Post-Fed
Follow-Up

I sat on the porch
Listened to the rain
Smoked a cigarette
And counted to ten

Oh no, here it comes again
That funny feeling

― Camper Van Beethoven, Oh No! (1985)

A quick post-Fed follow-up to “Tell My Horse”, the best-received Epsilon Theory note to date (thank you!). I’ll jump right into what I’ve got to say, without the usual 20 pages of movie quotes and the like. Well, I’ve got one quote above, because I can’t help myself. They’re the lyrics to the best break-up song ever, and they’re what Janet Yellen was singing to the market on Wednesday.

Let’s review, shall we? Last fall, the Fed floated the trial balloon that they were thinking about ways to shrink their balance sheet. All very preliminary, of course, maybe years in the future. Then they started talking about doing this in 2018. Then they started talking about doing this maybe at the end of 2017. Two days ago, Yellen announced exactly how they intended to roll off trillions of dollars from the portfolio, and said that they would be starting “relatively soon”, which the market is taking to be September but could be as early as July.

Now what has happened in the real world to accelerate the Fed’s tightening agenda, and more to the point, a specific form of tightening that impacts markets more directly than any sort of interest rate hike? Did some sort of inflationary or stimulative fiscal policy emerge from the Trump-cleared DC swamp ? Umm … no. Was the real economy off to the races with sharp increases in CPI, consumer spending, and other measures of inflationary pressures? Umm … no. On the contrary, in fact.

Two things and two things only have changed in the real world since last fall. First, Donald Trump — a man every Fed Governor dislikes and mistrusts — is in the White House. Second, the job market has heated up to the point where it is — Yellen’s words — close to being unstable, and is — Yellen’s words — inevitably going to heat up still further.

What has happened (and apologies for the ten dollar words) is that the Fed’s reaction function has flipped 180 degrees since the Trump election. Today the Fed is looking for excuses to tighten monetary policy, not excuses to weaken. So long as the unemployment rate is on the cusp of “instability”, that’s the only thing that really matters to the Fed (for reasons discussed below). Every other data point, including a market sell-off or a flat yield curve or a bad CPI number — data points that used to be front and center in Fed thinking — is now in the backseat.

I’m not the only one saying this about the Fed’s reaction function. Far more influential Missionaries than me, people like Jeff Gundlach and Mohamed El-Erian, are saying the same thing. If you think that this Fed still has your back, Mr. Investor, the way they had your back in 2009 and 2010 and 2011 and 2012 and 2013 and 2014 and 2015 and 2016 … well, I think you are mistaken. I think Janet Yellen broke up with you this week.

The Fed is tightening, and they’re not going to stop tightening just because the stock market goes down 5% or 10% or (maybe) even 20%. Bigger game than propping up market prices is afoot, namely consolidating a reputation as a prudent central banker before the inevitable Trump purge occurs, and consolidating that reputation means keeping the evilest of all evil genies — wage inflation — firmly stoppered inside its bottle.

Let’s be clear, not all inflation is created equal. Financial asset price inflation? Woo-hoo! Well done, Mr. or Mrs. Central Banker. That’s what we’re talkin’ about! Price inflation in goods and services? Hmm … a mixed bag, really, particularly when input price inflation can’t be passed through and crimps corporate earnings. But we can change the way we measure all this stuff and create a narrative around the remaining inflation being a sign of robust growth and all that. So no real harm done, Mr. or Mrs. Central Banker.

Wage inflation, though … ahem … surely you must be joking, Mr. or Mrs. Central Banker. How does that possibly advance economic efficiency and social utility? I mean, even a first year grad student can prove with mathematical certainty that wage inflation only sparks a wage-price spiral where everyone is worse off. What’s wrong with you, don’t you believe in math? Don’t you believe in science? Hmm, maybe you’re just not as smart as we thought you were. But I’m sure you’ll be very happy as an emeritus professor at a large Midwestern state university. No, Ken Griffin is not interested in taking a meeting.

