How would you like your returns skewed?

There have been several times in the past where I’m explaining ‘XYZ strategy’ to someone (hopefully they asked me beforehand), and the concept of skewness comes up.  A couple examples:

  • Several (successful) strategies lose far more frequently than they win.  It’s not always like playing the lottery…
  • Sometimes ‘the sure thing’ trade, which has made money every day, suddenly blows up.

Thus loops in the concept of skewness – how big are losses relative to gains?  On the lottery side, you’re almost certainly going to lose  USD 1 on a game with a (highly improbable) gain of USD tens of millions.  But other examples abound in financial markets:

  • Long-only (just about) anything: this is a negatively skewed strategy.  Most months/years you will have a gain, but some months will be TERRIBLE.  Don’t think about the little correction we just had…think about 2008.  It can take years to recoup the losses from long-only: for example, notice that the NASDAQ is still about 10% below its 2000 peak.
  • Venture capital: this is a positively skewed strategy, in its most basic form.  The VC fund manager selects (say) 10 companies at an early stage of development.  Financials don’t really mean much at this stage – they could do anything.  The hope is that, out of 10, there will be 1 big winner and maybe a few small winners.  The others are expected to be written off.  So, one gain outweighs the many.
  • Volatility selling: this is a classic negatively skewed strategy.  VERY negatively skewed, epitomising ‘picking up pennies in front of a steam roller’.  After premium selling funds lost about 50-70% in 2008 (or went completely bust), several actually hit high water marks in the past couple years.  So it’s a sustainable, if nerve-wracking, strategy.  By the way, insurance products and market making are roughly the same as option premium writing, in terms of performance characteristics.
  • Momentum trading: a classic positively skewed strategy.  Frequently momentum is classed as ‘long volatility’, which it is…kinda.  More long gamma…but anyway.  This is a ‘pain trade’, in that most of the time you’re losing money as markets oscillate back and forth and you’re trading with the trend.  Only occasionally do the big trends come; you can’t really forecast them, and you MUST be in the market when they come.  Otherwise this is a losing strategy.

I leave you with the following track records, harvested from Altegris’s managed futures website.  Interesting place to learn about volatility and momentum offerings.

Classic volatility selling strategy characteristics: nice, steady gains punctuated by large losses.  Source:

Classic volatility selling strategy characteristics: nice, steady gains punctuated by large losses. Source:

Screen Shot 2014-10-23 at 15.47.29

Classic example of a higher-geared momentum fund. Notice how the fund spends most of its time below high water mark; this is broken up with infrequent, large gains. Source:

Extra credit: those seeking more technical info on return skewness, and particularly how the time-variance of skewness is a function of strategy design, should look at this wonkish paper.


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