Hunting for Convexity
By Brian William Foote, CFA
Financial markets exist to compensate investors for bearing uncertainty. Yet, the characteristic of uncertainty today differs markedly from even a generation ago. Capital flows instantaneously. Information—both useful and fabricated—spreads virally. Allocation decisions are increasingly dictated by rules-based systems rather than judgment.
At the same time, valuations in key market segments have stretched to extremes. As of early January 2026, the Shiller CAPE ratio sits near 40, a level reached only during the peak of the dot-com era. Whether one chooses to label this a “bubble” is beside the point. These conditions will reward neither blind optimism nor superficial analysis. This regime demands preparation, humility, and a clear understanding of how markets behave at extremes.
A robust capital allocation framework begins here, shaped either by experience across cycles in my case, or experiencing them second hand through reading about them.
We all know that professional investing is not about forecasting a single future—indeed, it is not about forecasting at all—but about navigating a range of possible futures, including those most people prefer to dismiss as improbable. Perspective comes naturally when the dot-com bust, the Global Financial Crisis, and the collapse of Long-Term Capital Management all form part of one’s professional memory. Babies born during the GFC are now adults. Markets have evolved, but human behavior has not.
Markets do not fail at the average; they fail at the tails. Most lasting portfolio damage is not caused by routine volatility, but by rare, violent episodes dismissed as unlikely until they arrive—the so-called “six-sigma” events that somehow recur every decade. Any process that does not explicitly account for tails remains incomplete, regardless of how elegant it appears on paper.
The Fragility of Concentration
One of the defining structural changes of this era is the rise of passive investing. Passive strategies now hold nearly 60% of U.S. equity fund assets, up from roughly 50% just a few years ago. What was originally, and correctly, conceived as a way for the average investor to match the market at the lowest possible cost is now a potential source of risk. The road to hell was possibly paved with this great intention. Capital is increasingly allocated by index weight and market capitalization rather than business fundamentals, creating feedback loops in which quotational success attracts ever more capital regardless of valuation. Entire segments of the market outside the largest benchmarks are systematically neglected.
This dynamic is compounded by extreme concentration at the top with the so-called Magnificent Seven now representing roughly 34–35% of the S&P 500, rivaling historical extremes in market leadership concentration. When leadership narrows this dramatically, the market becomes more fragile, not more stable. Risk is disguised as diversification, and familiarity is mistaken for safety. At elevated valuations, even modest deviations from expectations can trigger sharp repricing as crowded trades attempt to exit simultaneously.
Crowded markets exit through narrow doors. Navigating this environment does not require precise prediction—only the recognition that protection is cheap relative to potential damage. Concentration amplifies tail risk, and tail risk is where convex strategies earn their keep.
Convexity in Practice
Probability, properly understood, is not about precision but about structure. A simple probability tree drawn on a whiteboard forces uncomfortable but necessary questions. What if growth slows instead of accelerates? What if liquidity dries up just as valuations compress? What if correlations spike precisely when diversification is most needed?
Each branch carries a probability. While those probabilities are never assigned perfectly, the exercise itself imposes discipline. It reminds investors that outcomes are not binary and that the most consequential paths often lie far from the center of the distribution.
This probabilistic framing naturally leads to a search for convexity. When outcomes are asymmetric—when downside can be swift and severe while upside accrues gradually—portfolios must be constructed asymmetrically as well. Convexity recognizes that a small, consistent cost can protect against catastrophic loss, and that optionality has value precisely because the future is unknowable. Linear portfolios assume smooth paths. Markets do not oblige.
Options and hedging translate this insight into practice. They shape payoff distributions, explicitly clipping the most damaging downside paths. Protective structures are built when complacency makes them cheap. Periods of suppressed volatility are not signs of safety but invitations to prepare. Far out-of-the-money puts can hedge tails at modest cost, while collars protect concentrated exposures without surrendering all upside. Convexity is architecture, not theory.
Inefficiency and Opportunity
Away from the crowded center of the market, small- and micro-cap equities continue to offer something increasingly rare: inefficiency. These segments are poorly covered, lightly owned, and often misunderstood. They still reward deep, fundamental work. Balance sheets matter. Incentives matter. Capital allocation decisions matter. The basic mechanics of business endure, even if attention shifts elsewhere.
History’s most powerful public compounders (those offering 10-100x + returns) almost always began life as small, obscure enterprises precisely because their potential was not obvious to the crowd. Exploiting this reality requires patience, but also humility about volatility and imperfect information.
Recent Reminders
Markets continue to provide reminders of these dynamics. The “Liberation Day” tariffs triggered an abrupt repricing, with the S&P 500 falling more than 10% in a matter of days as liquidity evaporated and correlations converged. Markets priced for perfection collided with uncertainty, and confidence vanished quickly.
The narratives differ from cycle to cycle—dot-com optimism assumed growth without cash flow; the GFC assumed housing prices could not fall nationally. Confidence is built on extrapolation. Leverage is justified by recent experience. Risk is dismissed because it has not appeared lately.
The Circle of Competence
This is where the concept of a circle of competence becomes essential. Knowing what one understands is important; knowing where one should not tread is even more so. Investors are rarely undone by a lack of intelligence. More often, they are undone by venturing into areas they do not truly understand, armed with borrowed conviction and bad models.
Discipline allocates capital where risks can be framed, probabilities assessed, and downside controlled. Where this is not possible, restraint becomes a competitive advantage.
Cycles repeat because human behavior does not change. Greed, fear, extrapolation, and denial recur in different forms but with familiar consequences. Experience does not eliminate uncertainty, but it sharpens judgment about where uncertainty tends to matter most.
A Coherent System for a Nonlinear World
Taken together, these elements form a coherent system designed for nonlinearity. Passive flows create neglect. Concentration creates fragility. Small- and micro-cap inefficiencies create opportunity. Probability trees impose discipline. Tail awareness shapes risk management. Experience tempers confidence. We aim to integrate it all.
Options and hedging translate these lessons into explicit risk definition. Deep value anchors the framework in economic reality, offering long-term return potential of buying actual businesses while “clipping the tail” limits the cost of being early—or temporarily wrong.
The future will not be smoother than the past. If anything, it will be more episodic, more crowded, and more prone to abrupt regime shifts as liquidity thins and positioning concentrates. Investors who rely on linear assumptions will continue to be surprised. The correct approach does not attempt to forecast the next shock. It assumes shocks are inevitable and prepares portfolios to endure them.
Brian William Foote, CFA
Founder & Portfolio Manager
Broadway Capital Management, LLC
As Portfolio Manager at Broadway Capital Management, Brian enables high net worth professionals to maximize their legacy through strategic wealth preservation, concentration, and hedging, as well as future-resilient value investments. Embracing Volatility and Seeking Asymmetric Returns.