I know I sound like a raving Marxist to be saying this, that the Federal Reserve system and all its brethren systems were established specifically to serve the interests of Capital in its age-old battle with Labor. But yeah, that’s exactly what I’m saying. Propping up financial markets? That’s a nice-to-have. Preserving Capital as the apex predator in our social ecosystem? There’s your must-have.

Whatever you think full employment might be in the modern age, 4.3% is at the finish line. And 4.1% or 3.9% or wherever the unemployment rate is going over the next few months is well past the finish line. You’re already seeing clear signs of labor shortages, particularly skilled labor shortages, in lots of geographies. Wage inflation is baked in, and modern populist politics make it impossible for corporations to play the usual well-we’re-off-to-Mexico-then card. Not that wages in Mexico or China are really that much better anymore, depending on what you’re doing, and there are inflationary wage pressures there, too.

Bottom line: I think that the Fed is going to do whatever it takes to prevent wage inflation from getting away from them, and shrinking the balance sheet is going to be a vital part of that tightening, maybe the most important part. Why? Because the Fed thinks it will push the yield curve higher as it lets its bonds and mortgage securities roll off, which will help the banks and provide an aura of “growth” and a cover story for the interest rate hikes. Otherwise you’ve got an inverted yield curve and a recession and who knows what other sources of reputational pain.

But here’s the problem, Mr. Investor. Ordinarily if the Fed was determined to take the punchbowl away by tightening monetary policy and raising interest rates, your reaction function was pretty clear. Get out of stocks and get into bonds. Wait out the inevitable bear market and garden-variety business cycle recession, and then get back into stocks. Or just ride your 60/40 vanilla stock/bond allocation through the cycle, which is the whole point of the 60/40 thing (even, though, of course, you’re really running a 95/5 portfolio from a risk perspective). But now you’re going to have both stocks *and* bonds going down together as the Fed hikes rates and sells bonds, in a reversal of both stocks *and* bonds going up together over the past eight years as the Fed cut rates and bought bonds.

Hmmm. ‘Tis a dilemma. What to do when indiscriminate long-the-world doesn’t work? What to do when nothing works? Maybe, with apologies to the old Monty Python line, active management isn’t quite dead yet. And just at the point of maximum capitulation to the idea that it is. Wouldn’t be the first time. In fact, that’s kinda how maximum capitulation works.

Is everything as neat and clean in reality as I’m making it out to be? Of course not. Other central banks are still buying bonds. Maybe global growth pulls everything through. Maybe President Pence/Ryan/whoever-is-fourth-in-line pushes through all the tax cuts and regulatory rollback and infrastructure build programs that your little old capitalist heart desires. Plus, this isn’t some cataclysmic event like “China floats the yuan” or “Italy has a bad election”. It’s a slow burn.

But I think that if your investment mantra is “don’t fight the Fed”, you now must have a short bias to both the U.S. equity and bond markets, not the long bias that you’ve been so well trained and so well rewarded to maintain over the past eight years. This is a sea change in how to navigate a policy-driven market, and it’s a sea change I expect to last for years.

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AI & Video Games, Tricky Chatbots and More… (by Silly Rabbit)

AI and video games (again)

Vicarious (a buzzy Silicon Valley company developing AI for robots) say they have a new and crazy-good AI technique called Schema Networks. The Allen Institute for Artificial Intelligence and others seem pretty skeptical and demand a throw-down challenge with AlphaGo (or, failing that, some peer-reviewed papers with commonly used terms and a broader set of tests).

In other AI video game news, Microsoft released a video of their AI winning at Ms. Pacman, with an instructive voiceover of how the system works.

