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Hedge Funds: So much for the upside

There's been plenty of market volatility in the last few weeks, as if you did 't know. That's the time the major hedge funds are supposed to justify their keep – especially as the hedge fund industry has dramatically lagged the S&P for years. According to this Bloomberg article, now is the time the funds should really shine and outperform. So what happened in August?

David Einhorn’s Greenlight Capital flagship fund fell 5.3 percent in August, putting it at –14 percent so far for 2015, according to Bloomberg News. Third Point, run by Daniel Loeb, saw a 5.2 percent decline in its main fund in August. Ray Dalio of Bridgewater Associates saw his macro fund decline 6.9 percent last month. These superstars performed more dramatically badly than the HFRX Global Hedge Fund Index, which was down 2.2 percent in August and 1.42 percent for the year. The Standard & Poor’s 500-stock index lost 6.3 percent in August and is down about 4 percent in the year to date.

The intellectual capital of the industry has dwindled away. Too many people reading the same old academic finance journals, too much “me too-ism.” But it's still good at persuading other people to let it manage their money.


2017-05-11T17:32:41+00:00 September 10, 2015|Industry Trends, Investment, Market Behavior|

Another day, another (Apple) disaster for prediction

Barry Ritholz at Bloomberg View is dazzled by the latest Apple earnings, but asks a tough question.

Far beyond what anyone forecast, the figures show Apple arguably had the single-greatest quarterly performance in U.S. corporate history. … The rest of the numbers were, by all accounts, stupendous, enormous, mind-blowing, record-breaking. Yet it seems analysts were, once again, blindsided by the data.

How is it even remotely possible that Wall Street analysts have no idea what the biggest company in the world is doing?

The answer is complex, involving many elements in the quarterly earnings dance.

[…]. But the shorter answer is that Wall Street analysts are not especially good at forecasting.

The deeper reason, he says, is analysts and traders get locked into narratives, and that leads to confirmation bias and cognitive dissonance.

Traders and investors might prefer the way technical analyst Ned Davis reduced it to its most important element: “Would you rather be right or make money?”

People most often prefer to be “right”, all the way up to the point of losing everything. That is our focus. Prediction sound good in principle, but fails in practice. It’s looking at assumptions and scripts and avoidable mistakes that actually moves the needle.


2017-05-11T17:32:42+00:00 January 29, 2015|Assumptions, Confirmation bias, Industry Trends, Market Behavior|

How Armchair Economics leads to Arbitrary Assumptions

Even as recently as ten years ago you could get a sustainable advantage in markets and business by having better information. You could have better contacts and sources and data. But the internet has eroded most of that away. Regulators have closed off many other private information channels. The hedge fund industry has struggled (at least in performance terms) ever since rules for equity analysts were tightened around 2003-4.

Of course, it is not too hard to be better informed than the average person on the street (even Wall St). But being sustainably better informed than your closest competitors is almost impossible, and that is what matters. In any case,  the real problem is now usually dealing with too much information.  You’re swamped with it. You’re drowning in it. You don’t have time to read all the information you get.

So the key to performance is now : what you notice in the midst of all the information.  That’s a matter of skill. It’s hard to replicate.  It depends on “feel” and experience, and what you expect to see,  and the assumptions you make.

The assumptions you don’t even realize you are making matter even more, because that is where the problems that lead to market crashes and company bankruptcies and shattered careers usually come from. It’s also where you are most likely to be able to move the needle on performance to the upside.

How do you look for those critical assumptions? That has to be on the mind of every responsible leader. But some of our ingrained habits of thought make the problem much worse. In its attempt to become a general science of rational choice, economics as a discipline has either ignored assumptions or made them for reasons of theoretical tractability, “as if” they reflect real world evidence. Theories become extended development of basic assumptions. Take this (a little bitter) criticism by Herbert Simon in an interview.

Again we have economic theory created in the arm-chair with no empirical evidence?
A. They don’t talk about evidence at all. You read the pages where Lucas talks about why businessmen can’t figure out what’s happened to prices and it is just what he feels as he sits there smoking his cigarettes in his armchair. I don’t know what Keynes smoked, but when you look at the pages where he talks about labor’s money illusion, no evidence is cited. So the real differences in economics, as compared with psychology, is that almost everybody operates within the theoretical logic of utility-maximization in the neoclassical model. When economists want to explain particular phenomena in the real world, they have to introduce new assumptions.The distinctive change in the behavior of the economic actors comes from a change in the behavioral assumptions. No empirical evidence is given to support those changes. They emerge from the mind of the economic theorist sitting in his armchair.

