Investment Strategy Returns: Volatility, Asymmetry, Fat Tails and the Nature of Alpha

Arthur M Berd


Introduction to 'Lessons from the Financial Crisis'


The Credit Crunch of 2007: What Went Wrong? Why? What Lessons Can be Learned?


Underwriting versus Economy: A New Approach to Decomposing Mortgage Losses


The Shadow Banking System and Hyman Minsky’s Economic Journey


The Collapse of the Icelandic Banking System


The Quant Crunch Experience and the Future of Quantitative Investing


No Margin for Error: The Impact of the Credit Crisis on Derivatives Markets


The Re-Emergence of Distressed Exchanges in Corporate Restructurings


Modelling Systemic and Sovereign Risks


Measuring and Managing Risk in Innovative Financial Instruments


Forecasting Extreme Risk of Equity Portfolios with Fundamental Factors


Limits of Implied Credit Correlation Metrics Before and During the Crisis


Another view on the pricing of MBSs, CMOs and CDOs of ABS


Pricing of Credit Derivatives with and without Counterparty and Collateral Adjustments


A Practical Guide to Monte Carlo CVA


The Endogenous Dynamics of Markets: Price Impact, Feedback Loops and Instabilities


Market Panics: Correlation Dynamics, Dispersion and Tails


Financial Complexity and Systemic Stability in Trading Markets


The Martingale Theory of Bubbles: Implications for the Valuation of Derivatives and Detecting Bubbles


Managing through a Crisis: Practical Insights and Lessons Learned for Quantitatively Managed Equity Portfolios


Active Risk Management: A Credit Investor’s Perspective


Investment Strategy Returns: Volatility, Asymmetry, Fat Tails and the Nature of Alpha

The key question in investment management is to understand the sources of investment returns. Without such understanding, it is virtually impossible to succeed in managing money. Even risk management, usually a more scientific endeavour compared with the murky craft of predicting directional or relative movements of asset prices, becomes difficult if we have no proper framework within which to think about the future return distributions.

In this chapter, we explore the importance of non-Gaussian features of returns, such as time-varying volatility, asymmetry and fat tails. We demonstrate, using an empirical model of hedge fund strategy returns, that these non-Gaussian features significantly affect the expected returns. Moreover, we demonstrate that the volatility compensation is often a significant component of the expected returns of the investment strategies, suggesting that many of these strategies should be thought of as being “short vol”. The notable exceptions are the CTA strategies11 CTA funds are commonly known as “commodity trading advisors”, though the modern CTA investors often trade in futures of all asset classes, not just commodities. and certain fixed income and FX

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