Tricky chatbots

I recently stumbled upon Carl Icahn’s Twitter feed which has the tag line: “Some people get rich studying artificial intelligence. Me, I make money studying natural stupidity.” Me, I think in 2017 this dichotomy is starting to sound pretty quaint. See: Overview of recent FAIR (Facebook Artificial Intelligence Research division) study teaching chatbots how to negotiate, including the bots self-discovery of the strategy of pretending to care about an item to which they actually give little or no value, just so they can later give up that item to seem to have made a compromise. Apparently, while they were at it, the Facebook bots also unexpectedly created their own language.

The quantum age has officially arrived

I’ve been jabbering on and pointing to links about quantum computing and the types of intractable problems it can solve for some time here, here and here, but now Bloomberg has written a long piece on quantum we can officially declare “The quantum age has officially arrived, hurrah!”. Very good overview piece on quantum computing from Bloomberg Markets here.

Your high dimensional brain

We tend to view ourselves (our ‘selfs’) through the lens of the technology of the day: in the Victorian ‘Mechanical age’ we were (and partly are) bellows and pumps, and now we are, by mass imagination, a collection of algorithms and processors, and possibly living in a VR simulation. While this ‘Silicon Age’ view is probably not entirely inaccurate it is also, probably, in the grand scheme of things, nearly as naive and incomplete as the Victorian view was. Blowing up some of the reductions of current models, this new (very interesting, pretty dense, somewhat contested) paper points towards brain structure in 11 dimensions. Shorter and easier explainer here by Wired or even more concisely by the NY Post“If the brain is actually working in 11 dimensions, looking at a 3D functional MRI and saying that it explains brain activity would be like looking at the shadow of a head of a pin and saying that it explains the entire universe, plus a multitude of other dimensions.”

And in other interesting-brain-related news:

Taming the “Black Dog”

And finally, three different but complimentary technology-enabled approaches to diagnosing and fighting depression:

  • basic algorithm with limited data has shown to be 80-90 percent accurate when predicting whether someone will attempt suicide within the next two years, and 92 percent accurate in predicting whether someone will attempt suicide within the next week.
  • In a different predictive approach, researchers fed facial images of three groups of people (those with suicidal ideation, depressed patients, and a medical control group) into a machine-learning algorithm that looked for correlations between different gestures. The results: individuals displaying a non-Duchenne smile (which doesn’t involve the eyes in the smile) were far more likely to possess suicidal ideation.
  • On the treatment-side, researchers have developed a potentially revolutionary treatment that pulses magnetic waves into the brain, treating depression by changing neurological structures, not its chemical balance.

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Does It Fly, Really?

On episode 22 of the Epsilon Theory podcast, we’re in Las Vegas at the 2017 EQDerivatives conference. Both Dr. Ben Hunt and our guest, Devin Anderson, managing director in equity derivative sales at Deutsche Bank, were speakers at the event this year. In a nod to David McCullough’s 2015 book, The Wright Brothers, this episode explores whether the ubiquitous ideas floating around finance today actually have wings and can fly.

2016-07-et-podcast-itunes 2016-07-et-podcast-gplay 2016-07-et-podcast-stitcher

Long Short-Term Memory, Algorithms for Social Justice, and External Cognition (by Silly Rabbit)

DARPA funds graph analytics processor

Last week I posted a bunch of links pointing towards quantum computing. However, there are also other compute initiatives which also offer significant potential for “redefining intractable” for problems such as graph comparison, for example, DARPA’s HIVE which aims to create a 1000x improvement in processing speed (and at much lower power) on this problem. Write-up on EE Times of the DARPA HIVE program here.

Exploring long short-term memory networks

Nice explainer on LSTMs by Edwin Chen: “The first time I learned about LSTMs, my eyes glazed over. Not in a good, jelly donut kind of way. It turns out LSTMs are a fairly simple extension to neural networks, and they’re behind a lot of the amazing achievements deep learning has made in the past few years.” (Long, detailed and interesting blog post, but even if you just read the first few page scrolls still quite worthwhile for the intuition of the value and function of LSTMs.)

