Q&A: A Black Swan Waits For The Storm

Aug 14 2012 | 2:31pm ET

36 South Capital Advisors’ Black Orlov Fund, a single-client tail-risk vehicle named for the world’s most famous black diamond, gained 101% in 2011. Impressive as those results are, they actually pale in comparison to the 2008 returns posted by the firm’s Black Swan Fund, which generated 234% before being shuttered in 2009. But despite announcing plans to launch a new "black swan" fund more than a year ago, the London-based firm, which moved to the U.K. from New Zealand in 2009, is still waiting for the right time to start.

That time is nigh, principal and chief investment officer Jerry Haworth tells FINalternatives Senior Report Mary Campbell. The U$500 million, 11-strong firm is planning to launch Black Eyrar—"eyrar" is a medieval term for a brood of swans—within the coming months.

You were about to launch Black Eyrar, a tail risk fund, when we last spoke. What happened?

We delayed the launch as volatility spiked. It has now come back down to more appealing levels so we are looking to launch in the coming months. 

What funds do you currently run?

Our flagship strategy is the Kohinoor, an absolute-return long volatility strategy, which incorporates our best ideas through both bullish and bearish positions and caters to two different risk appetites. We’ve got the Kohinoor Core Fund, which invests up to 95% in options, and then the Kohinoor Series Strategy, which is the strategy we’ve run since inception in January 2002. The Kohinoor Series Strategy invests up to 25% in options and the balance is in Treasury bills.

We also run an inflation fund, the Cullinan Fund. The Black Orlov Fund is a single-client mandate which, until the end of 2011, was designed to capture profits on the left tail, so it essentially would have done the same as the Black Eyrar.

I understand Black Orlov did very well last year.

Yes, for the year it returned 101%, which we were pretty happy about. When we first started it we thought volatility was a bit high and expressed that to the client. They said, "Look, it’s really high consequence to us if there is a left-tail event, so we want to put it on anyway." We were able to find some really good positions for that fund which resulted in the great year—and those profits came at a time when the client really needed them, so that was good.

How do you view the current economic climate?

My take is that there’s still significant deleveraging taking place. I look at the world as a sort of three-legged stool with China, the United States and Europe each a leg. And if any one of those economies falls over, the other two legs will fall over as well. So I think we’re still looking deleveraging squarely in the eye and I don’t know what sort of quantum we’re looking at, but it’s continuing.

Sort of opposed to that is central bank liquidity: They’re trying their hardest to add liquidity to counteract this deleveraging of worldwide credit. They are doing as much as they possibly can to do that and there is talk of them running out of ammunition. I don’t think this can happen to America or China because they can basically print. Europe is perhaps the one worry: They could run out of bullets because they don’t have an effective mechanism to monetize the debt and to monetize the banks, so I think really what everyone’s concerned about is that the current deleveraging could snowball and overtake Europe in the first instance and then, using the three-legged stool analogy, eventually overwhelm America and China as well.

And once the central banks do get on top of it, I think we’re going to have significant inflation or, probably more realistically, stagflation. So either or, in five years’ time, I don’t think we’re going to be anywhere near where we are now, today. We’ll either be overwhelmed by the black swan or we will be significantly higher in terms of asset prices, but not necessarily in terms of wealth.

In terms of your decision to launch a tail risk fund like Black Eyrar, what are you waiting for? When will you decide it’s time to launch, because I can imagine that many investors right now are looking for a fund that could protect against tail risk?

Often the very fact that there’s huge demand probably means you shouldn’t do it. Probably the best investment to counteract tail events is volatility assets and these are very counterintuitive. Everybody normally wants volatility investments just after major volatile moves, when the price of insurance is very high. We believe in buying when it is cheap and having the patience to ride out the cycle. Currently, volatility levels are not too bad, around the long-term mean, and we feel people and the markets may be a little too complacent about the risks of a downside move beyond two standard deviations. We are excited about the opportunities we can find to launch a tail risk strategy.

If I use the analogy of a roulette table: If the croupier offers you the odds on a single number at 5 to 1 when the real odds are 37 to 1, you should never take the bet. Yes, you might take the bet and your number might come up; it will be a good result but a bad bet. We could launch a fund when volatility is high and buy very expensive tail risk insurance, but in all likelihood, there wouldn’t be a positive expected return from investing and we just don’t think it would be the right time to institute a tail-risk strategy.

Having said that, we essentially always wanted to make positive returns from the left tail fund but people are more interested in the insurance aspect of it, which is, "We don’t mind if we pay as long as it’s not too much in order to get that hedge in place. It doesn’t have to be a positive return because the marginal utility of those returns when the market’s down 30% or so would certainly make up for it." So, that’s why even if volatility stays around here, we expect to launch in the next couple of months.

Where do you see opportunities in the current market? What do you find interesting?

There seems to be a lot of contrary opportunities—especially in terms of long-dated call options and things like that, in that they represent value, but just because they represent value doesn’t mean that they’re worth investing in. I couldn’t put my finger on any one thing at the moment.

What about geographically speaking? Do you find any part of the world particularly interesting from an investment perspective?

I still think euro/U.S. dollar volatility is probably too low, given what’s happening, and I think Europe remains a very interesting place. If there’s anywhere there’s going to be opportunity, it’s going to be in Europe. As we invest globally and across the asset classes we can generally find opportunities in various places; for example Asia and emerging markets also provide good value currently.

You have said that you are not about predicting what’s going to happen but about “understanding the macroeconomic factors at play.” Can you talk about that?

It’s one of the forces we look at. We’re looking for a trade where we can buy cheap convexity, on the one hand, and we can buy it on an asset that is about to become unstable, hopefully in the direction that we pick. If we buy an option on very cheap convexity but on a very stable stock, it doesn’t help us. We need some sort of sense of the macroeconomic factors that are driving the underlying assets in order to take a position and some sense that it’s about to become unstable, or it’s about to move in some way.

And instability can also be good—upside volatility is like, if you have good and bad cholesterol, you’ve got good and bad volatility. Good volatility is, you are long Apple and there’s upside volatility. That’s great; I’ve never heard a person complain about that. So we’re looking for drivers of the underlying asset price that are going to drive it within the timeframe of which we’re buying the convexity.

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