Simon won the Nobel Prize in Economics in 1978, eight years before giving the interview.  If anything, the problem has got worse since, and it shows up in policymaking and the way economists approach markets. When it comes to real decisions, arbitrary assumptions are very often fatal.

2017-05-11T17:32:43+00:00 September 29, 2014|Assumptions, Decisions, Economics, Industry Trends|

Raise the champagne (but not until you learn the lessons of 2013)

We’re all one year older as we reach the end of 2013, but are we one year wiser?  The end of the year is a time to look back and see if there are any ways to do things better next year.

For the hedge fund industry, there just has to be new approaches to sustain long-term survival.  The industry had a very bad year in 2013, at least measured in terms of investment returns.  The average “smart money” hedge fund made 8.2% and charged 200bp for that positive performance. But if you put your money in the dumbest, cheapest global equity index fund, you made almost 21%, and got charged less than a tenth of the fees for it.

So it is essential to learn from the experience of a rough year for the industry. Clearly, it’s difficult to improve or turn things round without trying to learn from outcomes and mistakes.

The problem  is it is also often extremely difficult to learn from experience, for a range of different reasons. There are multiple serious blind spots in individual and organizational learning.

One bedrock theme for me is insight about macro policy, like the Fed, or market behavior and opportunities for outperformance, are basically about sensitivity to evidence. People’s assimilation and “stretchiness” in response to evidence and events is actually more important than the objective underlying evidence itself. So paying very close attention to how and when and why people learn from experience is essential.

The most obvious issue is people often just prefer to move on to the next thing. They are reluctant to review outcomes or try to learn from them at all.  Raise the champagne anyway. 2013 is already history.  At least next year might be better. (It ought to be a little bit better ,  just because of regression to the mean.)

Markets have remarkably short memories. Policymakers have remarkably selective ones.

The Person and the Situation

But here’s one deeper problem. Who or what do you blame for bad outcomes?  If something goes wrong (like horrendous investment returns or policy errors),  do you blame the person or the situation?  There are some frequent deep distortions here, so much so that social psychologists call it the “fundamental attribution error.” (see the classic analysis by Nisbett and Ross in Human Inference: Strategies and Shortcomings in Social Judgement).

People pay too much attention to the constraints and headwinds in their situation when it comes to explaining their  own success or failure.

So if a fund manager has a bad year, it’s because of the situation. Blame the Fed and Congress and the tough challenges in the markets. You can expect to read variations on that in a lot of fund manager reports to their clients on 2013. This also means you don’t have to think much about potential mistakes or errors you might have made.  If you don’t recognize mistakes, you can’t correct them.

But if you had a good year, it’s all because of your own talent and skill and effort. This also means you don’t have to think much about the drivers of the situation or the prior likelihood of success.

In sharp contrast, people also believe that other people’s success or failure is almost entirely due to their personal qualities or dispositions,  and not their situation. We pay too little attention to situational factors in other people’s decisions.   You will read plenty of variations on that in comments on Bernanke’s tenure at the Fed when he steps down in  few weeks. It will be all about Bernanke’s skills and judgments, with less attention to the situation in which he found himself. Hedge fund clients will be much less sympathetic to claims that poor performance was because of a tough general situation.

It pays to be aware of when and why people are invoking the person or the situation as explanations for outcomes. And it is critical to observe  signs of how they learn and adapt.





How good people end up in jail

Another day, another management life destroyed by foolishness. Following yet another conviction, this time of a former head of structured credit at Credit Suisse, this NYT article muses on why apparently good people end up committing white collar crimes.

Perhaps misconduct by some groups can be ascribed to the belief that so long as everyone else seems to be doing something, it cannot actually be wrong. Continuing investigations into global banks’ manipulation of the London interbank offered rate, or Libor, as well as foreign currency exchange rates are replete with examples of traders exchanging information and boasting of their ability to artificially raise or lower a benchmark rate. These are not isolated instances, but part of a pattern of conduct over months and even years. So it cannot be chalked up to the heat of the moment.

What is so puzzling about people who have led otherwise good lives is that they are unlikely to have engaged in the misconduct if it is presented to them in stark terms. Ask a Wall Street trader, for example, whether he or she would trade on material nonpublic information received from a corporate insider, and the answer from most would be “no” — at least if there was a reasonable chance of being caught.

