitigation
investment; rather, its value is unique to a given portfolio, and is

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 Achieving higher sustained CAGRs through volatility tax
relative to how it interacts with and thus mitigates risk savings is the name of the game in risk mitigation; it is
in that portfolio. This sound theory behind true risk precisely how risk mitigation adds value. All such
mitigation shows that a portfolio’s geometric return strategies aim to do it, but not all are created equal. They
can truly be greater than the sum of its parts. all ultimately require a tradeoff between the degree of loss
protection provided (the amount of the portfolio’s negative
compounding that is avoided) versus the degree of
In practice, however, such attempts at risk mitigation opportunity cost paid by the allocation of capital to that
through diversification tend instead to lower CAGRs (in the protection rather than to the rest of the portfolio (or the
name of higher Sharpe ratios); while measured risk may amount that the portfolio’s arithmetic average return is
be lowered, it tends to be accompanied by lower geometric lowered). These are the two sides of the safe haven coin,
returns as well. One is then forced to apply leverage to and we can only measure each side vis-à-vis the other.
raise the CAGR back up, which just adds back a different Evaluating this highly nonlinear tradeoff is tricky, and is
kind of risk by magnifying the portfolio’s sensitivity to errors fraught with mathematical mistakes, as the effect on the
in one’s spurious correlation estimates. Diversification is volatility tax is often indirect or invisible. The best risk
unfortunately not “the only free lunch in finance” that it has mitigation solution can be a counterintuitive one.
been made out to be. So much risk mitigation is simply
about moving from concentration (or typically beta) risk to The hope for this piece, then, and the ones that follow in
levered model risk. this series, is to help make these solutions more intuitive,
and perhaps even change our idea about what risk
True risk mitigation shouldn’t require financial engineering mitigation is and what it can do. And analysis being
and leverage in order to both lower risk and raise CAGRs. performed can mostly be replicated and verified in a
After all, lower risk and higher CAGRs should go hand in spreadsheet in ten minutes or so. (Some of the results are
hand! It is well known that steep portfolio losses (or so odd that verification may be in order.)
“crashes”) crush long-run CAGRs. It just takes too long to
recover from a much lower starting point—lose 50% and We will thus focus on a straightforward criterion: higher
you need to make 100% to get back to even. I call this cost portfolio-level compound annual growth rates from lower
that transforms, in this case, a portfolio’s +25% average risk (or specifically from paying less volatility tax). We will
arithmetic return into a 0% CAGR (and hence leaves the use this criterion to evaluate cartoon versions of the three
portfolio with zero profit) the “volatility tax”: it is a hidden, canonical prototypes of safe haven strategies out there,
deceptive fee levied on investors by the negative where each exhibits a very distinct protection-cost tradeoff.
compounding of the markets’ swings. They are depicted in Figure 1 on the next page.

The destructiveness of the volatility tax to a portfolio Each of the three cartoon safe haven prototypes has its
explains in a nutshell Warren Buffett’s cardinal rule simple dynamics bucketed by four corresponding ranges
of annual total returns in the SPX (a natural proxy for the
“don’t lose money.”

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 STORE-OF-VALUE ALPHA INSURANCE
Annual Real Return Annual Nominal Return Annual Nominal Return
50% 50% 1000%

40% 40% 800%

30% 30% 600%

20% 20% 400%

10% 10% 200%

0% 0% 0%

-10% -10% -200%

<-15% -15% to 0% 0% to 15% >15% <-15% -15% to 0% 0% to 15% >15% <-15% -15% to 0% 0% to 15% >15%

Annual SPX Total Returns

systemic risk we’re trying to mitigate). Think of these as

contractual contingent payouts, with no noise or
counterparty risk. They represent actual safe haven The “alpha” prototype in the center makes a 20%
strategies only by virtue of the “principle of charity”, as nominal annual return in the crash bucket (when the
they are in most cases idealized, optimistic interpretations SPX is down 15% or more for the year), 10% in the
of such strategies (for instance, classical diversification second bucket (when the SPX is down less than
doesn’t come close to mitigating risk like any of these); this 15%), and 5% in the other two buckets; it provides a
of course makes their usefulness even greater in this nice negative correlation in a crash, and is always
thought experiment exploring the limits of even what the positive-carry. This looks somewhat like the
best risk mitigation can do.
intended performance (and even the historical
performance of the best of survivors, at least for a
while) of systematic trend-following CTA strategies,
The “store-of-value” prototype on the left makes a “contrarian global macro” and “long volatility”
fixed 2% real return (or annuity) each year, strategies, or even gold.
regardless of SPX returns; it provides great
diversification, with a zero correlation in a crash.
This might be short-term US Treasuries (being very
generous), or even Swiss franc. The “insurance” prototype on the right makes an
explosive profit of 900% in the crash bucket, and

