In the late 1990s, Nassim Taleb had a radical new idea for an investment strategy: He wanted to start a hedge fund designed to lose money when the market went up. The appeal would be that the fund would generate huge gains any time the market took an unexpected hit. Taleb — a trader, writer, professor and all-around renaissance guy — had the clout to get financial backing for his idea, but he needed a partner of like mind to help execute it. He found that in Mark Spitznagel, a young trader known for his skill at minimizing losses. Spitznagel was studying at New York University’s Courant Institute of Mathematical Sciences, where Taleb was teaching. In 1999, the two founded hedge fund firm Empirica Capital, which at its height had nearly $500 million under management.
By 2007, the teacher and student had gone their separate ways. Taleb stepped down from trading and published the bestseller The Black Swan: The Impact of the Highly Improbable, which explained how an unforeseen event could topple global markets. Spitznagel launched a new firm, Universa Investments; like Empirica, it aimed to make money from black swan events. For both men the timing was impeccable. The financial crisis made Spitznagel a wealthy hedge fund manager and turned Taleb into a celebrity who could go around saying “I told you so” to heads of state.
Although Taleb, 51, holds the title of distinguished scientific adviser to Universa, these days the 40-year-old Spitznagel doesn’t see a lot of his mentor. They live 3,000 miles apart, and Taleb is busy with a rock-star-like schedule of public appearances around the world, including discussions with British Prime Minister David Cameron about how to save the U.K. economy and meetings with top officials at the International Monetary Fund about how to detect hidden risks in the financial system. In fact, Taleb has visited Universa’s Santa Monica, California, office only once in the past year. Although he and Spitznagel talk on the phone weekly and regularly exchange e-mails, they never discuss trading. “Nassim is a high-level guy, and I don’t bring him down to mundane things like prices of securities,” says Spitznagel, president and CIO of Universa.
Instead, they have what they call epistemological discussions and ponder the precarious state of the world. “You voted for Obama,” Spitznagel ribs Taleb.
They share a belief that both George W. Bush and Barack Obama have been disasters by allowing zombie banks to keep sucking blood from the economy. Taleb says the world is more vulnerable to shocks today than it was in 1999. “Even earthquakes seem to have a bigger impact on world GDP now,” he notes. Taleb has some answers on how the world can keep itself safe from black swans. His latest book, scheduled for publication in September 2012, is about robustness and fragility, expanding on an essay that appeared in the second edition of The Black Swan. Nature is robust, according to Taleb, in that it can recover from a disaster and start over; his new book talks about how economic systems, now suffering from serious fragility, can become similarly resilient.
[quote_left]Nassim Taleb: Fragility eventually breaks the system[/quote_left]“People think you can predict a black swan using forecasting methods,” he says. “I try to get them to understand that the best idea is to keep the system robust so that you aren’t vulnerable to black swans.” Taleb likes to talk about robustness as a way of life. He has given up riding a Vespa scooter and jogging because both were hazardous to his personal robustness.
Spitznagel has his own ways of taking precautions against fragility. He frequently uses the phrase “intellectual humility”: He might think he’s right, but he doesn’t want to jinx it. He does yoga, and he earned his instrument-rated pilot’s license following a bad experience flying from the Hamptons to Teterboro Airport in New Jersey. At Universa he is expanding the firm’s range of strategies — another way of keeping his business robust. In January, Spitznagel plans to launch the Universa Convex Macro Fund, which he expects will start with about $1 billion in assets.
Universa is best known for its flagship Black Swan Protection Protocol (BSPP) funds geared to hedging tail risk: unforeseen risks that might result from black swan events. These funds specialize in protecting equity exposure through options on single stocks and indexes. Though the tail-risk funds make up the bulk of Universa’s $6 billion in assets (Spitznagel won’t say exactly what percentage), the firm also has a small inflation fund, launched last year, that invests largely in interest rates and commodities, and an asymmetry fund, started in 2008, that is designed to capture downside returns in any market.
