A Page From Cornwall Capital's Playbook


In his book The Big Short, Michael Lewis chronicles how Cornwall correctly predicted and benefited from the subprime housing crisis, via a "Fat Tail." While reading the book, I remember thinking that the approach was different from many other funds that I've encountered. Some tidbits that particularly resonated were the following:

Fat Tail ≠ Probability of Positive Outcome is High

Fat Tail actually implies:

  • Low Probability of Positive Outcome, but…
  • Positive Outcome is more probable than market expectations (therefore the ratio of expected return relative to cost is asymmetric and attractive)

Upon further reflection, I wondered if Cornwall’s approach could be beneficial to more traditional investors, such as:

  • Being creative and looking for other non-traditional securities through which to express certain views and convictions
  • Spending more time to understand how certain securities, options, hedges, or derivative structures are priced by the market and sellers – thus understanding the counterparty’s motivation and rationale (remember, it’s a zero-sum game)
  • Paying closer attention to the ratio of Expected Return vs. Cost (both actual and opportunity)
  • Effectively utilizing and sizing Fat Tails (instances where the probability of occurrence is low, but the ratio of Expected Return to Cost is asymmetrically high) in a portfolio context

Above all, investors should remember that Fat Tails are usually rare occurrences because it involves not only the formation of a view/conviction, but also the identification of an attractively priced security (with asymmetrically high reward relative to cost) to express that view/conviction. Post the subprime crisis, there have been no shortage of views and convictions (hyperinflation, European CDS, etc.), but few securities priced to offer the type of asymmetric reward required to achieve "Fat Tail" status.