But under pressure to produce profits for a hedge fund or a bank, traders are often on the lookout for an “edge” on the market that can slowly take them closer to crossing the line into illegality. Add to that the vagueness of the insider trading laws in determining when information is “material,” and it can be easy to cross into illegality without necessarily noticing it.

There are a whole range of ethical blind spots. I talked about it before here. Incidentally, if you haven't seen Orange is the New Black on Netflix yet – upper-middle class New York woman ends up in correctional facility – it's intense but great.


2017-05-11T17:32:50+00:00 November 26, 2013|Decisions, Industry Trends, Mindfulness|

People can’t see problems coming

Why do companies like SAC get themselves into such (alleged) trouble? It’s an important question for anyone who wants to make sure their own organization isn’t crippled by bad behavior. Just think how many incidents of foolish behavior we’ve seen in recent years, from LIBOR manipulation to Madoff’s theft and the exploitation of clients at some investment banks. HSBC narrowly avoided criminal indictment for money laundering, but got hit by a $2 billion fine.

It’s not just finance, either, despite finger-pointing by activists. The biggest-selling British newspaper was vaporized by phone-hacking journalists. Detroit has just gone bankrupt in large part because of a generation-long looting of the city by corrupt “progressive” politicians. And let’s not mention the church.

Sometimes there is clearly pure venality, and every barrel has a few rotten apples.

Just as often, I think, people just can’t see the serious risks they are running. Or, because certain kinds of behavior seem normal because “everyone is doing it”, it is convenient not to ask questions. Groupthink takes over. People lose perspective. They see the immediate gain and deny the existence of longer-term costs. They focus on one goal to the exclusion of all others, and common sense as well. Indictments and billion-dollar fines follow.

As Dan Ariely says in his book Predictably Irrational: The Hidden Forces That Shape Our Decisions:

We can hope to surround ourselves with good, moral people, but we have to be realistic. Even good people are not immune to being partially blinded by their own minds. This blindness allows them to take actions that bypass their own moral standards on the road to financial rewards. In essence, motivation can play tricks on us whether or not we are good, moral people. As the author and journalist Upton Sinclair once noted, “It is difficult to get a man to understand something when his salary depends upon his not understanding it.”

People find it convenient to be in denial right up to the point everything collapses. Decision-makers often have an astonishing capacity not to see things right in front of them. Blind spots destroy organizations.


Information is no longer an advantage

Information has become either commoditized, or potential bait for insider trading charges. That’s the reality the Street is coming to grips with.

This article on CNBC argues the SAC indictment is a sign “human- driven information advantages” are in deep trouble.


In pursuing and winning an indictment of SAC Capital Advisors LP, federal prosecutors are intent on shuttering one of the largest and most successful stock-trading hedge-fund firms in Wall Street history.

If they succeed, it will also mark the effective demise of a whole mode of hedge fund investing, that which hunts for returns based on fleeting, human-driven information advantages – legal or, allegedly, not – from analysts, industry executives and brokerage-house trading contacts

Of course, this is a sign markets are working, in the broader sense. If you have a profitable edge, it attracts competition, which eliminates your advantage.

That applies even more when the distribution costs of information have plunged and technology has changed the environment almost beyond recognition. The Internet has melted barriers to entry.

Strong information niches used to exist. A few (like seeing client order flow) will continue to linger. Selling aggregate personal information is lucrative, at least for now. Material nonpublic information will still be temporarily valuable to those who like the hospitality in federal prisons.

But most durable information niches are gone like the buggy whip, or so commoditized there is no profit or advantage.

Competitive niches are always disappearing, and with them the firms that relied on them. “Information wants to be free,” say the tech people.

The “better information” niche in markets, surprise surprise, is disappearing too. Finance is not exempt from those trends.

Twenty years ago the Fed was barely announcing that it had decided to change fed funds at all. Now it puts out fifteen page PDFs of the minutes of its discussions and announces its policy through 2015 and beyond. Twenty years ago, if you wanted expert analysis of this morning’s economic data, you needed to have a rich relationship with an investment bank. Now you can read instant reaction and expert analysis on a dozen free blogs.

Does that mean, as the article implies, the only source of investment advantage in the future will be search bots roaming Twitter feeds?

No. That niche is almost impossible to sustain, too. Algorithms are extremely useful for certain kinds of problems. The problem is they are much more easily replicated than human judgment.

