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Guest Post: The Center Can Hold - More On Playing With Tails
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Guest Post: The Center Can Hold - More On Playing With Tails

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Guest Post: The Center Can Hold - More On Playing With Tails

By JM

The Center Can Hold: More on Playing with Tails

Every time series of prices reflects the ongoing valuation of worldviews in a collective sense. These prices can be used to generate a probability distribution that reflects that worldview. Is it best to buy the tails that reflect extreme events, or to be long the center, where the majority of views dominate?

Buying the tails is a barbell. Buying the center is well, a center bet. Which is best?

Here is an approximate answer from contemporary history. Center bets beat barbells pretty consistently. BB (XOver proxy) all beat other comers, followed by BBB (HiVol proxy), CCC (proxy for distressed debt), then AAA from 2010-2011.

What you get with AAA is low volatility offered by stable liquidity features and cashflow performance. What you get with CCC gives you huge volatility to be exploited by trading. The center, true to the intuition behind it, offers better credit risk profile than distressed debt plus lower liquidity than AAA debt.

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In fact, seldom does a barbell constructed this way outperform the center bet. Barbells lose too much from CCC defaults even during good times. In bad times, the AAA position doesn’t come close to covering the losses. Center bets outperform pretty much all the time. Check out the barbell and center I constructed below with AAA and B rated bonds instead of CCC, just to keep it close.

Barbell and Center Bet Total Returns, 1996-2011

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Guess what? The more extreme times are, the worse the barbell does. The barbell started massive underperformance in late 2008 and has performed even worse since then. Why because the extreme cancel each other out to an extent that makes them undesirable. Center bets cancel each other out less.



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