Taleb-Asness Black Swan Spat Is a Teaching Moment

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(Bloomberg Opinion) -- The recent Twitter spat between “Black Swan” author Nassim Nicholas Taleb and quant investing pioneer Cliff Asness over hedging against highly remote events reminded me why Luke Skywalker needed two droids: R2-D2 to ignore chaos and calmly proceed with the long-term plan, and C-3PO to point out all the exotic dangers that make everything hopeless.

The comparison, though, is not fair to Taleb. In the comic-book universe of Star Wars, we know the good guys prevail. But in real life, the small number of Taleb’s warnings that prove accurate can have more influence on long-term outcomes than the far more numerous times when things go as expected. Yes, C-3PO is annoying, but he has to be; no one wants to hear all the ways things might go wrong. (I’ve known Taleb for 35 years and I worked for Asness for 10 years and consider them both friends.)

If you read their publications instead of their tweets, you might be surprised to see that their views on so-called tail-risk hedging have a lot of overlap. Where the two agree, all investors should pay attention. But there is fundamental disagreement as well.

When Asness’s AQR Capital Management LLC discusses tail events, it refers to the worst events in history for investors, such as the 5% worst one-month returns for the S&P 500 Index. An important AQR paper showed that steep declines that last three months or less do little or no damage to 10-year returns. It’s the longer-term periods of mediocre returns, particularly three years or longer, that can kill performance for a decade.

Taleb defines “tail events” not by frequency of occurrence in the past, but by unexpectedness. He is scathing about strategies designed to do well in past disasters, or based on models about likely future scenarios. Taleb’s tail events go far beyond changes in the S&P 500 to include all the unexpected and novel things that happen at the same time.

This is a difference of emphasis only. AQR papers discuss the challenges of surviving tail events that go beyond market losses. But it’s fair to say AQR’s main concern is designing portfolios with the highest probabilities of delivering acceptable long-term returns, rather than the ones that will be most pleasant to hold during the bad times.

Taleb prefers tail-risk hedges that deliver lots of cash in the worst times. In his view, surviving a crisis takes more than waving a research report showing the 10-year plan is still on track. Investors are likely facing a host of challenges, both financial and nonfinancial, and cash is better than talk for addressing them.

Moreover, the strategies AQR recommends usually involve leverage and unlimited-loss derivatives, which to Taleb just add new risks. Just as Taleb often rejects taking pills that are backed by medical studies, he is often opposed to hedges backed by financial studies. In both cases because he believes the downsides are much greater than the upsides.

AQR responds with studies showing that Taleb’s preferred strategies are so expensive that they don’t reduce risk. If you buy put options on stocks, for example, you get a big payoff in sharp market crashes. Unfortunately that always leads to prices on put options going up so much, that you quickly give back your gain. It’s like an insurance company that raises your premium after a claim, so you end up paying for the claim yourself in a few years.

What’s worse, most people adopt these strategies after a crash, so they pay the high premiums but get tired of paying for them during the good times of the recovery, so they miss the payout on the next crash. Both AQR and Taleb discuss psychological pressures, but Taleb emphasizes the bad decisions people make during panics, while AQR spends more time discussing the bad decisions people make afterwards.

Taleb fires back that he has developed methods to deliver cash in crises that are cheap enough that they actually add to long-term returns while reducing risk. A key is asymmetry, in that it takes a 100% gain to make up for a 50% loss. If you can reduce both by 25%, so you have a 25% loss followed by a 75% gain, you end up with better than a 30% net return. Your hedge does not have to actually make money; in this case it broke even with a 25% gain during the crash and a 25% loss during the recovery, but it still turned a break-even result to a 30% gain.

There is one final difference. AQR has a long track record of actual results and publishes papers in peer-reviewed journals, with data easily downloadable for anyone who wants to check. Taleb’s arguments are harder to evaluate empirically. He advises a tail-risk fund, Universa Investments LP, for which we only have selective leaked information. While some of that information seems to support Taleb’s claims, it is not entirely consistent. Until Universa widely provides actual results, I’ll regard the ability to provide large cash profits during the worst times while adding to long-term portfolio returns as unproven. If it’s indeed possible, everyone should do it.

Investors need both R2-D2 to focus on the horizon, and C-3PO to point out all the things — however unlikely — that might go so wrong as to sink the ship before the horizon is reached. Both AQR and Taleb have written extensively on tail-risk hedging, and investors would do well to read them both. But it never hurts to have a public fight expose the disagreements in dramatic fashion.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Aaron Brown is a former managing director and head of financial market research at AQR Capital Management. He is the author of "The Poker Face of Wall Street." He may have a stake in the areas he writes about.

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