This is the major problem with the ‘big data” idea; the assumption that you will be able to sustain a durable advantage over the thousand other firms with Russian physics PHDs with copies of Mathematica and R doing Markov Chain Monte Carlo. If a hundred thousand bots programed by a thousand quants are scanning data, maybe a few will have a technical advantage for weeks or months. But most are going to have no advantage over other similar algorithms. The niche will rapidly get competed away. Efficiency will eliminate returns. 990 of the thousand quants will be in trouble, especially when they have to explain to their investors the nature of their distinctive advantage.

High tech products typically get commoditized at an especially frightening pace – ask semiconductor or hard disk or plasma tv manufacturers. Today’s smartphone is tomorrow’s doorstop.

So what can you do? Information is generally only useful as an input into decisions. Decisions are where the value lies, because information is usually inherently ambiguous and contradictory. There is a wide “moat” around genuine skill at judgment, because it is so rare.

People find it very difficult to make good decisions, as any look at the research on decision traps or expert prediction will tell you. But that only means there’s a lot of upside opportunity for improvements.

Interestingly, algorithms – the simpler the better – are much better at combining information together than human experts, as we’ve known for fifty years since Paul Meehl discovered simple linear models outperformed physicians at medical judgment. (Yes, computers were outperforming experts as far back as 1954. it’s not new.) But some people have an edge on recognition and cues and identifying assumptions and defining the problem. I’ll come back to this another time.

So that’s the future. Information wants to be commoditized. But small, marginal improvements in the quality of decisions are less replicable and more sustainable than algorithmic niches. If you’re a human trader, this is what will keep you in business. (And it’s our business).




2017-05-11T17:32:52+00:00 July 30, 2013|Big Data, Decisions, Industry Trends, Market Behavior|

The Pain of Being a Bear

CNBC decided to name a “Dirty dozen” of the very worst actively managed mutual funds in the US, which offered horrible performance for high fees. One name stood out for me: the Federated Prudent Bear Fund (BEARX). It has returned -10.48% annualized in the last five years, and charged investors 2.5% for the privilege. It’s associated with the Prudent Bear website, which is actually well-argued and has considerable influence in financial markets. It’s like a pure distillation of a bearish approach to markets. This isn’t intended to knock the bear fund, though. The website and blog was required reading for several years during the crisis. It has a consistent and serious set of ideas. Instead, it shows how dangerous it can be to get locked into one persepective in markets. It is painful being a bear, even in the worst five years the economy has seen in four or five generations. How could you not make stacks of money as a bear when we’ve seen such economic catastrophe in recent years? There was a brief bear heaven in 2008-9, and it has been downhill ever since. This is BEARX against the S&P over the last five years.

Of course, stocks have rallied massively from the troughs and are setting new record highs. The trick is to know when to stop being a bear, as well. Bears are close relatives of hedgehogs, who know “one big thing” and who find it hard to switch perspectives. For sure, if we get a massive market meltdown soon, there will be a brief moment of ursine elation and vindication again and these performance figures will look very different. But there’s two things to conclude. First, the odds are stacked against you long-term as a bear. The base rate is the economy and equities grow over time. It’s usually two steps forward, one step back. Bears have to be nimble and dance, not sit in a corner and growl that Armageddon is always just around the corner. Second, it shows why markets just don’t price future crises effectively. Let’s say the bears really are right that we’re about to drop off a cliff again. Indeed, the smart money is getting increasingly fretful about asset bubbles building up from excess liquidity. Most of the market is convinced the end of QE could lead to massive turbulence in equities, and the potential for a huge sell-off in bonds. But most asset managers just can’t afford to miss rallies, either. Timing is everything in markets. With a performance chart like the one above, there’s not that many pure bears left. They’ve died or evolved into something else. We are almost certain to get major market reversals again in due course. Predicting that isn’t hard. But bears need to survive until that happens, and not get too excited when it does. The next rally will be right behind.

2017-05-11T17:32:56+00:00 May 21, 2013|Adaptation, Cyclical trends, Equities, Industry Trends, Investment, Market Behavior|

How to be as good an investor as Buffett or Dalio

Still on the subject of Warren Buffett, here’s an excellent article by Jason Zweig in the WSJ on how it is essential to get alternative perspectives as an investor:

A deliberate, lifelong effort to find people to tell him why he might be wrong is one of the keys to Mr. Buffett’s success. It doesn’t come naturally to most investors.

