market folly

While many of the hedge funds we track on Market Folly employ a long/short equity strategy, Bill Ackman's Pershing Square Capital takes a slightly different approach, typically preferring credit default swaps (CDS) to shorting equities.

In fact, Ackman's approach is more akin to Seth Klarman's approach at Baupost Group. Klarman typically hedges against outlier events such as hyperinflation. These hedges typically cost very little and often expire worthless, but if the outlier event does occur, they can payout over 50x.

In fact, we've detailed Ackman's strategy briefly before in our profile of Ackman & Pershing Square. Given the recent market volatility, Ackman took this opportunity to outline his hedging strategy in his recent letter to investors to remind them that they don't attempt to manage short-term volatility.

Ackman purchased $600 million worth of investments recently and so let's take a look at the other side of the coin: hedging. Ackman writes,

"Unlike as we did in the past, we don’t own investment grade CDS because we believe these credits are mispriced. Rather, we continue to own approximately $7 billion of index CDS which serves as a form of disaster protection, but one that is unlikely to pay off in a material way unless and until there is another major systemic crisis.

We own almost no single-name CDS other than to hedge a modest amount of uncollateralized exposure we have to financial institution counterparties. We have been unable to identify large single-name, standalone CDS investments since 2009. This is largely due to the rapid improvement in corporate creditworthiness over the last two years."

And then turning back to Ackman's tail-risk protection, he goes on to note that the hedge fund has committed capital to asymmetric payoffs that won't protect the fund unless there is a very large market decline. He writes,

"Since the inception of the funds, we also have purchased options which offer asymmetric payoffs in the event of the occurrence of low-probability catastrophic or otherwise unanticipated negative events. These events could include large movements in interest rates, currencies, or other asset prices that we believe may occur during periods of market stress."

As such, it sounds like Pershing will underperform in times of mild market stress (like recently) but is more-so hedged against extreme outlier events. According to their investor letter, Pershing was up 1.7% for the year at the end of the second quarter. However, HSBC Private Bank data says that Pershing is now -10.5% through mid-August.

For more from the hedge fund, head to our post on why Ackman bought more Citigroup.