You can buy protection for a stock or bond portfolio. It won’t be cost-free.
Spring 2020. Paul Kim, a middle-aged father of three, with a house in the suburbs and a dependable job at a Midwestern insurance company, does something a little crazy. He quits the job in order to start his own company.
“It’s one thing to jump in the early part of a bull market,” he recollects, now on safer ground. “But people were freaking out. The market was tanking. It looked like a depression and a medical emergency.”
In fact, the timing was not entirely crazy. Kim’s enterprise, Simplify Asset Management, markets exchange-traded funds that protect portfolios from disasters like stock market crashes and interest rate spikes. The best time to sell such things is when the world is falling apart. As the pandemic unfolded, Kim persuaded himself that either he was going to start a company then or he was never going to do so and would go to his grave with regrets.
In the year it took him to wade through the paperwork of investment-company creation, the market recovered. If halcyon days had returned for good, the new venture would have been doomed. But happy times for the bulls did not last. For Kim, providence arrived this year in the form of a simultaneous retreat in both stock and bond prices.
That dual collapse delivered quite a shock to retirement savers who had been led to believe that bonds would balance out the hazards of stocks. They were desperate for a different kind of risk reduction. This is what Simplify sells.
One of Kim’s funds, the Simplify Interest Rate Hedge ETF, makes money when bonds sink. It’s up 50% this year (as of July 20). Another of his funds, which owns stocks along with partial insurance against bear markets, is down this year only half as much as the stock market. Simplify has hauled in $1.4 billion to its lineup of 21 funds, each offering an atypical pattern of risks and rewards, in stocks, bonds, commodities and cryptocurrency.
Kim’s cofounder and junior shareholder in this fling is David Berns, trained as a physicist. Like Kim, Berns is an escapee from the insurance industry. But they have had rather different career paths. Kim, 45, has the predictable Ivy League undergrad (Dartmouth) and Wharton MBA degrees you’d expect for a product manager at Pimco and then Principal Financial Group. Berns, 43, is the son of two New York City police officers and says he would have joined the force if not for his mother insisting on typing out for him an application to one college, Tufts.
“If you avoid large losses with a strong defense, the winnings will have every opportunity to take care of themselves.”
Berns got a degree from Tufts and then, in 2008, a Ph.D. in physics from MIT. His dissertation was about using superconducting circuits to make the quantum equivalent of a transistor. Classmates took jobs researching quantum computers, devices that might someday conquer mathematical tasks beyond the reach of ordinary machines. Berns veered off into theories of portfolio construction.
Physics, money—are there connections? There are. The diffusion of heat over time, for example, parallels the diffusion of stock prices. Putting his research into practical terms, Berns explains that it’s all about risk and how people perceive it.
Kim and Berns were taking a risk when they started a firm without an angel backing them. Maybe Kim was trying to prove something. He came to the U.S. at age 4. His parents, now retired, started out with a fruit stand in Queens, New York, and eventually built a wholesaling business. If they could succeed as entrepreneurs, surely he could. He says of his work launching ETFs at Pimco: “Once you’ve built a $20 billion platform, what do you have? You don’t own it. It’s just a job.”
Even the Great Depression was a boom time—for the few positioned to profit off market misery. Take Floyd B. Odlum, the “quiet, spectacled, sandy-haired financial genius” who sat out the 1929 bull run, predic- ting a crash, then amassed $100 million ($2.3 billion in today’s dollars) scooping up distressed investments for pennies on the dollar after Black Tuesday.
If you had wanted to run $1,500 up to $10,000 during the past four years, you would have had to do just about what Odlum did. Only he started with $15,000,000 and now controls $100,000,000! He believes in spreading risk by diversification; his portfolio includes banks; utilities; chain stores; farm machinery, petroleum, biscuit,
shoe and automobile companies. “But,” he says, “in times like these you’ve got to do something else than just sit on a portfolio.” When investment trust shares were kicking around the Street at as low as 50 per cent of their actual value, it was not difficult for a skillful negotiator like Odlum to buy control quietly. —Forbes, July 15, 1933
The duo raised enough equity from family and friends to get the business off the ground. At the half-billion-dollar mark in assets they had enough credibility to land outside money. A billionaire Kim doesn’t identify stepped up with $10 million for a 25% stake.