FairML: Auditing black box predictive models

Machine learning models are used for important decisions like determining who has access to bail. The aim is to increase efficiency and spot patterns in data that humans would otherwise miss. But how do we know if a machine learning model is fair? And what does fairness in machine learning mean? Paper exploring these questions using FairML, a new Python library that audits black-box predictive models.

Fast iteration wins prizes

Great Quora answer on “Why has Keras been so successful lately at Kaggle competitions?” (By the author of Keras, an open source neural net library designed to enable fast experimentation). Key quote: ”You don’t lose to people who are smarter than you, you lose to people who have iterated through more experiments than you did, refining their models a little bit each time. If you ranked teams on Kaggle by how many experiments they ran, I’m sure you would see a very strong correlation with the final competition leaderboard.” 

Language from police body camera footage shows racial disparities in officer respect

This paper presents a systematic analysis of officer body-worn camera footage, using computational linguistic techniques to automatically measure the respect level that officers display to community members.

External cognition

Large-scale brainlike systems are possible with existing technology — if we’re willing to spend the money — proposes Jennifer Hassler in A Road Map for the Artificial Brain.

Pretty well re-tweeted and shared already, but interesting nonetheless: External cognition: The Thoughts of a Spiderweb.

And related somewhat related (or at least a really nice AR UX for controlling synthesizers), a demonstration of “prosthetic knowledge” — check out the two minute video with sound at the bottom of the page – awesome stuff!

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The Summer Reading List (by Jeremy Radcliffe)

It’s that time of year, when the kids get out of school and somehow you’re supposed to have more time to spend reading. I’m going to share a few of my current, hopefully off-the-beaten-path favorites with you. These recommendations are going to focus on good old-fashioned free email subscriptions, kind of like Epsilon Theory. If you want to read great literature, please check out the McSweeney’s store, where the books are as beautiful on the outside as the words are on the inside. And if you want the list of finance-related classics, well, Ben’s already done that work for you here (I can’t recommend Fortune’s Formula highly enough!). So, on to my email list recommendations:

Bob Lefsetz

Ostensibly, Bob writes about music and the music business, so this is certainly most applicable for those with an interest in music and the music scene, but Bob’s near-daily communiques are about so much more than music. I’ve been reading Bob for about three years now and his advice for artists is applicable to business leaders as well — primarily to focus on being authentic and not to worry about appearing vulnerable, which is actually humanizing and allows others to bond with you.  http://lefsetz.com/wordpress/

Scott Galloway

I don’t know where I first came across Scott’s blog/newsletter, which is nominally about digital marketing strategy, but it’s now a weekly blessing. He’s a professor at NYU Stern and just sold his consulting business L2, but he’s continued to publish notes that are very much in the Lefsetz vein. Scott’s an expert in his field, and he also understands that transparency and authenticity drive the connection with the reader. His tagline or motto is “life is so rich,” and it is, especially when you’re reading his smart, beautiful, and brutally honest stuff.  https://www.l2inc.com/

Scott Belsky

When it comes to technology and the VC world, my go-to used to be Bill Gurley of Benchmark Capital and his wonderful Above the Crowd (great name; Bill’s super-tall); however, Bill is down to about a post a year of late, so don’t expect much on a regular basis, but consider signing up because when he does post, it’s a must-read. However, his friend and Benchmark venture partner, Scott Belsky has started doing a monthly-ish collection of his thoughts and links to interesting content in the technology and design arena which he is calling Positive Slope, and I highly recommend it.  http://digest.scottbelsky.com/

 Tim Urban

Tim’s WaitButWhy blog is tech-focused also, but his specialty seems to be explaining Elon Musk’s ambitions in relatively plain but plentiful (like 40,000 words at a time) English for those of us who aren’t engineers, using low-tech stick figure diagrams and clip art.  http://waitbutwhy.com/

