The Chaos Factor
When economies and markets go bad, most people including myself, tend to get tunnel vision or some form of psychological paralysis. In part, it is because the sheer volume of information inputs that indicate dire outcomes goes up dramatically and the mark to market value of a portfolio is dropping at an abnormally fast rate.
With respect to investments, I like to think about what the “chaos factor” of an investment is. Is it negatively affected by chaos, defined by flight of capital, slowing economic growth, and negative sentiment? Or does it thrive in these times?
Chaos Factor in Practice
Consider a publicly traded closed end fund as an example. The basic construct is the fund raises a defined amount of capital at IPO, and invests capital similar to a mutual fund or any other investment fund for a long period. It uses material amounts of leverage, say 30% of its total asset base. And it has collateral requirements against the leverage, meaning if the value of its assets drop below a certain level, the fund must sell assets to pay back the debt providers. A margin call, if you will.
In a deep drawdown, similar to March 2020, or the ’08/’09 credit crisis, this sort of fund (if packed with volatile assets) ends up having to puke its assets at the market bottom regardless of whether the assets are good long term investments or not. It is capped by the upper bound of return that the assets provide, meaning perhaps a group of equity investments may return 15% annually over a long period of time as a best case, but can permanently lose 50-75% due to a leverage unwind in a drawdown that isn’t recoverable and permanently ruins the capture of underlying portfolio performance.
Natural Negative Chaos Bias
Most investments are forced to run in a way that is negatively biased to chaos. If a corporation doesn’t run with an optimized capital structure, an activist often gets involved to force its return on equity higher (e.g., use more debt to juice returns). Closed end fund structures are compensated on total assets, so they are implicitly incentivized to use leverage to maximize fees.
Few corporations or investment structures have the authority to run in an un-optimized manner that skews them positively towards chaos. It sacrifices near or medium term returns, and we humans are impatient. A legendary P&C figure is known to run with an abundance of excess capital to take advantage of low priced assets in times of chaos. That strategy has in part made him who he is today (hint: this is Buffett). But examples like this are few and far between as these examples must often sit through an incredible amount of criticism during the good times.
Negative Bias Is Not Bad
That isn’t to say that negatively biased investments to chaos are bad investments. People spend fewer advertising dollars in a deep recession than in a boom time. Does that negative bias to chaos make Google’s search engine product an unattractive asset to own? I don’t think so. Most investable items are indeed negatively biased to chaos. Vanguard equity ETFs offer an incredible product to capture benchmark performance, but are undoubtedly negatively biased to chaos. However, it’s clearly okay to have that negative bias, so long as the investment does not have to unravel itself during the hard times.
Positive Bias As A Ballast
There are business models that are modestly positively biased to chaos. In a recent Capital Allocators podcast, Greg Lippmann of The Big Short fame (see resources tab for link) outlined how he actively built a drawdown fund business in parallel to his hedge fund, as during the worst of times his investors have the right to pull capital from the hedge fund whereas with a drawdown vehicle, he owns the right to call capital at any time.
The reason why I like to a handful of positively biased investments to chaos, is it helps my psychological stability during times of duress. It is comforting to know that while the stock price or NAV of an investment may be down substantially, it is a period that the investment can use to build value that is realized after the ensuing recovery. Ultimately, it provides a ballast to one’s mind when the tunnel vision sets in during the worst of times. And that’s just one thing that someone may do to help make the right decisions when the noise is the loudest.