Tuesday, 21 February 2017
Last updated 3 days ago
Mar 14 2011 | 12:04pm ET
36 South Investment Managers’ Black Swan Fund gained 234% in 2008. The fund, which capitalized on the unexpected, high-impact events known as black swans, was shuttered in 2010 after losses. Now the firm, relocated from New Zealand to London, is preparing to launch another tail risk vehicle, the Black Eyrar Fund. FINalternatives’ Senior Reporter Mary Campbell spoke to 36 South co-founder Jerry Haworth recently about the new fund, the decision to move to London and just what is an ‘eyrar,’ among other subjects.
What is a Black Swan fund and what sort of instruments does it employ to achieve its results?
Well, a black swan normally refers to both the tails of a normal distribution, so it would refer to both the up tail and the low tail of a normal distribution which are extreme events, very low-probability, occurring probably less than 3% of the time...But the common usage of the term ‘black swan’ is normally for the low tail events. And that is really what it’s come to be known as—the risk aversion or the systemic crisis or anything that drives asset prices down would be essentially what a black swan fund would hope to counteract.
By definition, then, black swans are extreme events that can’t be predicted?
The black swans are the Icelandic volcano, the New Zealand earthquake, the things that cannot be predicted with any certainty. Then you get kind of grey swans (and these are all pretty recent colloquialisms) which come to represent situations that reasonably could have been predicted, in fact, some of the more outspoken critics did predict them—like [Nouriel] Roubini on the subprime crisis, etc. And then you get white swans [which] are even more predictable and we should have all seen them coming but didn’t.
I do think that most extreme events do have these telltale signs that the situation is getting more unstable. I’m a believer in the [economist Hyman] Minsky school of thought that the more things remain stable the more instability is growing in the system—because the more you stabilize things, the more people will run a risk on top of the stability you’ve created. So the more stability you create, the more risks people will take.
You ran a very successful black swan fund, decided to close it, and are now re-opening a similar fund—the Black Eyrar fund. Can you tell me why you chose to close the original fund and what has changed that you’re ready to start a new one?
The fundamental question which everyone is asking about tail funds now is, are they insurance or can they be profitable, i.e., do you just buy them as sort of fire insurance for your health or should it be a part of your program in a pension fund or an endowment, and the answer to me is just blindingly obvious...if you go back to the turkey analogy: if turkeys bought life insurance on themselves, on turkeys, when would they pay the most for [it]? And the answer is in January, which is just after Thanksgiving and Christmas [when] there’s been a turkey genocide—and in reality, that’s actually 10 or 11 months before there’s going to be any more turkey deaths…that should be the cheapest time. And then just before Thanksgiving, after there’s been 10 months of absolutely no turkey deaths, that’s when probably you’d find within the turkey community that their life insurance would be the cheapest. And that actually is the time when it should be the most expensive. So the point I’m [making] is that volatility and tail events are totally counterintuitive, and the time you should be putting them in place is when the price of the protection is cheap.
The second point is that you’ve got to buy enough time to last a black swan cycle which is about five years. Black swans regularly occur on average about five years, so if you buy five years’ protection and it’s been awhile since the last black swan and your price of protection is low, you can reasonably expect to have a positive return.
With most people now…their kneejerk [entry] into tail risk [is] at a very high level—the protection they have to pay is very high because everybody is doing the same thing. So, when we closed the fund at the end of 2008, we had a mandate to be fully invested and we actually turned to our clients and said, ‘We don’t see anything worth investing in to hedge yourself against tail risk and yes, there might be a tail risk event happening but the price we’d have to pay for protection is too high.’ So we closed and returned the money, which turned out to be the right thing…And now we think the price of protection, [which] has been high for two years, has come down substantially and we think it’s a reasonable time to start putting tail risk protection back on.
What can you tell me about the name of the new fund, the ‘Eyrar’ fund?
It’s the collective noun for swans. The black swan fund implies just one swan…the Black Eyrar Fund alludes more to what we’re really doing and that’s putting together a diversified collection of potential black swan situations from across all asset classes. So, we’ve got currency positions, we’ll have commodity positions, equity positions and interest rate positions because black swans don’t just happen to equity markets and in fact, the best returns, even if there is an equity market crash, might not be equities at all.
There’s obviously a cycle to black swan events, does that imply this type of fund has a certain lifespan?
We’ve run a [tail] opportunities fund since 2002 and we’ve returned 15% a year in all kinds of markets and so, whilst I believe you can certainly make money in tail opportunities, what people are trying to hedge here is a systemic event like 2008, and that is a specific risk that you should hedge when it’s cheap, you should take off when it’s expensive, and you should re-establish when it’s cheap. So there is a certain period of time when you certainly de-leverage the strategy and then put it back on.
You spoke earlier about why this sort of strategy could be important for pension funds or institutions, are they your target investors?
Yes, institutional investors, pension funds are our target investors. We are best positioned to help them for a number of reasons, first, volatility has proven to be a new and uncorrelated source of returns—2008 has proven that most investors have overlooked the instability of correlation and assumed the benefits of diversification would kick in and that didn’t happen, all assets went down together.
Second, our strategy has a long-term investment horizon and has generated high and stable returns with a downside volatility of just 4%. Our most recent association with Reinet fund, the $3 billion investment arm of Compagnie Financiere Richemont—the Swiss luxury goods group—allowed us to achieve scale and efficiency necessary for institutional investors.
You’ve moved your headquarters from New Zealand to London, what was behind that decision?
Warren Buffet once said that if you make decent returns, people will find you at the bottom of a river. Well, that’s absolutely not true [laughs]…There are very good reasons [for] being in New Zealand—it’s a great place to live and it was actually very good to be away from the crowd and away from the noise to think—but it’s a very bad place to try to raise money, for the simple reason that people have to come and do due diligence and the people who do the due diligence are running around between Chicago, London, New York, Geneva—so to come to New Zealand for a relatively small fund is just not in their frame of reference, it’s a 30-hour flight. So, post 2008, we suddenly realized we had a very good strategy, we operate in a very good niche, and we were the prime adopters of this niche and we should take it to the next level.
It’s a lucrative niche market but it remains a niche market, why do you think that is?
Because it’s counterintuitive…and I don’t think, given the nature of human beings, that can change.