The rate hedge fund, which has $296 million, consists in large part of bets against Treasury bonds. It owns out-of-the-money put options that hit pay dirt if, six years from now, 20-year Treasurys are yielding a percentage point more than they are currently.
Rates don’t have to move past the strike point of those options for the options to become more valuable. When interest rates rise, as they have this year, long-shot puts have a much better chance of paying off, and rise in price.
Simplify offers no illusion that its rate hedge fund is, by itself, a way to make money. It’s more like fire insurance. Own some of it alongside a more conventional fixed-income asset, like a portfolio of long-maturity municipal bonds, and holding onto that asset through bull and bear markets becomes more tolerable.
A different sort of strategy is built into Simplify Hedged Equity ETF. This one has the put-option antidotes to bear markets already added to the S&P 500 portfolio they’re designed to protect. The combination is intended to compete with that old standby of pension investing, the 60/40 blend of stocks and bonds. So far this year, with the S&P down 16% and the overall bond market down 10%, Simplify’s offering is looking good. Hedged Equity is down 8%; the Vanguard Balanced Index Fund is down 15%.
Investors have a warped notion of risk, Berns says, and wind up with portfolios they can’t stick with during severe market moves. Their advisors don’t always prepare them. Indeed, he adds, “people on Wall Street work hard to hide the risk of their products.”
One culprit in this process is the nearly universal habit of measuring risk by a single number, the variance in the month-to-month moves in an asset’s price. Variance adds up the squares of the distances stock prices move from their starting point. Berns cares about the cubes. Arcane? Not at all. Look only at variance, and you’re going to love a strategy that combines a lot of small gains with the occasional big loss.
That’s what you get, for example, in a junk bond fund or a fund that enhances its monthly income by writing call options. Stuff like this sells because it deludes investors into thinking they can enjoy low risk and enhanced income at the same time.
HOW TO PLAY IT
By William Baldwin
Eliminate risk from a portfolio? Can’t be done, unless you eliminate return (Treasury bills don’t even keep up with inflation). You can, however, dull the pain of a bear market. The Simplify Interest Rate Hedge ETF (ticker: PFIX; expense ratio: 0.5%) is a strong analgesic, this year moving up not quite five times as fast as the overall bond market went down. A $10,000 dose should roughly halve the damage done by rising rates to a $100,000 stake in a total bond market fund. If interest rates go back down, PFIX will be a loser, but that would be a nice problem to have, since your core bond fund will be doing well.
William Baldwin is Forbes’ Investment Strategies columnist.
The calculation with the cubes, which statisticians call “skewness,” puts a red flag on such strategies. It favors the mirror image of return patterns: many small sacrifices in return for an occasional big payoff. A positive skew is what you get in the $449 million Simplify U.S. Equity Plus Downside Convexity ETF, which owns puts that don’t do much in a mere correction, of the sort stocks have had this year, but would kick into high gear in a crash. That pattern is right for certain investors, the ones who can handle a 20% decline but not a 50% decline.
Says Berns: “We sculpt return distributions. Options are the scalpel.”
Simplify’s ETFs cost more than plain old index funds but a lot less than private hedge funds offering customized return distributions. The rate hedge ETF has a fee of 0.5% a year; the hedged equity fund, 0.53%; the downside convexity fund, 0.28%.
“The ETF is a better mousetrap [than a hedge fund],” Kim says. “It’s cheaper. It’s more transparent. It’s more tax-efficient.”
Kim’s 23-employee firm is not yet in the black, but he expects that it soon will be. “ETFs are like a movie studio,” he says. “You’re looking for a blockbuster to fund the business.” He won’t admit to praying for a catastrophic bear market in stocks or bonds, one much worse than what we’ve had, but such an event would probably deliver that blockbuster.