Do All Portfolios Need Some “Long-Tail” Protection?

By Steve Ellis

May 2014

In the last article we applauded rats’ ability to decipher probability better than the average Fund Manager. This time we explore the downside to ‘rat psychology’ as it relates to investment ability.

The reason you would not want a rat managing your portfolio is that rats succumb to peer-pressure, in much the same way as humans. Science shows that Brown (or Norway) rats are prone to disregard personal experience and copy the behaviour of their peers (“herd mentality”). The urge to conform is so strong that they even choose to eat unpalatable food if they are in the company of other rats eating it. Finally we explore one redeeming feature – their long tails.

Hedge fund managers are always looking for an edge, that piece of financial analysis or company information that they recognise before the market realises and prices it in. When it comes to an ‘edge’ in analysing a country like China – so vast, so complex, and influential on the global economy, the stakes are too high to ignore. Until now the best asset managers have had analysts on the ground – but still the market prefers to focus on the aggregate financial statistics coming out of Beijing. These snippets of aggregate data are akin to the proverbial piece of cheese held out to trap the analytical rat, hungry for financial data. These investigative rats pull together reports and charts and make incisive recommendations. The bolder ones go in search of premium cheese nuggets and search through copper warehouses to disprove official statistics on so-called real end-demand. They report back to rat HQ with findings of blue vein quality and they make predictions of doom and gloom. But then – bang!… another dire prediction is stamped out by an official release that shows PMI manufacturing growth is on target (again) and the rats revert to peer pressure portfolios.

The problem with these predictions is that the metaphorical rats will never be allowed to see the full picture, because financial imbalances and stresses are covered up by Chinese authorities. For example the Chinese authorities averted another financial accident early in 2014 when emergency measures ensured repayment of the ICBC loan which had previously been packaged and sold to wealthy investors. If the Chinese government continue to bail out the local investor then it’s only a matter of time until funding distress at the local level will transmit to the sovereign/systemic level. We have seen it before in the emerging markets where a local event can cause shocks to aggregate credit growth, currency instability, financial conditions, interest rate curves and the fiscal outlook.

Others argue that for a “market meltdown” you need to have a proper market and China does not have one. Instead, Beijing technocrats dictate outcomes (they leave pieces of financial cheese at well-known rat holes). Because Chinese leaders have the power to prevent corrections they do so. Because they do so the underlying imbalances become greater. Back in my childhood I used to play “Australian rules” (i.e. no rules) football, and I recall we squared-up against a team twice our size to which my old coach told us “the bigger they are, the harder they fall” (we lost but they went home very sore!). When the Chinese imbalances finally come down to earth with a thud, you’ll want some protection in your portfolio because these cumulative imbalances are huge. If China is “an elephant riding a bicycle”, as some proclaim, then when it eventually falls the earth will quake, foreign capital will evaporate and a rapid collapse in the renminbi will result. The trading band was widened recently, but should the Middle Kingdom overtly use its currency to prevent a deflationary bust a tail event sized collapse might occur outside of its control.

So instead of running around like those peer-pressured rats, we need to look to one of their other attributes – their long tails! Rats’ long tails help them to balance and regulate their temperature. If our portfolios are to remain balanced and ‘cool in a crisis’ we need smarter “Long-Tailed” hedges in place well before that crisis. The tail of the financial bell curve distribution is cheap, very cheap, and it’s where all the results will be felt during an eventual Chinese crash landing.

Finally be aware that one long-tailed event (think a 9 standard deviation event such as the LTCM disaster) is often connected to another (think the 1997 Asian Crisis). These tail-end events prove markets are not normally distributed and remind us of the strange freak accidents called “Rat Kings” wherein many rats clustered together become inexorably tangled together by their tails. Several examples can be cited since the Middle Ages. Although not strictly reserved to Germany, the vast majority of “Rat Kings” seem to have been there. The largest “Rat King” known is a cluster of 32 mummified black rats found in a miller’s fireplace in Buchheim, Germany in 1828. It can be seen on display at the Mauritianum Museum in Altenburg, Germany. So instead of worrying about China, perhaps we should be protecting our portfolios against a long-tailed event in Germany?

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