(Originally published here.)
Depending on whom you ask, Herbalife Ltd. is either a pyramid scheme that preys on the poor or the innovative manufacturer of dietary supplements favored by a former secretary of state. Bill Ackman, a member of the first camp, admitted in an interview with Bloomberg TV to losing $400 million to $500 million since his Pershing Square Capital Management LP hedge fund started short selling Herbalife shares about a year ago. Ackman also said that this wasn’t “just a trade” for him — he promised to keep betting against the company “to the end of the earth,” a phrase reminiscent of Captain Ahab’s vow that he would chase the white whale “round perdition’s flames before I give him up.”
This illustrates an important point: It isn’t enough to have valuable insight that others lack, though far be it from me to say whether Ackman is right in his analysis. You also need to structure your bets so that the downside from being wrong is less than your potential upside.
Pacific Investment Management Company, one of the world’s biggest asset managers, is a great example of an investor that nailed the fundamentals only to underwhelm when it actually came to trading the markets. (Funds that blew up after trying to short the tech bubble in the late 1990s are also instructive.) At the end of 2009, the Federal Reserve was projecting that U.S. gross domestic product would increase by about 3 percent in 2010 and then by about 4 percent in both 2011 and 2012. The actual numbers were 2.5, 1.8 and 2.8 percent. In 2010, the White House promised a “recovery summer” that turned out to be so underwhelming it prompted the Fed to start its second round of asset purchases, or quantitative easing, at the end of August that year.
Pimco saw this coming. By the middle of 2009 it thought that the developed world had entered a “new normal” in which households and businesses would be more skittish about borrowing than they had been in previous generations. The implication would be a much slower recovery. Policymakers would feel compelled to do more than they were expecting to restore growth and still end up falling short. This analysis was thoughtful and prescient yet many of Pimco’s specific trading recommendations turned out to be wrong. Its flagship Total Return Fund has outperformed its benchmark index over the years, but it ought to have done much better given the superiority of its economic analysis.
Fortunately for Ackman’s investors, he seems to have a better command of risk management than the fictional old whaler. According to Ackman, the Herbalife losses represent less than 5 percent of the total capital managed by his hedge fund. That’s significant, but not devastating. And he seems to have made an adjustment by limiting his potential losses. In the same interview in which he committed to bet against the company to the end of the earth, Ackman said that he had recently modified his bet to protect himself from short squeezes with the help of long-dated put options.
If Herbalife ever gets shut by regulators, Ackman would end up making far more than he lost — and he wouldn’t have to worry about being forced to close out his position in the interim. In that case, he would have nailed both the fundamental analysis and the required trading strategy. If regulators never move against Herbalife, Ackman would continue to lose money, although at a more measured pace and with a limited downside. It’s cases like this that show why it’s so hard to beat the markets.
(Matthew C. Klein is a writer for Bloomberg View. Follow him on Twitter.)