Our Big Lesson From “The Big Short”

The story of Michael Burry and his clients is a case study in what it takes to be on the right side of financial history.  Spoiler alert: it’s not easy…for anyone.

If you don’t know who Burry is, then you’ve failed to consume Michael Lewis’s The Big Short in either book or movie form.  Burry was one of the more interesting characters, and one of the small band of investors who bet against the mortgage market prior to the 2008 meltdown.  In doing so, he obviously made a killing.  And yet, the status as a historically great trade notwithstanding, his story deeply resonates with us for a different reason: the emotional dynamic that existed between Burry and his clients.

It’s fair to say that there was some tension. According to Michael Lewis (author of The Big Short):

And so in January 2007… Michael Burry sat down to explain to his investors how, in a year when the S&P had risen by more than 10 percent, he had lost 18.4 percent.

“OK,” you’re probably saying to yourself, “that seems like a reasonable thing to have to answer for.” Except that:

A person who had had money with him from the beginning would have enjoyed gains of over 186 percent over those six years, compared to 10.13 percent for the S&P 500 Index.

Burry’s firm, Scion Capital, focused on deep value investments.  In other words, they sought to both buy long-term investments at depressed prices and sell short those that were overhyped.  It is worth noting that from 2000 through 2005, most of Scion’s investment returns were derived from going long value stocks.  Clients could wrap their minds around this investment concept – buying stocks “on sale” – and it had payed off.  But in 2005, Burry found a far more attractive trade: shorting mortgage bonds.  It’s easy to recognize the discomfort an investor might feel when the execution of an otherwise consistent investment philosophy changes dramatically.  But that’s exactly what happened: after five years buying undervalued stocks, Burry decided he was going to short a specific segment of the mortgage market.  And not only that, his weapon of choice was a new-fangled derivative called credit default swaps (CDS).

The mechanics of a CDS are beyond the scope of this article, but it’s easiest to think of it as “bond insurance.”  Effectively, Burry convinced Goldman Sachs to sell him a contract that would pay off handsomely in the event that the underlying mortgage bonds defaulted.  These contracts, it must be said, were not inexpensive; during a period where Scion managed roughly $555 million, the contracts required that the Scion’s portfolio pay premiums amounting to about 8 percent of the portfolio, every year, for the lifetime of the underlying loans.  Investors were not happy about the performance drag this caused from 2005-2007.

And yet, acknowledging that a cause for angst exists doesn’t necessarily justify it.  From both the world of academia and our first-hand knowledge, we know that investors tend to respond adversely to even the shortest bouts of underperformance.  Whatever the bias – anchoring, prospect theory, or the deleterious effects of herding – investors tend to have short memories and an inability to give well-reasoned investment strategies the appropriate amount of time to prove out their value.  Burry himself asked for three to five years for his thesis to bear fruit, a reasonable period given that his CDS positions were designed to profit during the bearish half of the market cycle.  And yet in his book Lewis describes just how difficult it was for investors to focus on process when short term returns aren’t positive:

When he opened his fund in 2000 he only released his quarterly returns and told his investors that he planned to tell them next to nothing of what he was up to. Now they were demanding monthly and even fortnightly reports.

And lest you think that things were easier from Burry’s perspective:

[Burry] was now undeniably miserable. “It feels like my insides are digesting themselves,” he wrote to his wife…

Indeed, the period from 2005 to mid-2008 was so stressful for Burry that at one point he required treatment for bleeding ulcers.  This might seem extreme until you recall your own, very-likely-ulcer-inducing emotional state from late 2008 to early 2009.  These were the very definition of difficult times: Burry suffered for being short too early, while most suffered from being long too late.

At ReSolve, our investment processes are in no way close to those of Burry from The Big Short; the degree of concentration of his wager is completely antithetical to our emphasis on diversification.  Rather, what resonates is just how difficult it is for investors to focus on process over short-term outcomes.  In that regard, there is much both professional and individual investors can learn from the story.

First, try to have a long-term orientation in terms of decision making and results analysis.  Second, embrace contrarian thinking.  Third, before investing a single dollar, make sure you fully understand and have strong conviction in the investment process. And fourth, make sure to have the prerequisite self-discipline, patience and fortitude for persistent implementation of your chosen approach.