Like Universa’s other offerings, the new macro fund will invest almost entirely using options. Spitznagel determines all trades and weightings, overseeing a staff of five derivatives traders, all of whom are under 35. “It’s very hierarchical,” he says. Spitznagel doesn’t like to give the names of his staff to the media because the decisions are all his. Nor does he like to think of himself as a mentor. Still, running a macro fund represents a departure from an idea that history will remember as Taleb’s, and a chance for Spitznagel to separate from the eloquent but somewhat single-minded concepts of black swans and robust systems and bring his own insights into the public spotlight.
The main ingredient of a robust economy in the gospel according to Taleb is lack of debt. He fears that the U.S. and Europe could implode from debt as Fannie Mae, Freddie Mac and Lehman Brothers Holdings did. “I’m not into short-term decision making, but governments should have surpluses at all times to avoid fragility,” says Taleb. As a macro manager, Spitznagel will have to consider the potential side effects of the austerity that Taleb champions.
Spitznagel is as motormouthed as his fund’s famous adviser, but he tends to go on about geekier concepts, such as arbitraging the volatility surface. (“That means we sell expensive stuff and buy cheap stuff,” he explains without coming up for air.) He throws in frequent references to other mentors and heroes. These include Karl Popper, the Austrian philosopher who said scientific theories should be tested through efforts to prove them false — “I think an investment is a hypothesis that is continuously exposed to refutation,” says Spitznagel — and the Austrian economist and social philosopher Ludwig von Mises.
[quote_right]Spitznagel: People react without thinking about the mathematical expectation[/quote_right]And for all the talking he does about achieving small losses and outsize gains, Spitznagel is a disciple of Benjamin Graham who adheres to the theory of value investing and investing defensively, at a discount to intrinsic value and with promises of safety of principal and adequate returns. He considers Graham’s Intelligent Investor an investment bible. “To my mind, Graham was the most significant thinker in investing,” says Spitznagel. “His margin-of-safety principle is central to the practice — certainly to my practice.”
Thanks in large part to Taleb’s popularizing the term “black swan,” the investment world is now obsessed with hedging tail risk. Assets under management in tail-risk funds rose from less than $500 million just before Lehman filed for bankruptcy in September 2008 to about $43 billion in September 2011, according to a report by JPMorgan Chase & Co.’s global asset allocation and alternative-¬investments research team. Bennelong Asset Management, Capula Asset Management, Man Group, Pine River Capital Management and Saba Capital Management all started tail-risk funds last year. These funds gained anywhere from 5 to 29 percent when the Standard & Poor’s 500 index nosedived in August of this year, and 5 to 12 percent in September.
The funds weren’t around for the market crash of 2008, when Universa’s BSPP funds rose 120 percent, according to an investor. Hedge funds in general lost 6.85 percent that year, as measured by the HedgeFund Intelligence Global Index. BSPP lost about 4 percent in both 2009 and 2010 and was down again this year before August, when it rode the market turbulence to a 23 percent return.
Spitznagel calls the other funds “copycats” and doesn’t see much point in setting up a tail-risk fund after the market has crashed. But the Black Swan Protection Protocol Inflation fund, up 20 percent for the 12-month period ended September 30, according to investors, and the Universa Asymmetry Fund, up 4.7 percent year-to-date as of March, have shown him the value of something the copycats do: running additional funds that they hope will make money when the market goes up.
“Their tail-risk funds are a great thing for investors, but they aren’t meant to be stand-alone,” says Claude Bovet, founder and managing director of Lionscrest Capital, a Vancouver, Canada–¬based firm that gives wealthy investors access to Universa’s products. Lionscrest has $25 million currently invested with Universa and an additional $100 million in commitments.
Although 1.5 to 2 percent in management fees can earn a tidy profit for a firm the size of Universa — with $6 billion in notional assets and just 14 employees including Spitznagel — depending on a strategy designed to lose money most years means its tail-risk funds have earned performance fees just one year so far (2008). As Spitznagel sees it: “We’re a liquidity provider when investors make money in a downturn. So you can take the money you’ve made and invest like Warren Buffett just when asset prices are depressed. Why not give investors the option of putting the money into our funds?”
