Rewarding Risk

Webonchina. The global response to China's devaluation of the yuan shows how crucial hedging risk is.

Octavian Report: Can you explain what it is you do at Penso, and how you see that working for investors?

Ari Bergmann: At Penso, our focus is derivatives, macro-strategies, and convexity. Which means we look at the world to find opportunities with convexity -- i.e. a limited downside and a leveraged upside. Our focus is macro, and we have two flavors of it, so to speak. We do hedging, but we don't like the term “tail hedging.” Tail hedging means that you're hedging very unforeseen, surprising events, and we think that most of the events we hedge are foreseeable. Most of the events we hedge are not that rare, and just because others choose not to see them doesn't make them tails.

The first flavor is our focus on systemic risk: where there is a situation that the market moves in tandem with correlations becoming plus one or minus one, and risk assets go down and safe assets go up. In other words, diversification won’t help you. We create portfolios which hold trades and positions that will benefit a lot on a leveraged basis if the market falls. Our goal is, basically, to have these hedging strategies pay for themselves. In other words, they can make money -- or at least break even -- if the market goes higher. They'll make a lot of money if the market goes down.

The second flavor is our attempt to grab, irrespective of market direction, missed opportunities, to take advantage of big market moves.

OR: Do you tend to make money more when the event you're hedging actually happens, or do you see the market correct itself anyway, even if the event doesn't happen?

Bergmann: We don't need the event to happen. Market perception of the risk drives our gains. We'll make money when the perception of the risk by the market changes. If the market, right now, is ignoring specific risks, we'll buy hedges and protection based on those risks. If the perception changes, the pricing changes, and we make money. We sometimes make more money if the event actually happens, but really we're just assessing the risk probabilities assigned by the market.

OR: You were one of the creators of the CDS, and there's been a lot written about derivatives themselves being a major systemic risk. How do you think about that issue when you're putting together your hedges? Or do you think it's such an outlying risk that it's not relevant?

Bergmann: Derivatives are powerful tools. They are like nuclear energy. Properly used they are very beneficial, very helpful; improperly used they become very dangerous. That's why derivatives are very powerful tools, because they have a lot of convexity. They have a lot of leverage. They zero in on risk, which most people misprice, or even ignore, because they don't understand it fully. Therefore, derivatives are very, very useful, if properly used. If people who don't know what they're doing start playing with them, clearly it's more dangerous.

CDS are a great way of understanding credit risk and of hedging credit risk, but they can be used also to leverage credit risk. When people who don't understand take those risks, you see what happens, as in 2008.

OR: When you look at the world and at global markets right now, what's the biggest risk you see?

Bergmann: Our hedging strategies are divided into two categories. One is based on something called proactive risks, the risks that we see on the horizon. Those are the things that we hedge. Let me say here that half of our book consists of what are called reactive hedges. Reactive hedges are trades, positions, that make a lot of money if the market goes down. Irrespective of why it went down. In other words, they are basically reactionary to the market, rather than predictive. But if I look at the market risks on our proactive book, the main things that have us worried are the following.

One issue is clearly China. We have been saying that this is an issue for a long time, and the reason is because the economic and political situation there is unclear. It's very unclear where its government is trying to go. It’s not an open economy. They're extremely big, and very important to world trade. Therefore, the mere fact that China’s policy is an unknown -- a policy so mixed with politics, run by so few people in such an opaque way -- creates in itself a huge risk. I don't think the risk is internal so much as external, less of China blowing itself up than the people who depend on it for trade: countries, the economies of which are commodity-based, as well as the Asian currencies which depend on exports to China.

China is shifting from an infrastructure economy -- an economy that depends on building roads to nowhere, so to speak -- to a consumer economy. An infrastructure economy is an imbalanced economy. It's an economy that produces things. They sell, they keep the money, but they don't create a consumer base. The natural outgrowth of that is the creation of oversupply. That's what they're going through. China is shifting to a consumer economy and a lot of economies that are dependent on the old China are going to get hurt -- I mean economies that depend on exporting commodities to China. That works with an infrastructure economy. Not as well on a consumer economy. The risk there is that as this shift is going on, the world is not prepared.

The second big risk is geopolitical risk, as such. The geopolitical risks out there are many and growing. Consider the instability in the Middle East: we see its primary foci as Syria, Iraq, and ISIS. It's a matter of time before that last group crosses the ocean. Connected to this is the mass migration to Europe we’ve been seeing in the past months. I think this mass migration to Europe creates a different set of risks. It puts even more pressure on Europe, it creates a lot of strain on the European Union. Already we have the issue of economic imbalance within the euro zone; added to this is a phenomenon that will put political strain on union in Europe. I think Europe is a risk, and remains a risk, because of this marriage of countries called the E.U., which lacks any real mechanism for orderly breakup or exits. It's clearly, to some members, a bad marriage. At some point, I think, this instability will come more prominently to the fore. There’s another specific political risk here, too: the massive migration of Middle Easterners into European countries gives a lot of ammunition to the extreme right. And the extreme right is not a fan of a unified Europe.