Will You Even Notice When the Tide Goes Out?

By Venk Reddy

Originally published in Q4 2018 letter

That was some end to 2018! Have you caught your breath yet?

We’ve invested a lot of ink in past commentaries cautioning investors about the potential for volatility in the markets. However, this comment is not intended to be a victory lap. We will be the first to admit that our concerns came with the caveat that we couldn’t say when. The case we made then was that investors should seek managers and strategies which don’t depend on knowing when the markets might go up or down in order to reach their goals. All too often, investors make the mistake of comparing what should be a tactical bet with long-term strategic holdings. In doing so, it is inevitable that a tactical exposure would appear to be a candidate for the long-term, in large part due to the natural distraction from risk that comes from deceptively similar if not temporarily more attractive performance.

While the risk-minded among us can caution about potential risks and volatility until we are blue in the face, only in markets like the one we experienced this past quarter do investors tangibly feel risk. The question that faces every investor now is whether they liked that feeling. The choice is no different than it was a year ago, three years ago or in late 2007: Should you do the work now to better line up risks with your portfolio goals before the next market decline or will it be another hard lesson learned after the fact. We are here to help tackle this tough task. All you have to do is ask.1

We will certainly not be the first to reference the quote from Warren Buffett’s Chairman’s Letter in Berkshire Hathaway’s 2001 Annual Report: “[You] only find out who is swimming naked when the tide goes out.” But we feel confident we’ll be the only ones who don’t fully agree that the quote applies today, because we aren’t convinced market participants have truly internalized a key truth about the relationship between risk and return: the risk of an event in the future is not retroactively non-existent because it didn’t happen, and return alone does not measure in hindsight the risks taken.

To be clear, we are not saying Mr. Buffett is wrong. Quite the opposite. But it’s important to understand the context in which he wrote this line. In the letter in which it first appeared, this quote was not a commentary on the overall markets. Rather, it was a clever illustration of our key truth above as it pertains specifically to an analysis of the reinsurance industry. In particular, he compared Berkshire Hathaway’s National Indemnity reinsurance business, which retains its risks, to reinsurers who transfer some of their risks to other reinsurers – think of this latter practice as insurance for the insurer. Or, to be more precise since reinsurers already protect front-line insurers similarly, it is insurance for the insurance for the insurer. In other words, leverage, and lots of it.

Some readers will already recognize this is similar to the risk we’ve discussed in the past regarding asset- backed structures such as collateralized loan and debt obligations (CLOs and CDOs) and mortgage-backed securities (MBS). Whether in a collection of insurance policies or in a portfolio of debt, the theory is that any one loss event or default would be paid for by the income from the remaining performing policies or debt. To attempt to reduce the impact of losses (and to achieve higher credit ratings), these structured products employ various forms of risk redistribution (e.g. tranching or reinsurance). This is not easy - investors (and reinsurers) often rely on complicated models to convince themselves that a redistribution of risk also lowers it.

In particular, these models tend to assume that the correlation of loss events is relatively low, or put simply, that bad things don’t happen in groups. An explanation of why this is the case is beyond the scope of this letter. It requires a somewhat complicated deep dive into derivative pricing theory, market implied vs. actual correlations and costs of financing and leverage. However, making and selling bets on correlation are the primary ways in which Wall Street profits from derivatives such as the structures we have discussed. That it is so complicated is why we regularly urge caution and suggest staying away from such exposures. Most investors learn too late the actual risks they were taking.

In the case of structured mortgage products, never was this more evident than during the 2008 financial crisis, when supposedly safe, AAA-rated tranches of low-quality subprime debt fell victim to a high correlation of mortgage defaults that the models assumed wouldn’t happen, mainly because the risk of one homeowner defaulting is typically not tied to the risk of another defaulting. Until it was. In the case of reinsurance, a second layer of leverage, in the form of reinsurance for the reinsurers, can be insidious in its use of the theory of risk diversification (reinsurers laying off risks to reduce exposure in their own portfolios) to inadvertently drive risk concentration (all reinsurers being exposed to the same risks).

Here, we see two potential breakdowns of correlation: (1) Many reinsurers, in an effort to diversify their portfolios by laying off some risk to peers and taking on other risk from the same peers, end up highly correlated to a single major loss event; and (2) if there is a major loss event, this “daisy chain” of dependencies leaves all of those reinsurers financially exposed to any one “weak link.”2 Add these to the traditional correlation risk in the insurance business of having to pay claims on multiple loss events back- to-back, and we can see why Mr. Buffett warned against the hidden leverage in the industry.

