What Makes Us

Different
"If you can think it, it can happen"

Lone Wolf Asymmetric differs from other investment managers because

of its occasional divergences from conventional investment theory
 What Makes Us Different

What Makes Us
Different Testing before
Using
"If you can think it, it can happen"

My Commodities Corp. background taught me that Not all

over the years, lots of allegedly helpful investment investment
advice and wisdom has been dispensed. But before
advice is good
using any of it you need to test it for yourself. The
key learning point for me was that not all investment or applicable
advice is good or is it applicable at all times. all the time.
Additionally, not all advice is applicable for
everyone. Sometimes only a select few can actually
use the advice to their benefit. It is important to In fact
determine what ideas really work and when to apply
sometimes
them.
good advice
Early in my career I looked at many financial theories
doesn't apply
along with their assumptions and compared them to
my real world trading results. I saw differences to everyone.
between the theoretical and the practical that I
couldnt explain. Coming out of business school
negative interest rates were supposedly an
impossibility. But I saw it in the 1970s, when
Switzerland used it to counteract a strengthening
franc. This is when I started to develop my own
views and started to deviate from conventional
thinking.

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 What Makes Us Different

To understand how Lone Wolf Asymmetric differs

from other investment managers we need to take a
brief detour into investment theory. Modern
Harry
investment theory came about in 1952, when Harry
Markowitz &
Markowitz presented an idea for which he later won
MPT
the Nobel Prize in Economics. He proposed the idea
that there is a trade-off between risk and return. This
In today's
became the essence of Modern Portfolio Theory
(MPT). In his paper, he further advanced the idea by
environment
saying that it is not enough to look at the expected do these ideas
risk and return of one particular stock. Instead an really reflect
investor needed more than one stock
an investor's
diversification to reduce the riskiness of a portfolio.
preference?
MPT quantifies the benefits of diversification and
calls it the only "free lunch" in finance. All of these
ideas have become central tenets of today's modern
Isn't time to
finance. But are these ideas still appropriate for
today's market environment and do they reflect
challenge
investors' true preferences? We think not, but let's some of these
review and see where we start to deviate from sixty year old
conventional thinking.
ideas?
Markowitz Defines Risk

Let's start with his definition of risk. Markowitz

defined risk as the standard deviation from the
average return. Each stock has its own standard
deviation from the mean which represented its
risk. Furthermore, Markowitz saw risk being

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 What Makes Us Different

symmetrical and any deviation (up or down) from that

expected return was unwanted.

The Symmetry of risk made sense to him as just about Harry

everything in nature back then could be explained Markowitz &
from a normal bell shape curve. The bell shaped curve MPT

represented the best of his known world at that time
and the advent of personal computers to crunch What is your
financial data was still years away. The little testing definition of
that they did on financial data uncovered some
risk?
anomalies but were later thrown out and explained as
outliers that did not represent the real world.
Therefore, to Markowitz, any deviation (up or down)
Is it any
from the expected return was viewed unfavorably.
variance from
In the years that followed, new concepts such as Post-
Modern Portfolio Theory (PMPT) developed a
an expected
different measure of risk. They used the standard return - be it
deviation of negative returns to measure risk. either up or
Meaning this "downside risk" captured what investors
down?
feared most: negative returns /big losses. After all, in
the real world investors will take all the upside
volatility / the variance from expected returns that they
can get, as large positive returns are viewed as a good Or are you
thing! Effectively, investors want as much upside more
skew as possible. This is one of the main differences
concerned
between these two risk measures. The asymmetrical
view is one that best reflects an investor's desire of about
taking small losses while participating in as much up- containing
down-side
3 Lone Wolf Asymmetric
risk?
 What Makes Us Different

side as possible. And wasn't that the original intent of a

hedge fund?

Markowitz and others believed that a single asset when Harry

combined with other uncorrelated assets lowered the Markowitz &
overall risk to the portfolio. The combing of several MPT

assets' expected returns and their weights in a portfolio
forms the "efficient frontier." At first blush this kind of Diversification
makes sense until you start asking questions. "Exactly and
how many assets do I need to combine to create an
correlations do
efficient frontier?" There is no definitive number.
Additionally, when building a portfolio we would use they help or
their correlations to decide which assets to add. But hinder my
how uncorrelated do they have to be to be added into the
portfolio?
portfolio?

The problem with correlations is they work when things

are calm but in times of crisis they all revert to one - What do I
meaning they all move together. This provides no benefit really want
and is instead a drag on the portfolios overall return.
from my
When we see a portfolio that is well diversified we see an portfolio?
upside skew that is watered down. The benefit of an
upside skew that an investor was counting on is
effectively neutralized at the cost of lowering the risk to
the investor. We think there is a better way to structure a Do I need to
portfolio and still give the investor what they are looking rethink my
for a quantifiable downside risk along with the strategy?
possibility of unlimited upside gains. This can be
achieved through options.

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 What Makes Us Different

Diversification a Free Lunch?