Mr. Buffett once noted about the scientist Charles Darwin that “whenever he ran into something that contradicted a conclusion he cherished, he was obliged to write the new finding down within 30 minutes. Otherwise his mind would work to reject the discordant information, much as the body rejects transplants. Man’s natural inclination is to cling to his beliefs, particularly if they are reinforced by recent experience.”

Another vehement believer in the importance of challenging your own investing ideas is Ray Dalio, founder of Bridgewater Associates, the world’s largest hedge-fund manager, which oversees more than $150 billion.

“When two intelligent parties disagree, that’s when the potential for learning and moving ahead begins,” Mr. Dalio told me last week. “The most powerful thing that [an investor] can do to be effective is to find people you respect who have opposite, different points of view [from yours]—and have an open-minded exchange with them about what’s true and what to do about it.” …

“When you think you’re right, you don’t go looking,” says Mr. Dalio. “When you think you’re right, your mind isn’t open to learning. The more you think you know, the more closed-minded you’ll be.”

Successful investment is about exploring misperception and understanding different perspectives, not simply predicting the short-run performance of the economic cycle (where few people,  if any,  have demonstrated consistent ability.)


Better than Hollywood: Looking at Human Nature

For all the glitz and glamor of the Oscars last night, movie stars aren’t at the top of the heap in Southern California. Last month, a house in Malibu sold for  $75 milion, the second most expensive sale in Southern California history. The seller of that little Malibu pad, Howard Marks, also bought the most expensive co-op sale ever recorded in New York City last year. He and his fund Oaktree Capital Management must be doing something right.

In fact, he published a book on how he thinks about the market in 2011: The Most Important Thing: Uncommon Sense for the Thoughtful Investor .

You don’t learn to be a billionaire just from reading a book. But it can pay to pay attention to how the best investors think. The key, says Marks, is you have to have “second-level thinking.” (my bolding)

First-level thinkers look for simple formulas and easy answers. Second-level thinkers know that success in investing is the antithesis of simple. That’s not to say you won’t run into plenty of people who try their darnedest to make it sound simple. Some of them I might characterize as “mercenaries.”..

Second-level thinkers know that, to achieve superior results, they have to have an edge in either information or analysis, or both. They are on the alert for instances of misperception.

You have to think about how people think. I keep arguing perception matters. According to Marks:

 The discipline that is most important is not accounting or economics, but psychology. The key is who likes the investment now and who doesn’t. Future price changes will be determined by whether it comes to be liked by more people or fewer people in the future.

Of course, it’s not academic psychology he’s talking about. I think that’s useful, but often too simple and lab-based for sophisticated market and policy decisions. Marks continues:

Inefficiencies—mispricings, misperceptions, mistakes that other people make—provide potential opportunities for superior performance. Exploiting them is, in fact, the only road to consistent outperformance.

Why do mistakes occur? Because investing is an action undertaken by human beings, most of whom are at the mercy of their psyches and emotions. Many people possess the intellect needed to analyze data, but far fewer are able to look more deeply into things and withstand the powerful influence of psychology.
To say this another way, many people will reach similar cognitive conclusions from their analysis, but what they do with those conclusions varies all over the lot because psychology influences them differently. The biggest investing errors come not from factors that are informational or analytical, but from those that are psychological. Investor psychology includes many separate elements, which we will look at in this chapter, but the key thing to remember is that they consistently lead to incorrect decisions. Much of this falls under the heading of “human nature.”
For me, it’s  not only a matter of market psychology any more, essential though that is. It has been recognized since Keynes’ famous “beauty test.” and before.

I’d add a need to understand the motivations and intentions of other actors, such as Congress, or central banks, or military planners who can do things which have an immense macro impact on the market. Human nature is pervasive. Misperceptions and mistakes are the key to outperformance.

Marks is also skeptical of pure quant approaches to making money.

This is one of the reasons why I say risk and the risk/return decision aren’t “machinable,” or capable of being turned over to a computer. Ben Graham and David Dodd put it this way more than sixty years ago in the second edition of Security Analysis, the bible of value investors: “the relation between different kinds of investments and the risk of loss is entirely too indefinite, and too variable with changing conditions, to permit of sound mathematical formulation.”  



There is far more in the brilliant little book which I will come to in time, including the difference between “winner’s games” and “loser’s games”.
2017-05-11T17:32:58+00:00 February 25, 2013|Bonds, Decisions, Industry Trends, Market Behavior, Perception, Psychology|