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 STORE-OF-VALUE ALPHA INSURANCE
CAGR Outperformance……………. -0.17% CAGR Outperformance…………… +0.18% CAGR Outperformance…………… +0.67%
40% 40% 40%
100% SPX 100% SPX 100% SPX
90% SPX + 10% Store-of-Value 90% SPX + 10% Alpha 97% SPX + 3% Insurance
20% 20% 20%
Annual Return

0% 0% 0%

-20% -20% -20%

-40% -40% -40%

<-15% -15% to 0% 0% to 15% >15% <-15% -15% to 0% 0% to 15% >15% <-15% -15% to 0% 0% to 15% >15%

Annual SPX Total Returns

effectively mitigated the systemic risk in a portfolio and

loses 100% in every other year (whenever the SPX
thus added the most value by improving its CAGR,
isn’t down by over 15%); it is highly nonlinear or historically? Let's see what the empirically correct answer
“convex” to crashes (a “9-to-1 longshot”). This looks is by testing three portfolios where each strategy was
a lot like a tail risk hedging strategy (at least when paired with an SPX position. We used a weighting of 90%
done right, though most such funds seek profiles SPX + 10% safe haven prototype in the first two cases,
much more like the alpha prototype), and this and 97% SPX + 3% in the insurance case. Changing the
extreme asymmetry is the touchstone for what I do 10% allocation sizes would not have materially changed
as a practitioner. the results, and the much smaller allocation size of the
insurance prototype is due to its extreme convexity. The
higher a strategy’s “crash-bang”-for-the-buck, the less
Over the past 20 calendar years (an arbitrarily selected
capital it requires to move the needle and the more capital
round number), the stand-alone arithmetic average returns
is available for the rest of the portfolio, in this case for the
of this store-of-value, alpha, and insurance payoff profile
SPX. All are rebalanced annually, and of course the
have been about +4% and precisely +7% and 0%,
insurance allocation is replenished each year that the SPX
respectively. (There are two years in the crash bucket, or
isn’t down over 15%.
10% of the data—not exactly “black swans”.)
Figure 2 depicts historical performance profiles of each
Which of these three strategies would have most

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hypothetical portfolio over the past 20 calendar years, How did the insurance prototype compare, with its meager
bucketed again by corresponding annual SPX total 0% average return? With only a 3% allocation, the crash
returns. bucket SPX losses were almost entirely offset and hence
the portfolio CAGR outperformed that of the SPX alone by
The blue bars are the average annual portfolio returns for 67 basis points (almost four times the outperformance of
that bucket, next to the SPX alone in gray, and the line the alpha portfolio). The insurance added the most risk
plots are the ranges of annual returns. mitigation value to the portfolio by saving so much of the
volatility tax.
Keep in mind that Figure 2 does not account for the
volatility tax savings that continue to compound even To put this in perspective, in order for a 3% allocation
during non-crash years—as volatility tax savings are to a store-of-value strategy to similarly raise the
essentially invested in the market. We have erroneously portfolio’s CAGR by 67 basis points, that store-of-
compartmentalized each volatility tax savings into a single value strategy would require a fixed almost 30%
year, and have thus hidden those savings that accumulate nominal annual return (which would of course attract
beyond that year. We have appropriately left it to overall, all the capital in the world).
unconditional CAGR outperformance to fully capture this
hidden accounting and show the true risk mitigation value While we just saw in the alpha prototype example that the
added. expected geometric return of a portfolio can be greater
than that of any of its component parts, it is nonetheless
The portfolio with the store-of-value prototype showed hard to believe the severity in the insurance prototype
some, but not much, risk mitigation in the crash bucket, case. It simply runs contrary to the common perception of
though the portfolio CAGR was actually lower than SPX this type of payoff as expensive, as well as the
alone by 17 basis points. The opportunity cost of the safe conventional wisdom that for a risk mitigation strategy to
haven versus owning more SPX shows itself quite clearly. add value it must have a positive expected return. What at
first appears to gratuitously lower the arithmetic return of
The obvious pick for most would have been the portfolio the portfolio (and drag on the portfolio as a line item in 9
with the alpha prototype, with its 7% average return and out of 10 years) turns out to be a CAGR boon.
impressive negative correlation in the crash bucket.
Adding it to the SPX portfolio lowered the arithmetic return We can crank up the alpha allocation size further, up to
of that portfolio (since its arithmetic mean is lower than about 30%, and increase that portfolio’s outperformance a
that of the SPX), but in turn also raised the CAGR of that bit, but it still never gets anywhere close to the 3%
portfolio by 18 basis points. It thus created a modest cost insurance allocation’s level of outperformance.
savings on the volatility tax. But that savings was
surprisingly low, and the portfolio still realized heavy 20%+ Moreover, during this time period the insurance
crash losses.
portfolio outperformed both the HFRI hedge fund

