James Montier on Contrarianism and Tail Risk

“Long ago, Keynes argued that the “central principle of investment is to go contrary to general opinion, on the grounds  that, if everyone is agreed about its merits, the investment is inevitably too dear and therefore unattractive.”  This powerful statement of the need for contrarianism is frequently ignored, with disturbing alacrity, by many investors.

The latest example in the long line of such behavior may well be the general enthusiasm for so-called tail risk protection.  The range of tail risk protection products seems to be exploding.  Investment banks are offering “solutions” (investment bank speak for high-fee products) to investors and fund management companies are launching “black swan” funds.  There can be little doubt that tail risk protection is certainly an investment topic du jour.

I can’t help but wonder if much of the desire for tail risk protection stems from greed rather than fear.  By which I mean that it seems one of the common reasons for wanting tail risk protection is to allow investors to continue to “harvest risk premium” even when those risk premiums are too narrow.  This flies in the face of sensible investing.”

So begins the latest piece by James Montier of GMO on risk and investing.

This reminds me of 2007 and 2008 when Goldman Sachs thought it had offloaded the tail risk from the housing bubble onto AIG, allowing it to “harvest risk premium”. In fact, had AIG not been bailed out, Goldman would have suffered huge losses from this approach.

Montier goes on to identify three groups of tail risk protection available to investor: cash (liquidity risk), options/contingent claims (event insurance like CDS or catastrophe bonds), strategies that are negatively correlated with tail risk (paired short/long hedge trades, going long volatility). If investors are concerned about other types of tail risk like inflation, Montier believes these strategies offer limited protection.

In Montier’ view, “value investing is the only risk-averse way of investing” that addresses tail risk. He identifies, value risk, fundamental risk and financial risk as three main risk characteristics value investing captures. The subtext of his piece is that these tail risk strategies will fail to adequately protect investors utilizing them who do not pay attention to the risks that value investing inherently does. Caveat Emptor.

Source: A Value Investor’s Perspective on Tail Risk Protection: An Ode to the Joy of Cash, James Montier, GMO (available to registered users at gmo.com)