The failure of tail hedging, and why barbell strategies are misleading

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2024-05-09 20:00:06

Early in an interview with Tim Ferriss, Nassim Taleb discusses the closure of his old Fund, Empirica Capital, and the launch of his new fund, Universa:

Not surprisingly Taleb glosses over why Empirica closed, nor does Mr. Ferriss press him on the matter. If I had to guess, it closed due to poor performance, until catching a break in 2008-2020 with his subsequent fund, Universa, launched in 2007.

To recap, Black swan funds benefit from major, unforeseen spikes in volatility. This is can be visualized as a lopsided barbell. The idea is to allocate a small percentage of a portfolio, typically 1-2%–analogous to a light weight–to out-of-money put options or some other hedging instrument that pays an outsized return when said black swan happens, and the rest is invested in the S&P 500 or other conservative investment such as treasury bonds. The hedge can be thought of as insurance and is a recurring cost to protect the much larger part of the portfolio (the heavier side of the barbell).

During Empirica’s short existence, this hedging strategy failed to be profitable. Even 911, despite meeting Taleb’s criteria of being a black swan event, was not enough, nor was the 2000-2002 ‘tech bust’ or the 2001 recession. Combined with negative performance of the S&P 500, Empirica likely experienced a steady and significant bleed owing to its unprofitable barbell hedging strategy and was eventually shut down. This is what I am sure happened.