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 incrementally higher portfolio CAGR, higher than
index and a 60% SPX + 40% Treasury bond
allocations to either the store-of-value or the alpha
portfolio—including over the past 5 years and,
prototypes tested (as well as just about any other
remarkably, over the majority of the years in
alternative out there); this portfolio’s geometric return was
frequency.
greater than the sum of its parts.

Importantly, these results are extremely robust to the time

This is how risk mitigation adds value to a
period selected, as they don’t materially change whether
testing over the past 10, 20, or even all the way back over
portfolio, and is its ultimate goal. Effectively
the past 100 years (though the alpha strategy’s CAGR achieving this goal—through an effective
outperformance to the SPX completely disappears as we savings in volatility tax, or minimizing
lengthen the time period).
negative compounding—means achieving an
To be clear, one needn’t have assumed an explicit 97% optimal protection-cost tradeoff, and this
SPX + 3% insurance portfolio in order to have benefitted tradeoff seems to thus greatly favor maximal
from the risk mitigation as we have seen here. We have convexity. The implications for how pension
simply shown how various types of risk mitigation
allocations proportionally transformed, and as a result
funds might best approach underfunding
outperformed—or not—the returns from one’s systemic problems through risk mitigation are huge.
exposure (or beta). For instance, one could have moved
from a 50% systemic portfolio exposure, or beta, to a
48.5% exposure + 1.5% insurance prototype allocation
and realized the same incremental risk mitigation value
added proportional to that 50% systemic exposure.

The value of a payoff with crash convexity as extreme as

the insurance prototype is almost entirely derived from the
perspective and context of the end user, from what it
specifically does to that end user’s portfolio. As a
standalone strategy, the insurance prototype’s value was
an arithmetic average return of 0% and geometric return of
-100% (both by design); it had no long-term value. As a
3% allocation added to a portfolio composed entirely of the
SPX, for instance, the insurance prototype’s value was an

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IMPORTANT DISCLOSURES

This document is not intended to be investment advice, and does not offer to provide investment advice or sell or solicit any offer to buy securities.
Universa does not give any advice or make any representations through this document as to whether any security or investment is suitable to you or
will be profitable. The discussion contained herein reflects Universa’s opinion only. Universa believes that the information on which this document is
based is reliable, but Universa does not guarantee its accuracy. Universa is under no obligation to correct or update this document.

Neither Universa nor any of its partners, officers, employees or agents will be liable or responsible for any loss or damage that you may incur from
any cause relating to your use of these materials, whether or not the circumstances giving rise to such cause may have been within Universa’s or any
other such person’s control. In no event will Universa or any other person be liable to you for any direct, special, indirect, consequential, incidental
damages or any other damages of any kind even if such person understands that these damages might occur.

The information shown in Figures 1 and 2 is purely illustrative and meant to demonstrate at a conceptual level the differences among different types of
risk mitigation investment strategies. None of the information shown portrays actual or hypothetical returns of any portfolio that Universa manages.