Since the credit crisis in 2008, risk has come into sharper focus across the financial sector. Within asset management, questions have been raised about the efficacy of conventional measures of risk (e.g. Value at Risk and a variety of stress testing models) as tools for helping to prepare a portfolio for unforeseen (a.k.a. Black Swan) events that can lead to the significant destruction of capital.
The analysis of influential market practitioners such as Nassim Nicholas Taleb and Emanuel Derman has highlighted the inherent blindness of risk management processes to unforeseen events and also the complacency that these measures can engender in fund managers and the investment public alike.
If I was to identify one overarching conclusion of their analysis it would be this: mathematical models help to place a value on hunches and expectations about risk and allow us to compare the value of like assets, but there is no immutable law for the vagaries of human behaviour that play a big role in how an asset will be valued tomorrow. It is an inconvenient truth in finance that the risk associated with any investment decision will only be fully understood in hindsight.
Turning fragility on its head
In my role as the fund manager of an absolute return fund, it is my job to take calculated risk in my attempts to grow clients’ money. In practice, this involves trying to find rigorous tools (empirically tested formulas and investment strategies) that help to achieve a positive return for the investor while trying to keep the risks associated with those vagaries to a minimum (although this is not guaranteed). Analysis of risk is also central to my academic research in the area of speculative short selling.
A concept that caught my eye as part of my recent reading on the subject is Nassim Nicholas Taleb’s notion of anti-fragility. This comes from his 2012 book Antifragile: Things That Gain from Disorder. To be anti-fragile is to respond positively to shocks, stressors, randomness or volatility. Taleb lays out a spectrum, starting with fragility at one end, through robustness at the mid-point and on to anti-fragility at the other extreme.
Taleb suggests that anti-fragility can relate to living creatures, to social or political systems, but also to financial markets and I believe it has a lot to offer when thinking about absolute return funds. These types of funds aim to perform positively over a specific time horizon, regardless of market conditions (during both rising and falling markets; during calm or turbulent conditions).
A fund would clearly be fragile if it contained nothing but exposure to risky assets (say, to equities). It would be extremely fragile if it then levered this same exposure (i.e. money is borrowed to increase this exposure). It would be robust (generally speaking) if it held long and short positions but was market neutral, duration neutral, or style- and risk-factor neutral. The fund might rise or fall as shocks hit it, but a priori, we’d guess at the fund holding steady (being robust) to shocks.
What about an all-cash portfolio? At first glance, this seems perfectly robust, but no more. However, as Taleb mentions, excess cash can provide valuable optionality – the ability to take advantage of turmoil. Of course, the manager must have the nerve to take advantage of this option and it might be hard to prove that they have the ability to execute such a strategy, but nevertheless, a portfolio of cash is actually somewhat anti-fragile – it likes turmoil.
A fund that is rich in assets that rise in price as volatility increases is clearly anti-fragile. This could include gold: something that people want to hold when they fear turbulence or calamity. It could include the sovereign bonds of countries that issue their own currency and fund this debt in their own currency. And of course, long positions in options thrive on increased volatility, everything-else equal. A portfolio that is long gamma or long vega is distinctly anti-fragile. These are common options strategies whereby the buyer hopes to profit from an increase in market volatility.*
Anti-fragility doesn’t usually come free, but it sometimes comes cheaply. Cash returns in most major currencies are today negative in real terms, so holding cash comes at a cost. Gold yields nothing (and so costs something relative to other yielding assets). Options cost money to acquire. But the cost of these aids to anti-fragility is generally not prohibitively high at present. As the work of Taleb suggests, we are arguably a little complacent about future events. The drop in the cost of derivatives, such as options, while an expression of market confidence, can also be seen as a barometer of this complacency.
From my perspective, the nub of Taleb’s quite compelling idea is whether it is possible to measure the anti-fragility of a portfolio in a formal, repeatable manner. I’m not sure of this. Consider how cash is anti-fragile, but how this depends on the attitude and behaviour of the fund manager. Think about gold – how exactly would you measure its contribution to anti-fragility?
Intuitively, we can spot an anti-fragile fund or portfolio manager when we see one (in all of its detail). I’m not sure we could easily rate the anti-fragility of a fund on a 0 to 10 scale (where 0 is extremely fragile; 5 is robust and 10 is extremely ant-fragile).
But this does not necessarily make the idea redundant. Against the vagaries of the unknowable future, anti-fragility certainly seems worth considering, if only to provide alternative ways of analysing risk and optionality in a fund, in conjunction with more conventional methods.
*Options are derivatives that can be used for investment or hedging purposes. They can provide low-cost exposure to rising or falling markets and are partly priced on a statistical assumption about how volatile the underlying security/market is expected to be. They has some similarities to insurance contracts that are priced on the statistical likelihood of a particular event occurring.
The views expressed are those of the James Clunie at the time of writing and may change in the future. Any data or views given should not be construed as investment advice. Every effort is made to ensure the accuracy of the information but no assurance or warranties are given.
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