Nassim Taleb's Black Swan Appeared

Nassim Taleb, author of the recent hedge-fund-related book, "The Black Swan," directly influenced the optionization of the equity strategy which my business partner and I have been operating for over a year. In this second Taleb-related post, based upon a Wall Street Journal piece, I noted the likely inconsistency of returns to Taleb's strategy,


"In it, Taleb's approach is described in more detail than prior articles I have read. It reinforced my feeling that his is a very inconsistent strategy. That is, he is constantly buying puts, losing a little money routinely, in hopes of profiting from the really big market meltdowns. This is what I more or less sensed from my prior reading about Taleb's hedge funds.

In the Journal piece on Friday, however, Taleb's performance is discussed. His last fund earned a 60% return in 2000, then lost money in 2001 and 2002, with only low single-digit gains for the next two years. He closed the fund on the heels of such mediocre performance, during years when conventional hedge funds rack up much higher gains.

Thus, Taleb's approach, and, probably, that of the new fund using his ideas, tends to be erratic, and depend upon high volatility to earn large returns."

Of course, the events of September and October, with their double-digit negative monthly returns, provided the once-in-several-decades windfall that is the payoff of Taleb's deep out-of-the-money put strategy.

The question now, of course, is how the Taleb-inspired fund will do in the coming months. Yesterday's Journal piece noted,

"He also helped start a hedge fund, Universa Investments L.P., which bases many of its strategies on themes in the book, including how to reap big rewards in a sharp market downturn. Like October's.

Assets under management at Universa have neared $2 billion since the fund launched early last year with $300 million under management. While Mr. Taleb frequently consults with Universa's traders, the Santa Monica, Calif., fund is owned and managed by Mark Spitznagel, who worked for several years in the 1990s as a pit trader on the Chicago Board of Trade.

The strategy, which keeps more than 90% of assets in cash or cash equivalents such as Treasury bonds, either breaks even or loses small amounts in most months while waiting for periodic, infrequent spikes in volatility.

While the black-swan strategy has paid off handsomely this year, it hasn't always. Mr. Taleb's previous fund, Empirica Capital, which used similar tactics, shut down in 2004 after several years of lackluster returns amid a period of low volatility. The strategy may face another test after the current bout of market turmoil."

The piece goes on to question whether investors will remain with the fund, once the prospect of more deep market downdrafts has lessened.

My partner and I have considered this question, of course. It's a variant the one which was resolved for me years ago by a wealthy private investor during a brief stint doing research with him. A former economics professor who ventured out on his own and made a tidy fortune, he was interested in developing the equity strategy engine for a potential hedge fund group, and wanted to assess my strategy for that purpose.

While not putting it into quite these words, this investor was unequivocal in noting that, in some market conditions, one simply has to be out or short. Long-only strategies get so badly mangled in a downturn like the one of the last two months that they struggle to repair the resulting damage. Especially since most equity strategies which outperform in up markets tend to lose a lot more in serious down markets.

This brings me to Taleb's work, because he has a viable approach for the rare, but spectacularly damaging sudden bear equity market of short duration.

Few investors correctly saw the sudden wind shear-like drop coming, thinking, instead, that the evolving financial markets troubles and looming recession would temporarily dampen equity returns.

Truly, these past two months were the sort of 'black swan' event for which Taleb is so well-known.

The trick to being able to maintain a long-running equity or derivatives strategy is to have functioning approaches for both healthy, upwardly-trending market periods, and the few, dramatically falling periods. Effective transition between these two different types of market conditions is key.

It seems that Taleb's huge gains in short periods of tremendous market declines are not matched by his provision of any type of reasonably competitive long-oriented equity or derivative strategy. But investors will look for either a strategy capable of switching gears to match market conditions, or will simply switch allocations out of such single-market condition funds.