Covid-19 has posed a mind-bending question for companies, investors and policy makers: How to protect against the next extreme “black swan” event? The temptation to find a concrete answer is best resisted.
This is the financial teaser at the heart of political questions such as whether airlines are victims of the pandemic or undeserving recipients of taxpayer money. Last week, U.S. carriers reached an agreement to receive $25 billion in grants from the federal government despite the fact that, over the past decade, they have returned to shareholders essentially all of the free cash flow they earned—rather than investing or saving it.
Detractors say that carriers should have been forced to file for bankruptcy. Some analysts, such as UBS’s Victoria Kalb, have warned that regulators and socially minded fund managers may penalize buybacks and dividends, even after the Covid-19 crisis is over.
Limiting payouts during emergencies makes sense, and executive compensation should get more scrutiny. Yet except at debt-ridden American Airlines, the extra cash U.S. airlines sent to investors was the result of soaring profitability, and was disbursed only after ramping up capital investments. Data also suggests that S&P 500 sectors that pay more money back to shareholders tend to be more financially resilient. Western companies have actually increased their cash buffers substantially over the past two decades.
The debate boils down to the question of whether there is a certain level of preparedness that policy makers should enforce to help companies deal with unexpected events.
Economists Frank Knight, John Maynard Keynes, as well as mathematician Nassim Nicholas Taleb—who famously coined the term “black swan” to refer to events that are impossible to foresee—have all underscored the difference between “risk,” which can be measured to a reasonable degree based on past probabilities, and “uncertainty.” When betting on a coin flip, risk is the 50% chance of losing. Uncertainty is the immeasurable chance of being killed by a falling piano before collecting the prize.
The point was nicely underlined when behemoth hedge fund Long-Term Capital Management, which used mathematical models of risk to place leveraged trades, was undone by the black swan of the late-1990s Asian financial crisis.
Cash isn’t the only hedge against uncertainty. In addition to recommending cryptocurrencies, Mr. Taleb advises Universa Investments, a fund that uses options contracts to constantly bet on a stock-market disaster. Client letters show that Universa made a 4,000% return in the first quarter. The Eurekahedge Tail Risk Hedge Fund Index, which looks at similar, less extreme strategies, is up 66% this year.
The very idea that a price can be put on uncertainty, though, is a contradiction worth exploring.
Some data does point to markets structurally underpricing uncertainty: Shares in companies with stable profits and less debt historically outperform. Yet ever since the fall of LTCM, options markets do clearly price in an insurance premium for uncertainty. Remaining invested in the Eurekahedge Tail Risk index since 2007 would have delivered a loss for investors—in much the same way that, over long stretches of time, insurers tend to make money at the expense of the insured.
Of course, lots of money can be made by buying protection at the right time, just like with any other financial asset. Late last year, Ray Dalio’s hedge fund Bridgewater was among those to spot that options hedges were cheap relative to an overconfident equity market. Universa’s success may even suggest that the chance of extreme events was underpriced.
But this doesn’t mean that it will always be. The nature of uncertainty is that investors will never know ahead of time whether they should hedge more. Nor will companies.
Global airlines had enough cash to survive three months without income, which would have been enough to navigate most crises that didn’t involve an unprecedented 70% fall in air traffic. Even if their buffers were multiplied by 10 it might not be enough for the next pandemic.
So how should investors and officials take uncertainty into account? Individually, weak companies should indeed be encouraged to hold more cash. For industries as a whole, however, the strength of public institutions is what matters. Western governments are right not to rely on prolonged bankruptcy procedures during a systemic crisis, and would benefit from setting up faster mechanisms to bail out firms and households—in addition to expanding medical resources ahead of the next pandemic.
Yes, such moves would encourage risk taking, but that is what advanced economies are built on. Emerging markets, which often don’t have institutions capable of stepping in when needed, typically trade at a discount.
What investors should avoid is putting too much trust in hedges against uncertainty that are provided by the market itself. They could all too easily turn into the very black swan they are hoping to avoid.
Write to Jon Sindreu at jon.sindreu@wsj.com
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