Bill Gross and Nassim Taleb Sitting In a Tree, T-R-A-D-I-N-G.

David Merkel turned me onto this piece (gated) by Bill Gross wherein he describes the PIMCO strategy in a fairly readable way. It’s fascinating.

Gross opens by describing how some institutions can reap persistent returns by implementing a consistent (“structural”) financial strategy. Banks, for example live by borrowing at short term rates and lending at long term rates. Insurance companies live by borrowing for free and underwriting the risks of repayment timing and amount.

Gross then describes PIMCO’s strategy, which he calls their way of generating “long term alpha” (that really is such a silly term). Basically PIMCO does two things: first, they act as a mini-bank, by borrowing short-term and lending longer-term. The actual implementation he describes of this is a little over my head, given that I have no trading experience, but I get the principle. The second strategy is that they “sell volatility”, which he means they write options of all kinds, flavors and colors.

Gross’ thesis is that the market, from his perspective, overprices volatility. He makes the point that his perspective is extremely important here so it’s worth discussing a bit.

Gross feels that his investors have a time horizon of about 3 to 5 years. Since volatility (fluctuations in asset prices in this case) fades into the background over long time periods, Gross literaly measures volatility to be lower than other investors. If Gross has a longer than average time horizon the market will be more expensive to insure that volatility than him. This is his alpha.

This philosophy is the exact opposite of Nassim Taleb’s view of the world, which I might summarize like this: “You do not understand volatility. Order your portfolio (your life!) so that you are not harmed by volatility, but benefit from it.” He calls this philosophy “Anti-Fragility”. here’s an interview where he discusses it.

There are two ideas in this world view. The first is his well-known Black Swan idea, which is that there are massive, unpredictable events that occur without warning and reap devastation. Exposure to Black Swans can probably never be eliminated, almost by definition, but Bill Gross’ investment philosophy is to explicitly seek exposure to extreme events, arguing that at his time horizon the risk of Black Swans is immaterial. A quick search hasn’t turned up any data on PIMCO’s performance through the crisis. Wonder how they did.

The other half of Taleb’s Anti-Fragility idea is that one should seek out processes that benefit from volatility. He uses human bones as one example: they get stronger as they’re exposed to stress. Obviously a Black Swan for a bone is getting hit by a tank or something, but Taleb would say that if your bones are stronger because of previous stress, you have more of a hope against that tank.

So Bill Gross says sell volatility if your time horizon can take it because it’s systematically overpriced. Nassim Taleb says buy all the volatility protection you can get your hands on because since tail events are impossible to understand volatility is systematically underpriced.

Taleb might say to Gross that his key assumptions (this time about investors’ time horizons) will break down in a Black Swan event and everything will fall apart. Gross might respond by saying it’s easy to be a nay-sayer but big boys take risks and I’ve made tons of money for my investors with this strategy.

Sounds like opposite sides to a trade to me.

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