Still, a macro fund, even a systematic one, would seem to be a stretch for a manager whose proven expertise is in tail risk. “A macro fund is almost the opposite of what a tail-risk fund does,” says Aaron Brown, risk manager at $37 billion asset management firm AQR Capital Management in Greenwich, Connecticut. Brown is an old friend who used to hang out at the Odeon restaurant with Spitznagel and Taleb in their NYU days, talking esoteric topics such as dynamic hedging theories with a group that became known as “the Odeon gang.” Brown adds: “Macro requires spotting large trends, while tail risk requires seeing what nobody else sees. That’s not to say Mark can’t do both.”
Spitznagel sees his expertise as lying not so much in tail risk as in the risk management measure called convexity, which aims to minimize losses as the market falls and maximize gains as the market goes up.
“My whole investment methodology can be summed up as convexity,” he explains. “To me, convexity underpins the intellectual humility and margin of safety of value investing. From the start Universa has been focused on very convex macro strategies, which include tail hedging. And in grouping all of our exposures together, we end up spanning most if not all rather extreme macro scenarios.”
Universa’s main investment instrument — out-of-the-money put options — gives it positive convexity; the firm doesn’t risk losing huge sums of money because it never has to pony up a lot. Universa pays only the option premium, which might be $1 on a stock trading at $100 a share; for this reason the actual cash in Universa’s accounts on any given day is no more than 1 to 10 percent of the assets under management, which represent the notional amount that its investors are hedging. If the share price goes down over the period covered in the option contract, that $1 becomes more valuable, but even if the share price goes up, the investor can lose no more than $1 a share.
Spitznagel started trading when hewas 16. After a peripatetic childhood and adolescence that included moves from Michigan to upstate New York and back to Michigan as his father, a minister in the United Church of Christ, changed parishes, the family settled in Chicago. There the young Spitznagel got to know Everett Klipp, a family friend and longtime commodities futures trader, who brought him to the Chicago Board of Trade, where he worked as a runner during school holidays. Spitznagel liked the trading pit so much he took a semester off after his freshman year at Kalamazoo College in Michigan to work as a clerk at the CBOT, and then returned to the floor as a bond futures trader after graduating with a BA in political science. Klipp, who died in January, taught the young trader to go for steady small losses and occasional large wins.
“He wasn’t a sophisticated Wall Streeter,” Spitznagel recalls. “Actually, he was a farm boy. His mantra was: ‘You’ve got to love to lose money, hate to make money. A small loss is a good loss.’ He’d go around saying this in a Tourette’s-like chant.” What Klipp meant, and the young Spitznagel quickly absorbed, was that survival as a trader wasn’t about making accurate market forecasts but about having the discipline to constrain the losses.
[quote_left]Mark Spitznagel: I wanted to be away from Wall Street[/quote_left]By 1997, Spitznagel had been working in the pit for four years, and the frenzied yelling and hand signals were starting to give way to electronic trading. He decided it was time for a change and got a job as a proprietary trader at Nippon Credit Bank in New York. There he specialized in euro-dollar fixed-income options and made money from the Asian financial crisis and the blowup of hedge fund firm Long-Term Capital Management. In 1999, he decided to take time off from trading to go to graduate school. “I wanted to get a master’s in math because I felt like I was lacking some rigor,” he says. Spitznagel applied to the Courant Institute, generally considered the top applied-mathematics school in the world: “I can’t believe they accepted me.”
Taleb was by then a popular author in trading circles thanks to Dynamic Hedging: Managing Vanilla and Exotic Options, a highly technical book published in 1997 in which he presented options-trading theories he’d developed during a career that included stints at Bankers Trust Co., Banque Indosuez, BNP Paribas, CIBC Wood Gundy, the Chicago Mercantile Exchange, Credit Suisse First Boston and UBS. He was teaching a class at Courant titled “Model Failure in Quantitative Finance.” Spitznagel did not sign up for the course his first year, but a mutual friend told him he should meet Taleb because the two had so much in common.
