Some hedge fund bigwigs generate headlines with live arguments on CNBC, but Jeff Gundlach of Doubleline (while not exactly a ‘hedge fund guy’) has been opting instead to make huge – and for the most part, uncannily accurate – calls on various markets. These calls (what we have called the “Gundlach Spreads”) have generated a fair bit of buzz, and now there’s a piece from Business Insider quoting him on another catchy investing idea – something he calls Gundlach’s Rule of Investment Risk.

If you run things and you try to get them very smooth, without ever any downside, you’re trying essentially to eliminate the frequency of problems.  I believe the frequency of problems times the severity of problems when they occur equals a constant.  Frequency times severity equals a constant.

Essentially – he is saying that there is one pain point, and it is a constant. And it can be arrived at via frequent but small downside, or infrequent but large downside. Business Inside breaks it down in terms of the economy, saying the idea is essentially that you can have 1) frequent, yet shallow recessions or 2) infrequent, yet deeper recessions.

Now that sounds a lot like the description we give of managed futures and their long volatility profile – whereby they accept small but frequent losses for large but infrequent gains. Conversely, short volatility programs such as option sellers trade off small but frequent wins for large but infrequent losses. Throw in a little bit of Nassim Taleb’s thoughts on randomness happening lot more in financial markets than you would think, and you can see why we believe it is such a good idea to be on the side where you can benefit from these large outlier moves.

But Gundlach takes the idea a bit further by saying the frequency vs. severity difference is a constant. What that means for long volatility type programs is the less frequent the big moves are, the larger the next move is going to be – so that the frequency times severity equals the same number.  This meshes well with our experience watching markets and managed futures programs over the years, whereby the big moves often come out of the quiet periods. Just look at the Japanese Yen’s recent move, where that market followed 5 months of being in a tight 3% range with a decline of 16%.  As we read Gundlach’s “Rule” – with the frequency of “problems” nearly zero in the Yen during the quiet period, the magnitude of the next “problem” had to be much bigger in order for the frequency*severity to equal the constant.

Gundlach’s message appears to be that the Fed’s machinations are suppressing the frequency of problems, meaning the severity of those problems will be that much bigger when they come. The question then – is whether the Fed can suppress the frequency indefinitely to escape the severity.  Put us in the doubtful camp.