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

Arthur M Berd

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