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Managing the Downside of Active and Passive Strategies—Part 1: Convexity and Fragilities

Raphael Douady
The Journal of Portfolio Management November 2019, jpm.2019.1.112; DOI: https://doi.org/10.3905/jpm.2019.1.112
Raphael Douady
is a research professor at the Centre d’Economie de la Sorbonne at University Paris 1, Pantheon Sorbonne; a CNRS fellow; and a member of Labex ReFi in Paris, France
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Abstract

In this article, the author addresses the question of how to manage a large (or small) portfolio in low interest rate conditions while equity markets bear significant drawdown risk. More generally, he explains how to build an antifragile portfolio that can weather the most extreme market scenarios without affecting long-term performance. He also discusses how active strategies systematically create or increase existing market instabilities. By analyzing in depth market behavior during past speculative bubbles and credit crises, the author aims to address these issues. In this first part of a two-part series, the author describes as faithfully as possible the major mechanisms at stake, avoiding the trap of mapping the complexity of financial markets into a single mathematical model, which would necessarily be wrong at some point. Starting from Minsky’s financial instability hypothesis, he tries to disentangle the complex relation between dynamics and randomness, including the presence of fat tails.

TOPICS: Mutual fund performance, passive strategies, portfolio theory

Key Findings

  • • Financial crises are, in their vast majority, the result of internal instabilities. Exogenous causes are minor and at best serve as triggers. They can mainly be divided into two kinds: speculative bubbles and credit bubbles.

  • • Artificially antifragile (convex) strategies, such as trend following, portfolio insurance, momentum, and so on, are good for the marginal investor but create instabilities when used by the bulk of the buy-side industry.

  • • It is illusory to predict the date of a bubble burst and to catch either the top of the bubble or the market trough that follows it. However, even a small insight into the probability of a crisis can be highly beneficial for long-term performance and drawdown control.

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The Journal of Portfolio Management: 49 (2)
The Journal of Portfolio Management
Vol. 49, Issue 2
Quantitative Special Issue 2023
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Managing the Downside of Active and Passive Strategies—Part 1: Convexity and Fragilities
Raphael Douady
The Journal of Portfolio Management Sep 2019, jpm.2019.1.112; DOI: 10.3905/jpm.2019.1.112

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Managing the Downside of Active and Passive Strategies—Part 1: Convexity and Fragilities
Raphael Douady
The Journal of Portfolio Management Sep 2019, jpm.2019.1.112; DOI: 10.3905/jpm.2019.1.112
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  • Article
    • Abstract
    • THE CURRENT PARADIGM: BLACK–LITTERMAN AND MARKOWITZ
    • CONVEXITY: THE PANACEA?
    • NAÏVE DELUSION OF FAT TAILS
    • SKIN IN THE GAME
    • ACTIVE VS. PASSIVE
    • CONVEXITY FOR THE MARGINAL INVESTOR
    • CONVEXITY FOR THE MAJOR INVESTOR
    • DETECTING RISING SPECULATIVE BUBBLES
    • CREDIT BUBBLES
    • MARKET INSTABILITIES: PREDICTABLE DYNAMICS VS. PURE RANDOMNESS
    • CONCLUSION
    • ACKNOWLEDGMENTS
    • ADDITIONAL READING
    • ENDNOTES
    • REFERENCES
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