In an earlier post we talked about the advantages (and disadvantages) of being an individual investor versus an institutional investor. One way in which the individual investor often has an advantage is flexibility. Michael Arold at Holistic Swing Trading left a comment on the post noting the following:
There is a law in mathematical optimization theory saying “the fewer constraints are put on a optimization problem, the better the optimum”. Since individuals have clearly fewer constraints in their investment process, they should outperform (just theoretically).
This point was driven home in Gregory Zuckerman‘s book “The Greatest Trade Ever” which documents how John Paulson was able to suss out and profit greatly from the subprime/mortgage bubble. We would recommend the book as a companion piece to Michael Lewis’ “The Big Short” which we also enjoyed. (Only hardcore investors need both, however.)
As surprising as it is in hindsight, Paulson had a great deal of difficulty attracting investors for his Paulson Credit Opportunities Fund that was dedicated to shorting the subprime market. One big reason why many investors balked was the fact that the fund would have “negative carry.” Zuckerman writes:
A key reason even experienced investors resisted buying mortgage protection: CDS contacts were a classic example of a “negative-carry” trade, a maneuver that investment pros detest almost as much as high taxes and coach-class seating. In a negative-carry trade, an investor commits to paying a certain cost for an investment with the hope of untold riches down the line. In the case of CDS contracts, purchasers usually agree to make an up-front payment, and to shell out annual insurance premiums, both of which bake in a sure cost.*
Many investors were unwilling to take on the ongoing costs of trades. In so doing they missed out on untold profits that Paulson was able to reap. This institutional mindset did not allow for this type of risk-reward situation where relatively small costs could yield huge profits, especially in the world of mortgage bonds.
That is not to say there are not plenty of cases were positive carry, the flip side of negative carry, works out for investors. Indeed on area we touched in our earlier posts, distressed debt, has this characteristic. Investors who buy beaten down debt, provided it is still current, have both the opportunity to earn a high current yield and profit from a re-pricing of the debt instrument. Indeed, the best of both possible worlds.
However some investors focus exclusively on negative carry trades. Investors who follow a strategy popularized by Nassim Taleb purchasing (far) out-of-the-money option contracts in anticipation of greater than expected market moves. This strategy requires a steady stream of option purchases, many of which will finish out-of-the-money.
The bottom line is that investors need to remain flexible in their approach to the market. Sometimes that means positive carry trades make sense. Other times negative carry trades are necessary to capture sharp market moves. Some institutional investors recognize this, but many are hamstrung both by their investment mandates and their by-the-book thinking. Chalk one up for investment flexibility.
*p. 119, Gregory Zuckerman, “The Greatest Trade Ever”, Broadway Books, New York, NY, 2009.
Please note: We purchased our own copy of “The Greatest Trade Ever” and were in no way compensated for this post.