Lacy Hunt & Van Hoisington

OK, so this is a more straightforward investment management letter, but if you want to understand why interest rates are so stubbornly low in the face of unprecedented “money printing” by central banks around the world (spoiler alert: velocity of money!), you should be reading whatever Lacy and his partner Van Hoisington of Hoisington Asset Management in Austin, Texas are writing. Yes, they run a long-dated Treasury fund and are “talking their book,” but they’ve been so right for so long while almost everybody else in our business has used every 20-basis-point backup in rates as an excuse to call for the Death of the Bond Bull Market.  http://www.hoisingtonmgt.com/newsletter

Eknath Easwaran

I learned to meditate a few years ago using a simple technique called passage meditation pioneered (or documented!) by Blue Mountain Center of Meditation founder, Eknath Easwaran. You can sign up for a daily dose of wisdom, taken from his book Words to Live By and delivered via email.  https://www.bmcm.org/subscribe/

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Tell My Horse

You may be a business man or some high-degree thief
They may call you doctor or they may call you chief
But you’re gonna have to serve somebody, yes you are
You’re gonna have to serve somebody
Well, it may be the devil or it may be the Lord
But you’re gonna have to serve somebody

— Bob Dylan, Gotta Serve Somebody (1979)

Guede is a powerful loa. He manifests himself by “mounting” a subject as a rider mounts a horse, then he speaks and acts through his mount. The person mounted does nothing of his own accord. He is the horse of the loa until the spirit departs. Under the whip and guidance of the spirit-rider, the “horse” does and says many things that he or she would never have uttered un-ridden.

— Zora Neale Hurston, Tell My Horse (1938)

In voodoo, the loa are intermediaries between humans and gods, similar to saints or angels in Western theology. But here’s the big difference with Western theology. You don’t just pray to the loa to receive its help. Belief is a necessary but not sufficient condition. You must serve the loa.

Erzulie Freda requires her champagne and perfume. Baron Samedi his rum and cigars. Voodoo is an intensely transactional theology, which makes it the perfect religion for the Age of Trump.

The wind came back with triple fury, and put out the light for the last time. They sat in company with the others in other shanties, their eyes straining against crude walls and their souls asking if He meant to measure their puny might against His. They seemed to be staring at the dark, but their eyes were watching God.

— Zora Neale Hurston, Their Eyes Were Watching God (1937)

Zora Neale Hurston, William Faulkner, and Cormac McCarthy are my indispensable authors. Why? Because they teach us how the human animal responds to The Storm.

Hurston was born in 1891 and grew up in Eatonville, Florida, one of the first all-black towns in the U.S. She moved to Baltimore when she was 26, working as a maid, pretending to be 16 so that she could go to high school. She went to Howard University, where she studied Greek and started the school newspaper, and from there went to Barnard College in 1925 for post-graduate studies in anthropology. She was the only black student at Barnard. In the 1930s, Hurston published three novels, two anthropology books, and dozens of articles and short stories. She wrote a Broadway musical. She won a Guggenheim fellowship.

20 years later, Hurston was working as a maid outside of Miami, having been fired as a librarian at Patrick Air Force Base for being “too well-educated”. She died alone and penniless in the St. Lucie County Welfare Home in 1960, buried in an unmarked grave.

What happened? Hurston was black. Hurston was a woman. Hurston was a libertarian. Strike three! Hurston rejected the notion that “black literature” should “uplift the Negro” (yes, this was a thing), making her anathema in mainstream white culture, not to mention unfit for librarian work in Brevard County, Florida. But Hurston faced as sharp a rejection in black counterculture, where her refusal to kowtow to black men of letters (and they were ALL men) and their vision of art (and women) in the service of socialist political dogma ultimately made her an outcast in every social circle she entered. Hurston was nobody’s fool, and she was nobody’s bitch. That’s a hard road to travel in any age.