This discussion wasn’t theoretical – the letter we are citing was written just after 9/11, so the warning was timely and pointed. Many downstream reinsurers were facing significant uncertainty stemming from this mega-catastrophe and were poorly positioned to withstand another, should one happen. Ultimately, their (in)stability was a function of their highly imperfect assessment of the risk of a second catastrophe to their upstream3 peers on which they were dependent to satisfy claims. They couldn’t know the impact for sure unless the second one actually happened, at which point, it would be too late. It’s a tough spot to be in: At best, underwriting new business would be hamstrung by the uncertainty; at worst, the downstream reinsurer would be unable to make good on its obligations.4

Mr. Buffett’s meaning can be applied broadly and accurately to a wide variety of risk decisions. When one doesn’t (or can’t) know his exposures, the only way he finds out for sure is after loss events happen. This, to return to our metaphor, is the tide going out. As it pertains to fixed income, the prevailing dependence on economic factors such as interest rate bets or on aggregate-level exposures such as broad market indices fits the same pattern of aligning one’s outcomes with unpredictable risks. That said, it’s not that investors won’t make some money along the way because, as we pointed out earlier, risk doesn’t exist only when it is manifested.

Even more problematic, however, are the markets we have been in, where broad indices appear to succumb to one risk or another, only to snap back faster than they declined. In such an environment, even if an investor saw a few naked swimmers, how would he know if the tide was actually going out once and for all? Would he blindly double down into a terminal downward spiral expecting a FOMO5 bump to rescue him once again as it did during so many other head fake declines in the last few years?

It is for these very reasons, however, that claims of foresight (i.e. outlooks) are usually misplaced. Whether an outlook is explicitly stated or implied by bets on big picture factors like interest rates or credit spreads, investors can easily be deluded into believing they are outsmarting the markets. In reality, they are probably just getting lucky that the risks they don’t know they are taking didn’t happen.

At Zeo, we don’t set out with a goal of outsmarting anything or anyone.6 The risk profile we aim to deliver shouldn’t be dependent on what others are doing or what’s happening in the markets. We simply aim to identify straightforward opportunities to invest in companies we believe will repay their debts. It’s a discipline of details which explicitly aims to avoid being dependent on factors beyond our control. We are certainly taking on different risks in the process, as there is no free money, but our goal is to select risks with fewer erratic variables. When combined with our fundamental analysis of each issuer, we believe this process makes it possible for us to deliver the low volatility and consistency we seek for as long as our clients value our work.

For our money, we prefer to cite a different quote from that same Chairman’s Letter in the 2001 Annual Report, also written in support of National Indemnity and it’s head at the time, Ajit Jain, who is now Vice Chairman of Insurance Operations for Berkshire Hathaway and a favorite amongst oddsmakers to succeed Mr. Buffett as CEO someday:

“His extraordinary discipline, of course, does not eliminate losses; it does, however, prevent foolish losses. And that’s the key: Just as is the case in investing, insurers produce outstanding long-term results primarily by avoiding dumb decisions, rather than by making brilliant ones.”

Warren Buffett, 2001 Berkshire Hathaway Annual Report

So to our readers, we offer this thought: It may be prudent to stop watching the tide and aim to invest so you don’t have to care if the tide has gone out or not.

1 We’re not kidding. Among the consultative services we offer is a fixed income portfolio risk review. Anyone who has seen our presentations on risk-adjusted asset allocation will be familiar with the approach we take. We aim to help our clients identify and allocate portfolios which better and more consistently align selection criteria, benchmarks and portfolio goals. If you are interested in learning more about this service, please feel free to contact us.

2 Mr. Buffett’s words from the same letter

3 We use the term upstream to refer to a reinsurer providing reinsurance to another reinsurer. We use the term downstream to refer to the reinsurer who lays off risk to an upstream reinsurer. It’s confusing, we know. Yet another reason why leverage risk should be used with extreme caution.

4 Mr. Buffett goes on to argue that, since his company retains their risks, they aren’t at risk of this kind of multiplier effect and were able to satisfy claims and underwrite new policies quickly and voluminously after 9/11, which he touted (correctly in our view) as a competitive advantage.

5 FOMO (Fear of Missing Out): a hip description of a psychology attributed to the practice of indiscriminate buying during a market rally to ensure participation if it continues for a prolonged period, the use of which shows our coolness factor, or something.

6 Though we won’t be upset if we do anyway!

Important Disclosure Information

Zeo Capital Advisors is a fundamental investment manager with a short-duration credit mutual fund, a sustainable high yield mutual fund and separately managed accounts. Venk Reddy authored this piece and is the Chief Investment Officer and founded Zeo Capital Advisors in 2009.

For more information contact Zeo directly at 415-875-5604 or visit www.zeo.com.

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