Tavakoli Structured Finance LLC

The Financial Report

By Janet Tavakoli

Taleb Kills $20 Billion Mythical Swan

A recent GQ article quoted Nassim Nicholas Taleb as saying that in the falling market he “made $20 billion for our clients, half a billion for the Black Swan fund.” [1] 

I checked with Nassim Taleb regarding the $20 billion in gains and asked if he were misquoted. He responded via email: “The quote is inaccurate. THe (sic) 20 billion might correspond to the face value of positions.” This response is both vague and different in character from the mythical $20 billion in gains inaccurately quoted in GQ’s article. The total gains could be a tiny fraction of what Taleb loosely describes as “face value.” [2]

Why is GQ’s mistake important? In my opinion, public claims of enormous private hedge fund gains require credible back up, and one would think that GQ would have known that before it inaccurately quoted Taleb as having made a bell ringing gain of $20 billion for clients. Presumably, the error referred to outside clients, not the black swan fund itself, but it could have the side effect of attracting investors to the black swan fund, similar to advertising or salesmanship.

The black swan fund’s strategy is purportedly to buy out-of-the-money put options on stocks and broad market indices and hedge tail risk for clients. The strategy may produce long periods of mediocre—or even negative—returns followed by a large gain and vice versa. No one can tell you for certain exactly when (or for how long) large gains are possible. Initial success in a newly created fund may not be replicated in the future, and there is always the problem of scaling. Scaling refers to the fact that an individual fund may make a high return on an initial investment, say 100% on $100 million, but lose 10% on $1 billion.

The Market Can Stay Irrational Longer Than You Can Stay Solvent (or Patient)

We know that big unanticipated market moves always result in big winners and big losers. After the fact, many winners claim they were smart—not just lucky.

In my opinion, any claim of enormous gains for any strategy—including a black swan fund—should be explained and balanced with caveats. The siren song of enormous gains is always enticing, but the actual swan song may be off key.

A black swan fund strategy may produce future huge gains, but it may also produce mediocre returns (or even slowly burn cash for long periods) before producing another huge gain. The waiting period for the next big payday could be brief, or it could be longer than your investment horizon.

1 “I went for the jugular—we went for the max. I was interested in screwing these people—I’m not interested in money, but I wanted to teach them a lesson, and the only way you can do it is by trying to take it away from them. We didn’t short the banks—there’s not much to be gained there, these were all these complex instruments, options and so forth. We’d been building our positions for a while…when they went to the wall we made $20 bln for our clients, half a billion for the Black Swan fund.” (First page, second column, 7th full paragraph of “The Thinker,” GQ UK edition, May 2009)

2 Taleb’s web site home page showed this article as one of two “most representative overall profiles.” After my query, Taleb added a qualifier next to the link to the article: “(with typo on the ‘billions’).”

Hat tip to alert readers and Chicago’s option market makers. Thanks also to Nassim Taleb for confirming the inaccuracy of the quote. Will Self, the author of the GQ article, did not respond to an email sent to his agency.

Jim Rogers Questions Taleb’s $20 Billion “Face Value” (and So Do I)

Update July 31, 2009

I doubt anyone reading this needs the following recap, but just in case here it is. Jim’s words carry a lot of weight in this business. People listen up when Rogers says he is short a stock or that a company will go bankrupt. Jim Rogers has a brilliant and credible track record, backs his opinions with facts, tells you how it worked out in the end, and has his own money riding on the outcome. His books on his travels are filled with observations about economies, societies, governments, and life. They should be required reading in every business school.

Rogers: Taleb’s Gains Were Peanuts, Strategy Questions

Jim Rogers commented on my article and noted that I wrote: “’$20 billion’ referred to a ‘notional’ amount of derivatives that produced between $250 to $500 million in gains, it raises further strategy questions.” Rogers commented:

“Strategy questions? It raises more questions than that. A ‘$250 to $500 million’ gain on $20 billion is peanuts — 1 or 2%??”

Jim Rogers is absolutely right; I didn’t go far enough, and he raises a legitimate point.The fund in question is Universa’s “black swan” fund. The purported strategy was to buy out-of-the-money put options on stocks and broad market indices and hedge tail risk for clients (note that this is not a hyper-inflation fund or one of the other funds that may be managed by Universa). What are the details of the derivatives that required $20 billion in notional to produce so few gains?

Taleb Now Claims the $20 Billion Referred to “Face Value”?

It is unlikely Universa could justify using the over-the-counter market, which would have involved trading with the banks and former investment banks, because the strategy would also have created large counterparty credit risk, which would have to be hedged. That would seem inconsistent with a “black swan” fund.

If the strategy included shorting certain stocks, it can sometimes produce large losses, so that is inconsistent with the idea of the potential of only losing small amounts of money while awaiting a big payday, as a “black swan” fund is supposed to do. There can be unanticipated events resulting in a market upturn, and a short sale would create enormous losses, not get rid of tail risk for losses.

Perhaps credit derivatives were involved, but one would have to hedge the counterparty risk, and again, why the large notional amount with so few gains? Moreover, there would be huge counterparty risk, and I heard of no trades of this notional size that would track with Taleb’s story.

Deep out-of-the-money puts can be bought cheaply on large notional amounts. Taleb’s fund reportedly had only $300 million under management in January 2007. If Taleb did trades with “face value” (his word) size of $20 billion, given the market moves we had during the time period in question, one would think Universa would have captured more than 1% or 2% of the notional value in gains.

Now Taleb claims that the $20 billion might refer to “face value” of the trades. Yet as Rogers says, that raises strategy and execution questions at the very least. There may be a reasonable explanation, but it seems I am not alone in wondering what that explanation could be.

See also:

Taleb’s Stranded Swan?

Where Were the Drama Pundits [Whitney, Taleb, and Gasparino] When it Mattered?”

Dead Man’s Curve

Read finance articles by Janet Tavakoli


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