They’d both been traders on prop desks, where taking multiple small losses is generally frowned upon, and in the course of one week, they had a few conversations about trading. The next thing Spitznagel knew, the professor was inviting him to become his partner in a hedge fund. Taleb had already obtained a financial commitment from S. Donald Sussman, founder of Paloma Partners, a Greenwich-based investment firm that has provided seed capital to hedge fund managers like David Shaw who have gone on to great success. Taleb needed someone who understood both down-and-dirty pit trading and the esoteric world of quantitative analysis.
In 1999, Taleb and Spitznagel created the first-ever tail-risk fund, Empirica Kurtosis, named after the term used to measure the likelihood of extreme events in a probability distribution. For Spitznagel, the Kurtosis fund was a chance to hedge at a very low cost. The strategy consisted of buying put options, which were particularly inexpensive at the time because investors were so bullish. The Dow Jones Industrial Average broke the 11,000 barrier in May 1999, a month before David Elias published Dow 40,000. Spitznagel still shakes his head when he recalls those times. “People react based on emotion and herding, without thinking about the mathematical expectation,” he says. “Maybe humans will evolve out of this behavior in another 10,000 years.”
Spitznagel didn’t take Taleb’s class on failed quant models until a year after they opened Empirica. “It was kind of strange that we were sitting next to each other on the trading desk every day, then I’d occasionally show up at his class,” he says. “The real education we both got back then was as market clinicians.”
For the first four years, Taleb and Spitznagel worked out of Paloma’s office park in Greenwich, where, as it happens, they shared restrooms with another rising hedge fund firm, Amaranth Advisors. From time to time the two Empirica partners would take walks in a wooded area nearby. They would talk mostly about pricing options. Spitznagel never mentioned it to Taleb, but being around nature gave him some inspiration on how to approach investing. Spitznagel, who likes to quote the Tao Te Ching as a parable for finance, thought of the Taoist tale of the tree that stayed strong because it could bend with the wind, while the brittle tree broke.
“The mental model I’ve had since I was a teenager at the CBOT has been to yield to the market forces like the supple tree,” he says. Banks are brittle, he later found out, as was Amaranth, which in 2006 lost more than $6 billion on a bullish bet on natural gas and soon shuttered.
Spitznagel also learned that it made sense to deploy other strategies besides buying put options — he could sell them, for example. In 2000, Empirica’s first full year, the firm proved its worth when the technology stock bubble burst. As Spitznagel explains: “Anyone who didn’t see the collapse coming had blinders on. The asset bubble of the tech boom — now, that was a black swan. It was one of the great bubbles of history, a stampede, and not at all predictable.” Nevertheless, the bust sent shock waves through the market and allowed Empirica Kurtosis to earn 56.86 percent for the year, according to an investor letter the firm put out in 2003.
Tumultuous 2001, however, was a different story. The Kurtosis fund lost 8.39 percent that year as the U.S. economy sank into recession and stock markets around the world staggered in the wake of the 9/11 terrorist attacks — another event that could be considered a black swan. According to people familiar with the situation, Empirica made the mistake that year of continuing to buy put options after the 9/11 attacks instead of cashing in.
“It looks like the planes hit and investors panicked,” says Janet Tavakoli, who runs Chicago-based consulting firm Tavakoli Structured Finance and has spent many years researching tail-risk funds. “Instead of taking their gains, they wanted to keep buying put options as insurance, when they were expensive.”
Taleb does not dispute that account. “Some clients wanted to increase protection during the explosion of volatility, as they worried about the small possibility of a follow-up to 9/11,” he says.
Tavakoli has been a detractor of Taleb’s over other issues, publicly calling him on the carpet for being careless when talking about performance figures for Universa; she says all black swan funds should be required to file audited returns. Her suspicion that investors lost money if they went into Empirica Kurtosis after 2000 is borne out by Empirica’s 2003 investor letter, which shows returns of –13.81 percent in 2002 and –3.92 percent in 2003. Annualized returns were 9.90 percent as of 2003 and, according to Tavakoli, somewhat less than 6 percent as of 2005, when the fund shut down.
