The absolute return fallacy and the black swan revisited

The definition of absolute return, a term originally coined by the managers of the Yale endowment fund, refers to an investment instrument that is expected to provide positive returns irrespective of market conditions. In other words, it should be uncorrelated to market swings. Ever since the collapse of LTCM, however, the whole premise on which this concept lies has been put into doubt. The systemic backlash from what started off as a relatively benign and contained issue within the subprime space proves that there is a major failure in the modelling of risk for certain types of products. How else can one explain the bewilderment of managers? The ever so common excuse of late is that they were caught by surprise, that it was the first time that such a thing had occured and therefore they were unprepared for the consequences of such an event. It begs the question as to why they were unprepared or, more precisely, why they did not include such a scenario into their models in the first place? It is worrying enough to note that according to a recent Wall Street Journal article, the average return of hedge funds for the month of August was more than minus 1 percent (more than minus 2 percent for fund of funds). What is more telling, however, is that the average reflects only 40% of the total because the rest of them have not yet published their results and the delay could indicate far worse results ahead. Blaming systemic risk or an unprecedented chain of events is frankly not a justifiable excuse, particularly for an industry that is reputed for its exorbitant fees.