Wanted dead or alive: fat-tailed black swan

By Christopher Faille

The press still seems to be discovering “fat tails” and “black swans.”  In July, news outlets gave admiring coverage to the International Monetary Fund’s expression of interest in the ideas of Nassim Taleb, the perhaps-overexposed philosopher who made the phrase “black swan” a cliché upon the success of his 2007 book of that title.

Of course, Pyotor Ilyich Tchaikovsky and Natalie Portman share some credit for the ubiquity of the phrase, but their influence has tended to remove its use to a different context.

The point, though, is that hedge fund investors no longer need instruction in the basics of swans or fat tails, two ways of expressing the now-widely accepted idea that low-probability events are somewhat more common than they would be on the assumptions that were built into some old-fashioned risk metrics such as Value at Risk (VaR).

Assets are flowing into hedge funds that are committed to strategies built around those conceptions: fixed income arbitrage saw an inflow of $18.6 billion in the first half of 2011, according to a review of the state of the hedge fund industry after the first half of 2011.

The review, published last month by the Dow Jones Credit Suisse Hedge Fund Index (CS)  team, said that this was the largest inflow figure by strategy, followed by Global Macro (+$14.4 billion) and Long/Short Equity (+9.0 billion).  Those three strategies attracted those flows precisely because (according to the CS team), investors are discounting the increased likelihood of a ‘tail event’ given tumult in the Arab world, a rolling European debt crisis, and the possibility that the U.S. may lose its AAA credit rating.

The overall industry picture looks rosy.  Hedge funds “could potentially be on track to double 2010’s inflows,” with an inflow of $33.8 billion in just the first half of this year.  Total industry assets under management are at $1.8 trillion, up from $1.7 trillion at the end of 2010, though still well short of the peak AUM figure of $2.1 trillion reached in 2007.


One important industry trend is the continued flight of investors to the larger funds at the expense of their smaller and medium sized counterparts.  Small funds, those with less than $150 million in AUM, experienced a net outflow in the first half of 2011 of $3.9 billion.  The medium funds ($150 to $500 million AUM) didn’t bleed quite so profusely, but they did bleed: an outflow of $2 billion.  Thus, the whole of the industry’s AUM growth came into the larger funds.

There have been two hedge fund sectors that have experienced outflows in the first half: convertible arbitrage and dedicated short bias.


Eight out of the ten sector indexes recognized by the CS group have shown positive performance in the first half. The best performer was equity market neutral (+5.5 percent), followed by multi-strategy (+4.4 percent) and convertible arbitrage (+3.7 percent.)

Equity market neutral benefitted from “sector rotation and stock reversals.”  Equities saw a significant sell-off in the second quarter.  The Dow Jones Industrial Average, for example, hit its first-half peak at the end of April, just above 12,800.  By the end of June, it was nearly 400 points lower.  The report says that managers in the equity market neutral sector used “tactical and relative value models” to limit their exposure.

Likewise, managers in the convertible arb sector succeeded by positioning themselves cautiously, and have tilted their portfolios “toward idiosyncratic and special situation trades that benefitted from company-specific catalysts.”

Managed futures rode a boom in commodities early in the second quarter, and suffered when that move reversed itself in May and June.

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