Investments, tenth edition

  Tail Events and Hedge Fund Performance 

 Imagine a hedge fund whose entire investment strategy is to hold an S&P 500 index fund 

and write deep out-of-the-money put options on the index. Clearly the fund manager brings 

no skill to his job. But if you knew only his investment results over limited periods, and 

not his underlying strategy, you might be fooled into thinking that he is extremely talented. 

For if the put options are written sufficiently out-of-the-money, they will only rarely end up 

imposing a loss, and such a strategy can appear over long periods—even over many years—to 

be consistently profitable. In most periods, the strategy brings in a modest premium from 

the written puts and therefore outperforms the S&P 500, yielding the impression of con-

sistently superior performance. The huge loss that might be incurred in an extreme market 

decline might not be experienced even over periods as long as years. Every so often, such 

as in the market crash of October 1987, the strategy may lose multiples of its entire gain 

over the last decade. But if you are lucky enough to avoid these rare but extreme  tail events  

(so named because they fall in the far-left tail of the probability distribution), the strategy 

might appear to be gilded. 

 The evidence in  Figure 26.6  indicating that hedge funds are at least implicitly option 

writers should make us nervous about taking their measured performance at face value. 

The problem in interpreting strategies with exposure to extreme tail events (such as short 

options positions) is that these events by definition occur very infrequently, so  decades  

of results may be needed to fully appreciate their true risk and reward attributes. In two 

influential books, Nassim Taleb, who is a hedge fund operator himself, argues that many 

hedge funds are analogous to our hypothetical manager, racking up fame and fortune 

through strategies that make money  most  of the time but expose investors to rare but 

extreme losses.  

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 Taleb uses the metaphor of the black swan to discuss the importance of highly improb-

able, but highly impactful, events. Until the discovery of Australia, Europeans believed that 

all swans were white: they had never encountered swans that were not white. In their experi-

ence, the black swan was outside the realm of reasonable possibility, in statistical jargon, an 

extreme outlier relative to their sample of observations. Taleb argues that the world is filled 

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