Michael Burry - Big Short #2?
Updated: 14 hours ago
Client question: Should we derisk our portfolio if a crash/correction is likely?
Barely a week goes by without the news reporting on an investor who has made a bet/prediction about what the stock markets might do, as bad news sells.
The most recent featured Michael Burry, who has purchased around $1.6 billion of put* options across the S&P 500 and Nasdaq-100 indices. The press leapt upon this story as Michael Burry rose to fame during the Global Financial Crisis (GFC), where he made significant profits betting against U.S. subprime mortgages. He subsequently featured in a 2015 film, The Big Short, where he was portrayed by Christian Bale.
If he can do it once, why not a second time?
A link regarding this news story was sent to me by an understandably concerned client, asking whether we should consider adjusting their portfolio. (I always encourage clients to ask questions as if they have read something and have concerns, there is no doubt that some other clients will be thinking the same, and one of our main objectives is to provide our clients with peace of mind).
So, should we be reducing risk and/or selling some investments into cash and riding out the impending storm? The first thing to say is that Burry might well be correct; the two indices he shorted could well fall significantly, enabling him to make significant money.
Some things to consider:
Credit vs. equity markets - some big differences!
Burry made money during the GFC, purchasing credit default swaps on various mortgage securities. This trading style differs significantly from the equity markets (shares) in several ways:
The equity markets are transparent, with new information disseminated in near real-time and available to everyone.
Large share volumes are traded on exchanges, and these trades are visible to all market participants (with some exceptions).
Valuing shares of companies is relatively simple, and this information is available to all.
The credit markets were, and still are, very different, with less transparency, liquidity and much more complexity. I worked on a credit trading desk during GFC (before becoming an IFA), and pricing some structured products required significant technical and market knowledge and hard-to-obtain data. Typical equity investors were understandably unlikely to be familiar with Monte Carlo pricing, Cholesky decomposition, Mersenne Twisters and Gaussian Copulas, and to be honest, I'd probably struggle if someone asked me to rewrite a credit derivatives pricing engine similar to the one I built in 2007 (see below)!
Even for someone who could price these types of products, placing trades would not have been easy, requiring significant funds and building relationships with Investment Banks. Keeping track of whether your trade was profitable or not was equally tricky. You, therefore, have to have a lot of respect for what Burry achieved during the GFC, especially as he was under pressure from his investors at the time.
Directional bets - what do you know that the market doesn't?
Returning to the equity markets, someone making a directional bet (e.g., the S&P will fall heavily by Christmas) is effectively competing against many highly intelligent investors, all with access to the same information. Suppose we accept that the equity markets reflect the aggregate opinion of these investors. In that case, it's worth considering what additional information someone making a directional bet on the overall markets might have. There is also the problem of not knowing what future information might do to the markets. For example, how many people predicted the coronavirus pandemic, profited from shorting the market (e.g. purchased put options) before it fell, and bought back into the market (and therefore benefitted from the upside) before it unexpectedly (in many people's eyes) recovered quickly?
There is a scarcity of evidence to suggest that this approach is consistently profitable.
Note that this directional trading style is a very different approach to the quant firms I recently wrote about. These firms use vast data and computing power to make thousands of daily trades to extract a small profit per trade. They aim to be "market neutral" - the complete opposite of taking large directional bets on the market. Ask one of these firms which way the market might be going, and they are likely to shrug their shoulders, and that's despite them extracting considerable and consistent profits from the market!
If we sell, when do we get back in?
We are creating a potential problem for ourselves if we derisk/sell down our shares. How do we know when to get back into the market? Given the stock markets tend to go up over time (on average), we might find ourselves sitting in cash with the markets trending upwards, wondering when we should buy.
As noted above, Burry has shorted the S&P 500 and Nasdaq 100 indices. While it's fair to say that these indices (and the U.S. equity market in general) typically comprise a significant percentage of a typical client portfolio, it's important to remember that these portfolios are globally diversified. That's not to say the portfolios will be immune if these indices suffer, but diversification can help, especially over more extended periods. An example of this was the "lost decade", where the S&P 500 index effectively went nowhere for a whole decade from 2000-2010. In contrast, a diversified portfolio had a far better outcome.
You can get an overview of Burry's holdings by viewing his 13F filings. Note that this is not perfect, as it is backwards-looking and doesn't show all holdings, but there are a couple of things worth mentioning.
The two significant positions (SPY and QQQ puts) total around $1.6bn and represent about 90% of his portfolio. However, this information may be misleading, as we do not know what premium Burry paid for the options (the premium being dependent on many variables), but it's likely to be a small fraction of the $1.6 billion.
Burry has other investment holdings, and once these are considered, Burry's overall position might not seem quite as bearish.
Don't just do something, stand there!
It's perfectly understandable for someone to read a newspaper article or watch the news headlines, start to worry and think that something needs to be done to their portfolio to protect against an impending downturn. We humans hate uncertainty! I remember how nervous I was during the GFC meltdown, not knowing if the investment bank I was working at would fail, as many others did at the time.
However, it's important to remember that as a client, you have a multi-decade retirement plan, and the portfolios we construct are based on around a century of market data. While short-term noise and news headlines may seem important at the time, they are usually irrelevant over these multi-decade periods.
Portfolios will inevitably go through periods when balances fall (we don't know when or by how much), but history has shown us that we can be confident that they will recover. Perhaps more importantly, we can also be confident (again based on historical market data) that over the long term, our client portfolio will deliver the returns to ensure their retirement plan is a success without us having to resort to tactics such as market timing in an effort to boost returns.
As the late, great Jack Bogle once said
"Don't just do something, stand there"
Sometimes easier said than done.....
* A put option is an instrument that allows the purchaser to sell the asset at a specified price at a specified date. A purchaser of a put will (broadly speaking) generate a greater profit the more the market has fallen at the option maturity date.
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Please note: This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.
Although best efforts are made to ensure all information is accurate, you should not rely on this blog for your personal situation or planning.
The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.