Taleb: Definitely not a normally-distributed kind of guy
Day two was kicked off by a thought-provoking presentation by Nassim Nicholas Taleb, author of several best-selling books about risk, including: Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets, and recently: The Black Swan: The Impact of the Highly Improbable.
Taleb’s basic premise is that the familiar bell-shaped “normal” distribution has little relevance to the financial world. In fact, Taleb doesn’t even think it’s that useful for many non-financial applications.
He shows, for example, that approximately half of the cumulative return of the S&P 500 over the past 55 years was the result of only 10 trading days (of both up and down varieties).
(Source: Fortune Magazine)
Likewise, if you were an options trader, it is conceivable that most of your lifetime income could have been generated in one day during October 1987.
An author, Taleb also uses a book publishing example to illustrate his point. He says that 16,000 books are published in English each year. Yet approximately 50% of worldwide book revenues is driven by only 5 books (probably, like, one book last year we guess).
He also draws on income distribution statistics to show how so many distributions are far from “normal”. Quants out there will know that one famous mathematician, Benoit Mandelbrot was also inspired by the non-normality of income distribution as he developed his ideas on fractal geometry. So it may come as no surprise that Taleb and Mandelbrot have conspired to pen several articles including this one in Fortune Magazine and this one in the FT.
Taleb uses the term “Gaussian distribution” rather than the more common “normal distribution” for technical accuracy. But it also sends a secondary message to his audience that a “normal” distribution may not actually be that “normal” after all.
Hedge Fund Fee Replication
Toby Chapple thinks he’s really on to something. And he just may be according to many participants here. Chapple is the evangelical Aussie who is head of Deutsche Bank’s hedge fund replication offering.
Chapple says that most attempts to replicate hedge fund performance fall victim to a number of failures, namely a lack of daily liquidity and the delivery of after-fee hedge fund returns. As Chapple points out, this is inconsistent with the argument often made by replicators that hedge funds charge fees are too high. Regular readers may recall that this concern was raised after the last Alternative Beta conference (see posting).
Unlike many in his field, Chapple is a former proprietary trader. And unlike many funds in its class, the Deutsche Bank Absolute Return Benchmark (db-ARB), uses a mechanical trading strategy – executing representative trades in each of 7 markets commonly exploited by hedge fund managers. The result, says Chapple, is that his fund is able to replicate hedge fund returns before fees.
Does it work? Chapple says the results speak for themselves (blue line: db-ARB, other lines: various hedge fund indexes and hedge fund replicas)…
Chapple says he is most excited about the new possibilities now that a hedge fund replication offering can be traded not just daily, but intra-day (e.g. ETFs, CPPI structured products, leveraged products…)
Hedge Fund Persistence
The favorite phrase of anyone in the asset management industry is undoubtedly “Past performance is not indicative of future results”. While this makes intuitive (and legal) sense, Martin Eling of the University of St. Gallen here in Switzerland wonders if its really always true. Are hedge funds “persistent”?
His review of 25 previous studies and an empirical study of over 3,000 hedge funds and funds of funds showed that “persistence” is pretty significant in the short term, but falls off in the long term. He found that nearly half of hedge funds showed some statistically significant levels of persistence at a one month and two month horizon. However, returns achieved 24 months later bore much less relation to today’s results – with less than a quarter showing any persistence at a 24 month horizon.
As this table from Eling’s study shows, some hedge fund strategies also show more persistence than others. Specifically, convert arb and emerging markets managers seem to be a little more persistent than short bias managers (who show less ability to consistently make money).
Apparently Mikael Simonsen of Finland’s Ice Capital has borrowed a page from Richard Branson’s new book. To describe new forms of beta that are not yet commoditized, but that can’t accurately be called alpha, he coins the term “Virgin Beta”. This type of beta is still in its “early phase regarding tradability, liquidity, regulation, transaction costs and the number of potential counterparties.”
He told the audience that as tradability, liquidity, and regulation increase, “virgin beta gives birth to alternative beta”.
Biblical allusions aside, the notion that virgin beta, like the “virgin territory” of 19th century North America, seems quite appropriate. The original outputs of that virgin territory (timber, agriculture, minerals) were scarce and valuable. But over time, these outputs became commoditized. Over time, said Simonsen, virgin beta returns will likewise become cheap commodities.