Monday, 13 September 2010
CASE 083 - The secrets of the Black swan
Options trader turned author and philosopher Nassim Taleb has delivered returns of 50% - in some cases 110% - for investors he advises this year despite the market meltdown, thanks to his non-conformist view on managing risk.
Lebanese-born Taleb is scathing of traditional risk-managers and says they should be jailed for the pain they have caused. "We would like society to lock up quantitative risk managers before they cause more damage," he says.
Those same risk managers have scoffed at Taleb's theories but may have to think again after his extraordinary returns over the past months.
"I am very sad to be vindicated," Taleb says. "I don't care about the money. We're proud we protected our investors."
Taleb wrote last year at length about the market risks that have come home to roost lately. "The financial ecology is swelling into gigantic, incestuous, bureaucratic banks when one fails, they all fall," Taleb wrote in his book The Black Swan: The Impact of the Highly Improbable, published last year. He warned specifically of the dangers from mortgage finance giants Freddie Mac and Fannie Mae.
"The government-sponsored institution Fannie Mae, when I look at its risks, seems to be sitting on a barrel of dynamite, vulnerable to the slightest hiccup."
His theories are based on a contrarian view about risk. For years he has railed against the error of comparing randomness in the real world with "structured randomness" in game theory and quantum physics.
Such mathematical forecasts give a false sense of security, says Taleb. Instead, human history is a litany of high-impact rare events.
The current financial meltdown is not the first time he has profited from expecting the unexpected. Taleb first put his theories to the test by founding a New York-based Empirica in the late 1990s with a strategy based on options-trading to shield his clients from market crashes and to benefit from big rallies.
His strategy is fascinating because it works around the idea that it is acceptable to break even for most of the time or perhaps make a small loss in anticipation of a huge windfall from an extreme event.
"The Black Swan Protection Protocol is designed [only] to break even 90% to 95% of the time," explains Mark Spitznagel, Taleb's former student and now his trading partner, who runs Universa Investments in Santa Monica with $1 billion in funds. "We happen to be in that other 5% to 10% environment." In other words, Taleb and Spitznagel believe this is a rare opportunity to make a seriously large windfall.
So how exactly does their strategy work? They buy put and call options with a strike price up to 20% higher or lower than the underlying security. They have amassed puts and calls on a portfolio of stocks, S&P 500 index futures and some European shares but has steered clear of commodities, currencies and credit default swaps. "We refused to touch credit default swaps," explained Taleb. "It would be like buying insurance on the Titanic from someone on the Titanic."
While he made his name studying so-called Black Swans, he insists that the current market crash is not one, rather it is a "white swan" and was all too predictable. "I was expecting the crisis, I was worried about it," Taleb says. "I put my neck and money on the line seeking protection from it."