The Biggest Lessons from the Greatest Trade of 2020

There won’t be a lot of debate about the greatest trade of 2020. Bill Ackman’s bet that the coronavirus would roil the stock market and cause ripples in the macroeconomic economy and stock market. Yes, the timing of Ackman’s call—in February 2020—was prescient.

It’s easy for the headline to steal the show. After all, Ackman’s firm, Pershing Square Capital Management, reportedly made $2.6 billion in profits on the trade. That more than made up for the decline in his long equity portfolio as markets plunged 30% in a matter of weeks. More appropriately, the gains allowed Ackman to cash out and double down on the long-term bets he was making. Ultimately, he was right on both sides of the trade… both in the execution and timing.

But if we disconnect the trade from the result, we uncover the real beauty of Ackman’s trade, as well as the lessons it has for those of us who don’t manage $6 billion. Let’s dig into why.

Ackman’s View

In early February, Ackman developed the view that the COVID-19 epidemic would have a greater impact on the global economy than many imagined. As the market hit all-time highs in February, he worried that things did not add up.

Expecting the macroeconomic landscape to deteriorate, Ackman said that he was looking into what options he had for managing his roughly $6 billion fund, including whether he should liquidate the entire portfolio, according to the Financial Times.

But liquidating a $6 billion hedge fund comes with a ton of operational and transaction costs, potentially moving the prices of the underlying stocks as you unload holdings.

Alternative Ways to Make the Same Trade

Looking at correlated markets, however, Ackman saw that he could express the same view in a different way. The credit markets are often correlated to the equity markets. This should make intuitive sense: if the business of a company deteriorates, then the company is less likely to pay off its debt. That causes fluctuations in the price of credit.

More specifically, Ackman turned to the credit default swaps (CDS) market. Initially created as a way for investors to buy insurance on the debt they owned, CDS pays off if the underlying company cannot pay its debt obligations. You may recognize CDS as the instrument of choice for the hedge funds that made it big during the 2008 housing crisis. Those traders bought CDS on companies tied to the housing market, in addition to CDS on the mortgage bonds themselves.

The benefits of CDS is that, like options, the cost to buy them is fixed to monthly premiums. Ackman agreed to pay $27 million per month as long as he wanted to keep the trade on. In return, he had leveraged exposure to $64.8 billion in bonds.

Risk vs. Reward Well Balanced

Ultimately, Ackman paid just one month’s premiums ($27 million) before his bet paid off big. But given where equities were in their lifecycle (all-time highs) and the amount he had invested, the trade was a great example of a phenomenally-structured risk-to-reward payoff.

Why? On a $6 billion portfolio, Ackman was paying 45 basis points in insurance per month—in effect paying 0.5% to protect from an outlier that he expected was coming. (Again, whether Ackman was ultimately right or wrong is immaterial to whether this was a good trade.)

The opportunity to give up 0.5% of performance per month for an event that was coming to a crescendo and, if right, would result in a multi-percent move lower is putting the odds on his side.

What are some more “vanilla” ways Ackman could have expressed the trade?

He could have, as he thought, sold his entire equity portfolio. However, if stocks continued to move higher, he would have missed out on any gains—potentially eclipsing 0.5% per month. In addition, Ackman would have to be right twice: both on the sale of the equity portfolio and on the buy-back after the decline.

He could have bought equity puts on the names in his portfolio. This likely would have been a more traditional way to protect from downside in the portfolio on a fixed-cost basis. It’s probably what many of us with smaller portfolios would do. However, given the resources that a large hedge fund has in structuring trades, it’s likely that the CDS coverage was simply cheaper than put options on his equity names.

Or finally, he could have sold covered calls to collect premium on the names. This would help offset any losses he may experience with guaranteed income. However, this takes the opposite path to the one he traveled. It would give him guaranteed income while potentially taking away his upside if he were wrong. Additionally, his gains would be capped at the premium he collected, meaning that if the market declined more than that, his portfolio would still decline in value.

Ultimately the reason that Bill Ackman’s trade is easily the best of 2020—and maybe ever—is not because it was correct and well timed; it is because it was extremely well orchestrated. The potential return dwarfed the monthly outlays. And it accomplished its goal of being a hedge probably better than even Ackman anticipated.

What We Should Take Away

Lesson 1: There are always multiple ways to express the same trade. If you want to go long U.S. large cap stocks, you can buy the $SPY. You can sell a $SPY put and buy a call. Or you can break it down into its individual parts and trade those. There’s always more than one way to express a view. Ackman showed this by taking a macroeconomic view on stocks and expressing it in the bond insurance market.

Lesson 2: Your best trades are always going to be asymmetric. That means that they’ll have larger upside than they do downside. Ackman was paying just 0.5% per month of performance drag on his portfolio to insure against a big downside move.

Lesson 3: Know your catalyst. The risk for Ackman’s trade came if the market moved sideways for a time. He would continue to pay out the monthly premiums, while his portfolio neither gained nor lost money. The presumed value of the CDS would stay the same, bleeding him for months and months. The beauty was that this trade also had a catalyst: the coronavirus. If the virus news got better, he could exit the trade as the threat passed.

Lesson 4: When the catalyst happens, get out. We talk about this as it relates to unusual option activity quite a bit. There is no reason to stick around in a trade after the news breaks. In this case, Ackman not only exited his trade, but he reversed it to go long… conveniently near the March 23 bottom in the market. Well done all the way around.