Hedging, Trading and Investing

Two weeks ago, the S&P went from up 5% on the year to unchanged in a matter of hours. At about the same time, the US 10-year note moved from 2.35% to 1.85% in a move so large that it really only happened once during the 2008 financial crisis.  Of course, those moves have been entirely erased with equities up at new highs and fixed income still wallowing away at yields that nobody particularly likes. At Blue Elephant, we are the owners of thousands of loans made to real people who are using the money to finance their lives. Our returns are solid, looking to be 10-12% for calendar year 2014. However, we know that we are not immune to market volatility. In fact, we have the ability in our fund to hedge out broad market risk that would be disruptive to our returns. As October’s volatility played out, the Managing Partners of Blue Elephant sat down to discuss if there was any potential impact to our investment strategy. Was the volatility a harbinger of economic trouble to come? Or was it just a bit of indigestion magnified by algorithmic trading? Was there any way to know the difference?

I thought our conversation was fascinating. Admittedly, I made the argument that the volatility was a sign of trouble to come – QE was about to end, China and European growth was slowing, and the Ebola issue was not going away. My argument was to “hedge” our portfolio risk by buying puts on the S&P. It was a hedge in my mind because by buying puts, we knew what the maximum cost to the book would be.

My partners pushed back – while it felt like a hedge, it was in their minds nothing more than a “trade.” The difference here, while seemingly semantic, is important.  Our book of loans is a small window on how the economy is performing. Payment rates tend to slow ahead of or concurrent with economic slowdown. Looking at our real-time data, default rates in our book were low and stable – not pointing to any deterioration in the economy at all. While this isn’t perfect information, their broad point was important. To hedge our book, buying S&P puts needed to mitigate a specific risk that we had an edge on predicting. Otherwise, it was just a trade – a position we were taking based on some unquantifiable feeling on where the markets might be going.

We didn’t do the trade. In the heat of the moment, what looked like a hedge was really more of an emotional reaction to short-term market volatility.

There are few long-term investors left in this world. In the information age, it just isn’t exciting enough. I can’t write a weekly thought piece on how my long-term investment strategy did, and I certainly cannot tweet about it or post it on Facebook daily. Our thesis is that monitoring the business cycle and making loans based on that view will be very lucrative for our investors over time. We want the ability to hedge to protect our long-term thesis, but never want it to overshadow the thesis itself. We figure that even if we’re boring, good returns over time will keep our investors coming back for more. That doesn’t seem like such a bad trade after all.