If the fund had stayed in operation through 2008, the annualized returns would likely have been much higher. “That’s why I always tell investors to be prepared to have a ten-year horizon for investing in tail risk,” says AQR’s Brown. “Otherwise they’ll take their money out when the market is up — just before you need to be in this strategy.”
Spitznagel maintains that Empirica was at the peak of its assets through its separately managed accounts when he shut it down. “People thought we’d bled to death or that Nassim was sick again,” he says. Taleb had been diagnosed with throat cancer in the mid-1990s, and though he recovered, he has talked about the illness at length, calling it an important lesson on the existence of black swans, especially considering he has never been a smoker. In fact, Taleb wanted to retire from trading so he could work on his next book.
Spitznagel says he could have kept Empirica going but didn’t want to do it alone. So he shut the fund and started working at Morgan Stanley as a proprietary trader, heading equity options in the process-driven trading group. He decided to leave when the firm imposed strict noncompete agreements following two prominent defections. In February 2007, he moved to the Los Angeles area to launch Universa. “I thought a lot about where to go,” he says. “I knew I wanted to be away from Wall Street, where everyone basically has the same ideas. The opposite coast gave me some insulation against investment group think.”
Taleb has long maintained that hetries to be “broadly right rather than precisely wrong.” Unlike his friend Nouriel Roubini, the so-called doomsday economist, and hedge fund managers John Paulson and James Melcher, who in 2006 and 2007 were predicting the mortgage meltdown, Taleb wrote The Black Swan with the intention of moving away from finance and establishing himself as a philosopher and public intellectual.
He comes from a family of prominent public figures in Lebanon’s Greek Orthodox community: two deputy prime ministers, a supreme court judge and a great-great-great-great-grandfather who was a governor of the Ottoman semiautonomous Mount Lebanon Governorate. He experienced his first black swan moment as a teenager in Lebanon when civil war broke out there in 1975.
People close to Taleb say he can be arrogant, though he certainly has the credentials to back it up. He speaks five languages and has multiple degrees, including an MBA from the Wharton School of the University of Pennsylvania and a Ph.D. in management science from the University of Paris, as well as a 20-year trading career. “He was a great trader,” says Brown.
When The Black Swan came out in May 2007, the Dow was on its way to breaking 14,000, although the U.S. economy and real estate market were starting to slow. The book warned the public against becoming complacent. “Globalization creates interlocking fragility, while reducing volatility and giving the appearance of stability,” Taleb wrote. “We have never lived before under the threat of a global collapse. Financial institutions have been merging into a smaller number of very large banks. Almost all banks are interrelated. So the financial ecology is swelling into gigantic, incestuous, bureaucratic banks — when one fails, they all fall.”
As Taleb noted in the book, a black swan event is in the eye of the beholder.
“Once something bad happens, you can often point to evidence that the investment world didn’t believe the sky was falling until it did,” Spitznagel explains. All the most severe stock market drawdowns in history started from very high valuations that seemed perfectly clear after the fact and were black swans only to those who were focused on other aspects of the market, such as momentum or pie-in-the-sky growth. “But it should not be surprising that when valuations are stretched, markets become more susceptible to shocks,” Spitznagel adds.
Taleb saw the ripple effect of debt in 2008, when major financial institutions had far more money in jeopardy than their risk systems told them, because of excessive borrowing. He says debt is a main cause of the fragility in the world today: “Fragility eventually breaks the system. We should have a system that has mandatory government surpluses, as Sweden started in 1991 after its banking crisis.”
Taleb’s big-picture views do not include a plan for easing debt other than, as he has said in some of his public statements, through “blood, sweat and tears.” He has advocated that banks cut mortgage payments for troubled homeowners in return for half of the profits when the houses are sold, thereby turning debt into equity. He has spoken out against raising taxes on the grounds that those who did the right thing, himself included, should not have to pay more taxes to support those who didn’t. “I’m talking about how to achieve robustness rather than quality of life,” he says.