A second theory that we disagree on is diversification. But we're

not the only ones who differ with Markowitz's thoughts on Warren Buffett
diversification. Warren Buffett is quoted saying that
and Investing
"diversification is protection against ignorance. It makes
little sense if you know what you are doing." According to
Buffet's logic, it's better and more lucrative to study a few Diversification
industries in great depth, learning their ins and outs, and is protection
using that knowledge to profit on those industries than
spreading a portfolio across a broad array of sectors. against
ignorance. It
The need for diversification is a portfolio theory rooted in
the idea that an investor who puts all his or her money in makes no
one company or one industry is flirting with disaster if that sense if you
company or industry takes a dive.
know what
The problem with diversification, in Buffett's view and
other like-minded investors, is that even though risk is
you're doing.
mitigated by sector gains offsetting sector losses, the
opposite is also true sector losses offset sector gains and
reduce returns.

Returning to my opening paragraph not all words of How can I get

wisdom can be applied by all. Buffett has amassed a Skewness to
fortune by acquiring immense knowledge base of all things
finance and about specific companies and industries, that work for me?
he uses to hand-pick his investments. Few investors have
been better at picking stocks and timing entry and exit points.
An ignorant investor someone with little to no financial
or industry knowledge is bound to make blunder after
blunder if he or she attempts to play the market the way
Buffett does.

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 What Makes Us Different

An investor who studies trends and has a keen

understanding of how different companies and industries
react to various market trends profits much more by using
that knowledge to his or her advantage than by passively Warren Buffett
investing across a wide range of companies and sectors. Such and Investing
an investor is able to go long on a company or sector when

market conditions support a price increase; similarly, the I want

investor can exit his or her long position and go short when
indicators project a fall. The investor profits in either protection
scenario and those profits are not offset by losses in from the
unrelated industries.
downside but I
More recently a paper, Do Stocks Outperform Treasury Bills?*,
want as much
published by Dr. Hendrik Bessembinder states:
upside as
Most common stocks do not outperform Treasury Bills. Fifty eight
percent of common stocks have holding period returns less than possible.
those on one-month Treasuries over their full lifetimes on CRSP.
When stated in terms of lifetime dollar wealth creation, the entire
gain in the U.S. stock market since 1926 is attributable to the best-
performing four percent of listed stocks. These results highlight the Asymmetric
important role of positive skewness in the cross-sectional Trading
distribution of stock returns. The skewness in long-horizon returns
reflects both that monthly returns are positively skewed and the
strategies
fact that compounding returns over multiple periods itself combine risk
induces positive skewness. The results also help to explain why
active strategies, which tend to be poorly diversified, most often
management
underperform. with

In a private email conversation with Dr. Bessembinder he

investment
writes: management
The findings in the paper can support multiple views. I have
long thought that low-cost index diversification makes sense for

6 Lone Wolf Asymmetric

 What Makes Us Different

investors who dont have the time or inclination to seek out

opportunities. That would be many investors.

Warren Buffett
At the same time the paper shows that there are tremendous
opportunities for those who can identify the stocks that will end and Investing

up on that right tail of the distribution. And, for those investors
with a taste for skewness (i.e. big upside) the paper shows that it Leverage?
is there. A result that is buried in a footnote, but is relevant, is
that skewess disappears from portfolios. If one wants
skewness, then one does not want to diversify.
Would
The message that I got from Dr. Bessembinder is that
tremendous opportunities are there if you have the
leverage help
knowledge, time and can apply some sort of skew based meet my long-
investment process to your stock selection. Then there is no
term return
need to diversify. An options program that we run fits that
description. targets if it
was properly
Our final point that differentiates us from other managers is
Leverage. For certain institutions leverage / borrowing funds managed?
for investment purposes is not permitted Leverage helps
some funds meet their long-term return targets without
relying too heavily on volatile stocks, or tying up their
money for long stretches in private investments.

According to New York University researchers and AQR

Management, Berkshire Hathaway has historically levered
up around 60%. This means that Buffett's profits are 60%
higher than they would have been had Buffet used his own
money and not levered up. So if you are looking to replicate
Warren Buffett than you had better learn how to use
leverage. Because according to their results finding stocks
that beat the market is less important than the use of
leverage to enhance returns.
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 What Makes Us Different

But Buffett gives advice that is contrary to his own activity.

He says debt / borrowed money is the weak link that can
often be fatal to a fund. Yet he uses other debt alternatives Warren Buffett
to gain leverage. and Investing

Since we use options we can ratchet up our leverage up by The studies are
adjusting the options that we purchase. Option leverage
can be controlled by deciding whether we buy in-the- in and the
money, at-the-money, or out-of-the-money options. This firms' with the
affords us the advantage of not worrying about loans being
called. most skill
know how to
Finally one last study, Managerial Talent and Hedge Fund
Performance from Georgetown's McDonough School of manage
Business, sought to quantify the significance of derivatives
management skill. The result indicated that talent matters
for performance, for survival and for inflow. What is the and leverage
talent doing that the less fortunate can't do? It involves the best.
making good use of derivatives and leverage.

We think we have shown that we are knowledgeable about

the use of leverage and derivatives. We are actively The world is
researching, reviewing and applying our findings to our
investment process. At times our findings run counter to
changing and
conventional wisdom. But we do see mavericks such as new ideas and
Warren Buffett confirming our ideas.
approaches
We would humbly ask that you further read our literature will meet the
and posts to learn about us and what we want to
accomplish.
challenge.

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