1st-year Banker:   Look. I wanna be rich. I admit it. I want the car, the house, the whole show. But the idea that some global financial whatever exists independent of public and political accountability seems … naïve at best. Public opinion matters. Government regulations matter.

Viktor Eresko:  Young man … We finance culture. We buy entire nations.

— Jonathan Hickman, The Black Monday Murders (2017)

In his day job, Jonathan Hickman is responsible for orchestrating pretty much the entire Marvel Comics universe. Ever wonder how all those superhero movies tie in with each other? It’s Hickman’s story line. His best work, though, is found in indie comics far away from the Borg cube that is Disney.

Source: UBS Multi-Asset Sales, as of 06/07/17. For illustrative purposes only.

And in entirely unrelated news to the fictional notion of some global financial whatever that exists independently from public and political accountability, central bank assets recently topped the $14 trillion mark, growing at $2 trillion per year.

And speaking of endoparasitoids …

Wasps of the genus Glyptapanteles, also known as “voodoo wasps”, lay their eggs inside various caterpillar species. The eggs hatch and most of the wasp larvae eat their way out of the body of the caterpillar host and begin to pupate.

But some larvae stay behind and take over the caterpillar’s nervous system, effectively transforming the host into a zombie. The half-eaten-from-the-inside zombie caterpillar then proceeds to starve itself to death while protecting the baby wasp cocoons.

No, I’m not making this up.

Louis Cyphre:  Alas … how terrible is wisdom when it brings no profit to the wise, Johnny.

— Angel Heart (1987)

Tell me about it. Story of my life.

I’m having a hard time with this market, because I can see what a powerfully stable social equilibrium is being established around this transformation of capital markets into a political utility. I’m having a hard time with it because, like any powerfully stable social equilibrium, to be truly successful in that world you must give yourself over to that world. You must embrace that world in your heart of hearts. As Winston finally learned, to be happy you must love Big Brother. Or in our case, lever long, sell volatility, and love the Fed.

I can’t do it. I can’t embrace the machines and the vol selling and the ETF parade and the central bankers’ “communication policy”. So I’m NOT happy. I’m 20+ pounds overweight. I don’t sleep well. I DON’T trust the Fed, much less love them, and I never will.

I know, I know … boo hoo. First world problems and all that. No doubt Don Corleone would slap me around a bit for my Johnny Fontane-esque whining. You can act like a man! But here’s the thing. There are tens of thousands of people in this business who feel exactly like I do. Yeah, we’re privileged. So what? This is OUR existential crisis and we’re going to deal with it in the only way we can, by talking it through. Capisce?

So here’s my question. How do you survive, both physically and metaphysically, in a market you don’t trust but where you must act as if you do? How do you pass? How do you reconcile the actions and beliefs necessary to be successful in this market with the experiences and training of a lifetime that tell you NOT to act this way and believe in all this?

Here’s what most people do. Here’s the human answer. You make accommodations. You surrender little by little to the new religion and its transactional catechism. It starts off easy enough. At first it’s just staying quiet while others talk. Then it’s simple superstitious behavior that you can laugh off. Who does it hurt to pour a shot of rum and leave it out on the table for Baron Samedi? Ha ha ha. But then a friend testifies to you in a private moment. You can see with your own eyes the earthly rewards his faith has brought, while your caution and doubt have brought you nothing but portfolio underperformance and difficult conversations with unhappy clients. And then one day you feel it. Yes, I, too, can purchase Big Data. I, too, can purchase Cloud Computing. I, too, can purchase an ETF Model. I don’t need ideas of my own. I can transact for whatever ineffable machines or models I require to succeed in this market of ineffable machines and models, so that I can tend to more important things like “building my business” or “interacting with clients.”