Lionscrest’s Bovet believes Taleb is in the midst of developing an economic philosophy that will have a lasting influence. “Antifragility will have the same kind of impact that Harry Markowitz and John Maynard Keynes have had,” says Bovet, though he knows Taleb considers Markowitz’s Modern Portfolio Theory an instigator of the financial crisis. (Taleb is more favorably disposed toward Keynes, especially the latter’s view that uncertainty is a cause of market turmoil because it leads people to irrational behavior.)
In The Black Swan and a previous book, Fooled by Randomness, Taleb advocated what he called the “barbell” strategy of risk management: Avoid the middle and invest in linear combinations of extremes. He recommends an unfettered free market for industry but believes banks should not be allowed to take risks. He is especially livid about banks that were part of the bailout that have paid bonuses instead of lending.
Taleb and Spitznagel wrote an opinion piece in September in which they said investors should refuse to buy stock in banks, partly because these companies don’t show good return potential if their assets are properly marked to market but also on ethical grounds, as a protest against banks that “take risks, get paid for the upside, and then transfer the downside to shareholders, taxpayers, and even retirees.”
Says Taleb: “Before the  repeal of Glass-Steagall, commercial banks ate their own cooking. We should at least go back to that system. I’d go further. I’d go back to having banks that are smaller and more local, more entrenched in communities, and they should keep the loans they make. As it exists now, banking is a parasitic industry that will cost taxpayers $5 trillion in the next ten years.
“If you want to get a bonus,” he adds, “go to work for a hedge fund. Hedge funds can fail or make mistakes, but we aren’t bailing them out.”
Universa is located on two floors of a small building in downtown Santa Monica, a few doors down from a yoga center and less than three blocks from the beach. It is, as Spitznagel wanted, a world away from Wall Street. “You never hear anyone use the word ‘tranche’ in here,” he says, glancing around during a recent lunch at a nearby restaurant, where other diners are much more likely to be talking about screenplays.
Back at the office there’s a black swan painting and a Bach fugue playing on the sound system. (At Empirica, Spitznagel and Taleb used to argue about what music was good for trading; the latter favored Bach.) Whiteboards with mathematical formulas are scattered about. Spitznagel sits at one end of a long table in the loftlike room, amid his young traders, who all worked on Wall Street before coming west.
The atmosphere is somewhat like that of a trading floor, only quieter. Everyone sits in front of a computer screen, intently researching the universe of options; the name “Universa” is meant to describe the universality and ubiquity of tail risk. “You can work it out,” Spitznagel assures a trader who has asked him about adjusting the portfolio to accommodate an order. He lets the traders make such decisions for handling orders up to a certain size.
When Spitznagel decided to launch a macro strategy, he quickly realized it would have to be a systematic fund, making small investments in a wide range of market behaviors, rather than a discretionary fund, which would require trading on a select set of market views — something akin to forecasting. The latter would be anathema to someone whose whole career has revolved around the premise that trying to forecast specific economic gains and losses creates bigger losses. Instead, as a systematic macro manager, he will be able to take inexpensive positions in almost every conceivable theme, then continue to adjust the portfolio as a scenario unfolds and unanticipated developments emerge.
“A typical macro fund manager has to believe in a specific scenario and position his or her portfolio for it, over all alternatives,” says Spitznagel. “But with my nonlinear payoffs, I can simultaneously position for both 1970s-style inflation and Japanese-style deflation, for example.” For an inflation scenario he would want a whole basket of cheap options on agricultural commodities, metals, energy and nominal rates: “I don’t claim to know just how the inflation would play out, and with a basket of cheap options, I don’t have to.”
