The Nikkei 225 index fell 7.3 percent in one day, a stomach-churning drop made all the worse for the lack of an obvious cause. It could be anything from worries about the value of the yen to hints from the Federal Reserve that the U.S. could leave the monetary-easing party before Japan has opened its first beer.
Leave aside the reasons for the fall. A sudden decline of more than 7 percent brings to mind a great discussion of investing from MIT professor (and hedge fund manager) Andrew W. Lo. In a paper written some years ago, Lo asked readers to imagine a hypothetical hedge fund called Capital Decimation Partners.
CDP posts superb returns month after month, handily beating the S&P 500 Index and reaping returns of more than 2,700% over a hypothetical eight-year period. CDP can do that using a single strategy, saving on the overhead of analysts and office space. All that Lo’s fund needs to do is short certain stock options once a month.
The details are a little intricate, but the essence of the strategy is insuring other investors against a 7% drop in the market. That strategy will make money over and over again. Until it doesn’t, at which point (now you see why it’s called Capital Decimation Partners) it will essentially wipe out the fund overnight.
It’s these kinds of unexpected, unexplained turns in the market that tend to reveal hidden risks in surefire strategies. Yesterday, Goldman Sachs released a report noting that so far this year the average hedge fund is badly lagging behind the market. The ostensible justification for many funds is that they are also avoiding the worst market risks. A drop like today’s in Tokyo is sure to reveal some funds for which that just ain’t true.