Managing the Downside of Active and Passive Strategies: Convexity and Fragilities

Key Findings

“Convexity is a zero-sum game” is probably the most provocative sentence of this article, but also that which best summarizes it. Whereas putting in place a trading strategy that produces a “convex” reaction to market shifts is rather sound a practice for the marginal manager, once it reaches a significant portion of the bulk of the market, convexity induces dynamic instabilities that require utmost attention. Market dynamics are essentially driven by trends, bubbles, fears, overreactions and, most of all, herd behavior. At the system level, only a long-lasting Darwinian natural selection process produces robust antifragility. We have seen, in this article, how artificially created convexity (the core ingredient of antifragility) implies dynamic instability as soon as its implementation is mechanical and myopic, in the sense that the feedback loop between market observation and trading action only involves short observation periods. This appears as a severe concern at a time where more and more dynamically traded ETFs (whether active or purely quantitative) are being proposed to institutional investors.

Abstract

Question of the day: how to manage a large (or small) portfolio in low interest rate conditions, while equity markets bear significant draw-down risk? More generally, how to build an “antifragile” portfolio that can weather the most extreme market scenarios without impacting long-term performances? Do active strategies systematically create or increase already existing market instabilities?