The biggest drawback to forecasting, Spitznagel says, is that it often leads to increased risk as a result of ideas that become irrefutable. “The greatest hubris is when positions or policies are constructed based on economic hypotheses, which, if refuted, can bring down the entire portfolio or system,” he explains. As an example, Spitznagel points to Federal Reserve Board chairman Ben Bernanke, the man he considers the current architect of detrimental policies. “This describes typical bank proprietary trading and Bernanke’s insane policies today,” he adds.
Spitznagel has no shortage of opinions about what is wrong with the economy, and the Federal Reserve’s policy of imposing low interest rates, which he calls a “superficial façade,” is at the top of his list. Government-imposed low interest rates “say nothing about the attractiveness of capital investment or lending, but making us believe that they do is the Fed’s insidious illusion,” he explains.
Universa’s inflation fund lost small amounts from betting incorrectly on Treasuries early this year. On the other hand, in keeping with Spitznagel’s view that banks are not producing real returns, the firm’s other funds have made money from put options on bank stocks in the past year. Banks are by no means the only stocks Spitznagel believes are highly overvalued. Because he does everything through options, he devotes much of his research time to stock and options valuations.
In spite of his aversion to forecasting, Spitznagel made a couple of predictions in a white paper he published in June, titled “The Dao of Corporate Finance, Q Ratios, and Stock Market Crashes.” He warned that at current valuations there was a 20 percent chance of an equity drawdown of 20 percent and a 20 percent chance of a larger-than-40 percent correction in the next few years. He believes valuations in the U.S. equity market are still elevated, even after the August correction, making it highly likely that eventually there will be a large drawdown. Furthermore, he thinks the rest of the world is using the wrong measurements to determine value.
“Of all the misguided financial dogma in the world, and there’s a lot, the use of the one-year price-earnings multiple as a valuation measure for the aggregate stock market has got to be the most prevalent,” he says. “It measures relative value between stocks fairly well but not the stock market’s value on its own.”
Spitznagel is a proponent of the Q ratio, established by Nobel Prize–winning economist James Tobin. The Q ratio measures the ratio of aggregate enterprise value (that is, equity plus debt) to the aggregate corporate assets or invested capital — or, return on capital relative to cost of capital. The limitation is that the Q ratio can be used only to assess the aggregate stock market, not individual stocks. Universa regularly uses out-of-the-money options to bet against current individual stock valuations. For that research, says Spitznagel, “I subscribe to Ben Graham’s old-school methodology for valuing equities, and I focus on sensitivities of stock prices to changes in their key value drivers.” The Black-Scholes formula of establishing one right price for an option is superfluous, he says, calling it “exceedingly naive.”
“Mark’s portfolio is robust,” says Taleb — the highest praise he can bestow. He adds that the portfolio will hold up against various risks, not only because of its convexity, which allows Universa to guess wrong and still keep losses small, but also because the firm buys only exchange-traded options, thereby eliminating the risk that a counterparty to an over-the-counter derivatives contract will go under, as Lehman Brothers did.
Life is good in LA, where Spitznagel lives with his wife and their two young children in the posh paradise of Bel Air, on a gated estate they bought from celebrities Jennifer Lopez and Marc Anthony. Spitznagel loathes traveling, but he does venture as far as Michigan, where he has a vacation home and recently bought several hundred acres of farmland, having decided that self-sustainability is one of those hedges that allow an individual to stay robust if a really vicious black swan happens to attack. But it’s hard to imagine him ever going back to the Midwest to live off the land. One notable difference between Taleb and his protégé is that Spitznagel seems to eat, sleep and breathe trading, and has no plans to ever stop doing it.
“We’re living in a profound moment,” he says. “I’m going to be telling my grandchildren about this one day. I get such a perverse satisfaction from the way we act in the heat of risk-taking, I’m sure I’ll continue doing this forever.”
[This article first appeared in Institutional Investor Magazine and is written by Jan Alexander. Nassim Taleb is author of ‘The Black Swan: The Impact of the Highly Improbable’ and ‘Antifragility: Things That Gain from Disorder’. Mark Spitznagel is founder of Universa Investments and author of ‘The Dao of Capital: Austrian Investing in a Distorted World’]