Because it has never happened before – tail risks and convex portfolios

Letter # 37, 16 April 2021

In a series of interviews last week, Prashant Kishor—one of India’s finest political strategists (in my opinion)—reiterated, multiple times, a commitment which sounded bizarre. Prashant’s company, I-PAC (1) / (1b), is currently working with All India Trinamool Congress (AITC) for the ongoing assembly elections in West Bengal in a primary fight against the Bharatiya Janta Party (BJP). He claimed that BJP will struggle to cross 99 seats (in a 294-constituency assembly), and if it does cross, he will quit this space (2) (which he later clarified to mean that he would stop being a political aide to any other political party and shut down I-PAC (3)).

The claim is bizarre, predominantly on account of the disproportionate risk he seems to have taken; and not, at the very least, because he does not have the data or the on-ground reports or the absolute expertise to read the election. In the 2016 West Bengal assembly elections, AITC had won 211 seats and BJP had secured just three (with a vote share at 10%). By the 2019 Lok Sabha elections, BJP’s vote share in West Bengal had jumped to 41%. If BJP were to translate its 2019 parliamentary constituency win into the 2021 assembly constituency win, it would stand to win 127 seats. In addition, with a mere 3.5% vote swing, some 36 seats could swing from AITC to BJP.

Now, I-PAC has been years in the making and has already helped national (BJP and INC) as well as a few regional parties (JDU, YSRCP, AITC, DMK). In its field of operation, it is by far at pole position. Politicians making unsubstantiated claims may be par for the course, but for a professional, as astute as Prashant (who even chooses his words carefully), the upside from making this unsolicited bet is flummoxing. Until, in one of the interviews (3), he clarified the basis of his conclusion, “we have studied data for the last 30-40 years and have seen elections in most polarizing atmospheres. We have found that 50-55% is the limit beyond which it is not possible to polarize a community; it has never happened.” (3)

To simplify, Prashant is staking everything he has painstakingly built over the past decade, inter-alia, on the assumption that because it hasn’t happened before, it will not happen now. Whether he wins or not is not as much of consequence, as the realisation that even seasoned professionals can end up taking disproportionate risks based on erroneously calculated odds. And, if you think this hasn’t happened before, read on.

In 1991, John Meriwether, then the head of bond arbitrage desk of Solomon Brothers, resigned and founded Long-Term Capital Management (LTCM) in 1994. Members of LTCM’s board of directors included Myron Scholes and Robert Merton–who shared the Nobel Prize in Economic sciences for ‘a new method to determine the value of derivatives.’ John’s desk was responsible for 80-100% of Solomon’s total earnings between the late 1980s and early 1990s (4), and the other two gentlemen literally wrote the book on how to value derivatives. Clearly, LTCM was run by an exceptionally sharp bunch.

The idea behind the hedge fund was simple–exploit small pricing inefficiencies in bond markets and leverage the trade to generate a superior rate of return on equity. Among its core strategy was to purchase the old benchmark, say issued 3 months ago (which no longer had a premium attached to fresh issues), and to sell the newly issued benchmark, which traded at a premium. Over time, valuations of the two bonds would converge. Assuming this generates 50bps arbitrage, you leverage the position 25 to 1 and earn 12.5% return on equity (50bps * 25x leverage). LTCM generated annualised return of 21% (after fees) in its first year, 43% in second and 41% in its third year. The going, so far, was good.

By the end of 1997, LTCM broadened its strategies by including new approaches in markets outside of fixed income. Many of these strategies were not market neutral as they were dependent on directional movement in interest rates or stock prices (not traditional convergence trades). By 1998, LTCM had accumulated extremely large positions in merger arbitrage and S&P 500 options. The assumption was, because things have historically converged, they will in the future as well.

At the beginning of 1998, LTCM had equity of USD4.7bn and had borrowed over USD125bn, a debt-to-equity of over 25x. The markets, then, were just recovering from the 1997 Asian Financial Crisis when the Russian government had defaulted on its domestic local currency bonds. It hadn’t happened before; countries have access to the printing press, why would it default on local bonds instead of just printing more money. But it did, and in the ensuing flight to quality, prices that ‘should have’ converged went farther apart. By end of September 1998, LTCM had lost USD4.3bn, leaving it with debt-to-equity ratio of a staggering 250 to 1. Fourteen institutions had to bail it out under supervision of the Federal Reserve and the fund was dissolved in early 2000.

At the end, we must acknowledge that with investments, as with life itself, events that have not happened before, may happen. Prior to last year, markets had never fallen 25% in one month (and yet they did in March 2020). And, markets had never recovered to form new high in one straight line (which again they did by December 2020). These are tail risk events, ones that have an exceptionally low probability of occurrence, but when they do occur, they have a disproportionate impact.

As investors, all of us regularly draw conclusions from historical events. As the availability of data and the depth of our analysis increase, so does our confidence in decision making. And when rising confidence meets success, for every subsequent bet, we tend to increase the stakes. This can be a virtuous circle, only so long as we do not raise the stakes so high that when a tail risk event strikes, its impact delivers a devastating blow on our portfolios which we cannot recover from.

Nassim Taleb, in his book Antifragile, calls it making your portfolio convex–something that gains from disorder (including tail risks), whereas Mohnish Pabrai, in his book Dhandho Investor, elegantly puts his investment philosophy as, “heads, I win; tails, I don’t lose much.”

Even seasoned professionals can fall in this trap when the going is good. Being prepared that life will, intermittently, keep serving events that have never happened before, is the battle half won.

(1) The un-politics of Prashant Kishor | India News,The Indian Express;
(1b) IPAC is widely reported as Prashant’s company, but it is difficult to find in what capacity he is related to it from its website.
(3) Prashant Kishor Speaks To Rajdeep Sardesai Over His Explosive Chatroom Audio Leak On Bengal Polls – YouTube
(4) Long-Term Capital Management – Wikipedia

The letter was originally published here: Because it has never happened before—tail risks and convex portfolios –

Information in this letter is not intended to be, nor should it be construed as investment, tax or legal advice, or an offer to sell, or a solicitation of any offer to make investments with Buoyant Capital. Prospective investors should rely solely on Disclosure Document filed with SEBI. Any description involving investment examples, statistical analysis or investment strategies are provided for illustration purposes only – and will not apply in all situations and may be changed at the discretion of principal officer. Certain information has been provided and/or based on third-party sources and although believed to be reliable, has not been independently verified; the investment managers make no express warranty as to its completeness or accuracy, nor can it accept responsibility for errors appearing herein.


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