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The Archegos implosion teaches the same lessons that apparently need to be taught over and over again.

  1. High leverage eventually brings margin calls.
  2. Margin calls equal disaster.
  3. Margin calls come when too much leverage is attached to securities linked to market volatility.
  4. All securities are linked to market volatility.

There is no such thing as uncorrelated assets anymore. Investment strategies founded on the belief that the securities held are somehow immune from previously “uncorrelated” volatility are anachronistic. Combine these investments with substantial leverage intended to enhance returns, and this strategy ends in disaster.

If it’s zero eventually, great quarterly performance is meaningless.

It’s risk-adjusted return, idiot.

The importance of risk management, or simply put, protecting the downside, appears to have escaped most people’s memory. If return is the only metric that matters, that portfolio will run into the iceberg at full speed.

The new normal is heightened volatility within increasingly compressed time frames. None of these lessons are new, and anyone who has read either “The Black Swan” or “Antifragile” by Naseem Taleb understands these lessons well. Or, put another way, when your portfolio earns 20% on capital annually through a combination of overly clever securities choices and supercharged irresponsible leverage, eventually, that portfolio will be multiplied by, and be worth, zero.

Too clever by 3x to 10x 

Leverage kills. Archegos was reported to have about $10 billion under management and anywhere from 3x to 10x that amount in market exposure. This is where not understanding downside risk and, more importantly, only thinking of short-term performance, destroys value. Here’s an example. If someone with $10 billion invests all of it and loses 20%, the portfolio is still worth $8 billion. Not as good as 10 billion, but there is still a portfolio left. If that person instead were to take the $10 billion and leverage it to $50 billion and lose 20%, the portfolio is now worthless – 20% of $50 is a $10 billion loss, and the entire portfolio is gone.

Diversification? Hedging?

On top of that, leverage combined with excessive concentration with insufficient or nonexistent hedging magnifies risk disproportionately. Archegos was reported to have most of its market exposure concentrated in only a few positions, raising the risk that magnified volatility combined with leverage and no hedge against significant price drops would make it impossible to manage downside risk or protect the portfolio from uncertainty. The one thing we know about uncertainty is that it is always certain.

Haven’t I already answered all the questions?

Diligence matters. Questioning assumptions and decisions constantly are the table stakes for any investor. The too clever, overleveraged, overconfident manager believes work is done before an investment decision. That’s the beginning, not the end, and a failure to be diligent in a market with many more influences, uncertainties, and factors impacting a portfolio ends, well, the way Archegos ended. Watching carefully and acting quickly, getting out of suddenly unattractive positions, and revising thinking is almost as good as a good investment choice in the first place. 

Building a portfolio the way Archegos did is not investing. It’s gambling. The most important lesson is to know the difference.