In these increasingly uncertain times, plagued by crashing commodity prices, expensive stock markets, generationally low interest rates, and global currency volatility, periods of loss are to be expected.  Risk management isn’t about eliminating losses nearly as much as it’s about eliminating impairments that can call into question the viability of your financial goals.

Losses never feel good, especially when accompanied by the social exclusion of doing something different.  But that is a burden we gladly carry in order to be – at some point in the not too distant future – on the right side of history.

Disclaimer

Confidential and proprietary information. The contents hereof may not be reproduced or disseminated without the express written permission of ReSolve Asset Management Inc. (“ReSolve”). ReSolve is registered as an investment fund manager in Ontario and Newfoundland and Labrador, and as a portfolio manager and exempt market dealer in Ontario, Alberta, British Columbia and Newfoundland and Labrador.
These materials do not purport to be exhaustive and although the particulars contained herein were obtained from sources ReSolve believes are reliable, ReSolve does not guarantee their accuracy or completeness. The contents hereof does not constitute an offer to sell or a solicitation of interest to purchase any securities or investment advisory services in any jurisdiction in which such offer or solicitation is not authorized.

Forward-Looking Information. The contents hereof may contain “forward-looking information” within the meaning of the Securities Act (Ontario) and equivalent legislation in other provinces and territories. Because such forward-looking information involves risks and uncertainties, actual performance results may differ materially from any expectations, projections or predictions made or implicated in such forward-looking information. Prospective investors are therefore cautioned not to place undue reliance on such forward-looking statements. In addition, in considering any prior performance information contained herein, prospective investors should bear in mind that past results are not necessarily indicative of future results, and there can be no assurance that results comparable to those discussed herein will be achieved. The contents hereof speaks as of the date hereof and neither ReSolve nor any affiliate or representative thereof assumes any obligation to provide subsequent revisions or updates to any historical or forward-looking information contained herein to reflect the occurrence of events and/or changes in circumstances after the date hereof.

General information regarding returns. Performance data prior to August, 2015 reflects the performance of accounts managed by Dundee Securities Ltd., which used the same investment decision makers, processes, objectives and strategies as ReSolve has used since it became registered and commenced operations in August, 2015. Records that document and support this past performance are available upon request. Performance is expressed in CAD, net of applicable management fees. Indicated returns of one year or more are annualized. Past performance is not indicative of future performance.

General information regarding the use of benchmarks. The indices listed have been selected for purposes of comparing performance with widely-known, broad-based benchmarks. Performance may or may not correlate to any of these indices and should not be considered as a proxy for any of these indices. The S&P/TSX Composite Index (Net TR) (“S&P TSX TR”) is the headline index and the principal broad market measure for the Canadian equity markets. The Standard & Poor’s 500 Composite Stock Price Index (“S&P 500”) is a capitalization-weighted index of 500 stocks intended to be a representative sample of leading companies in leading industries within the U.S. economy.

General information regarding hypothetical performance and simulated results. These results are based on simulated or hypothetical performance results that have certain inherent limitations. Unlike the results in an actual performance record, these results do not represent actual trading. Also, because these trades have not actually been executed, these results may have under- or over-compensated for the impact, if any, of certain market factors, such as lack of liquidity. Simulated or hypothetical trading programs in general are also subject to the fact that they are designed with the benefit of hindsight. No representation is being made that any account or fund managed by ReSolve will or is likely to achieve profits or losses similar to those being shown. The results do not include other costs of managing a portfolio (such as custodial fees, legal, auditing, administrative or other professional fees). The contents hereof has not been reviewed or audited by an independent accountant or other independent testing firm. More detailed information regarding the manner in which the charts were calculated is available on request. Any actual fund or account that ReSolve manages will invest in different economic conditions, during periods with different volatility and in different securities than those incorporated in the hypothetical performance charts shown. There is no representation that any fund or account will perform as the hypothetical or other performance charts indicate.

General information regarding the simulation process. The systematic model used historical price data from Exchange Traded Funds (“ETFs”) representing the underlying asset classes in which it trades. Where ETF data was not available in earlier years, direct market data was used to create the trading signals. The hypothetical results shown are based on extensive models and calculations that are available for any potential investor to review before making a decision to invest.