And that’s where we are. By far the most common coping mechanism for a market we don’t like and we don’t trust and we don’t understand — but a one-way up market for all that — is to become smaller in spirit even as we become larger in scale. To become transactional. To collaborate with the forces that turn markets into utilities. To become positioners rather than investors. To become model followers rather than idea generators. To hedge out our most pronounced career risk — which is not a large portfolio loss, because so many others will be in the same boat, but is rather a small portfolio loss from independent decision-making while others are making non-independent, collective gains. How do we accomplish this hedge? By eliminating independent risk-taking and embracing collective risk-taking, that’s how. By blindly serving the loas of the market — sometimes ancient ones like Value Investing but more frequently new ones like Modern Portfolio Theory or Passive Investing — and letting them ride us like a horse.

Management fees doth make cowards of us all.

This gradual but massively widespread behavioral accommodation to what I’ve called the Hollow Market — where a shell of normalcy hides vast depths of faux trading volume, faux securities, and faux people — has different impacts in different parts of that market.

For discretionary stock pickers, particularly hedge funds, the Hollow Market has been a plague of Biblical proportion. The orange line in the chart below is the S&P 500 Index from 1998 to today. The white line and blue-shaded area is the HFRX Global Hedge Fund Index divided by the S&P 500 Index. It represents the relative underperformance or outperformance of hedge funds versus the S&P 500 (h/t to Howard Einhorn at Barclays), and today we are almost back to all-time underperformance lows, last seen in 1999.

Source: Bloomberg LP, as of 06/07/17. For illustrative purposes only.

Okay, you say, that’s the S&P 500, but this is a global hedge fund index. What about a global equity index? Below is the same plot against the MSCI World Index instead of the S&P 500. Oh yeah, that’s better. Merely a 17-year low in underperformance.

Source: Bloomberg LP, as of 06/07/17. For illustrative purposes only.

Accommodation to the Hollow Market is a miserable experience for discretionary stock pickers (and the same is true for any security selectors, whether it’s bonds or commodities or currencies or whatever), and the higher your fee structure the more miserable it is, which is why hedge funds have been particularly hard hit. Why is accommodation so difficult? Because the point of discretionary stock picking is taking independent, idiosyncratic risk. Seriously, that’s the whole, entire point. But if that’s where career risk squarely sits — and trust me, it does — then to survive the Hollow Market you have to give up your reason for being.

For the past eight years, whenever you’ve stuck your neck out with idiosyncratic risk sufficient to differentiate yourself and move the needle, more often than not you’ve been slapped around brutally for your trouble. So you stop doing that. So you make an accommodation by reducing your portfolio volatility to mimic a 50% allocation to the S&P 500 and a 50% allocation to cash, with a teeny-tiny idiosyncratic position here and there in order to have a good enough war story to keep your investors from redeeming (you hope). So you effectively lock in your underperformance and pray for the Old Gods to return and unleash their mighty wrath on global equity markets. Of course, you’ll be down 50% of the market in The Storm, just like you were in 2008, but hey … at least that would give you a reason to come into the office. Anything but this.

Or … you can convert to the new religion. You can reinvent yourself as a quant fund. It’s not who you really are, of course, so you’ll need to go out and buy the team and the computers and the data. But you can do that, and today it feels like every old school hedge fund is doing exactly that and only that. Because everything is for sale in the Hollow Market. Everything is transactional. IF I buy the team and the data and the computers, IF I perform the proper ritual in the proper way, why THEN I will start to generate uncorrelated positive returns again. That’s the promise of the modern loas of Big Data and Artificial Intelligence and Machine Learning. You don’t have to understand, you just have to believe. And serve.

What goes wrong here is what always goes wrong when too much money goes too fast into what is both the greatest creator of wealth in the modern world and the greatest destroyer of wealth in the modern world: financial innovation. And by financial innovation I don’t just mean the quants. In fact I probably mean the quants least of all. More pointedly I mean the financial innovation embedded in the Brave New World of ETFs and index products — of which there are now more such aggregated securities listed on U.S. markets than the company stocks which comprise them! — and more pointedly still I mean the financial innovation embedded in the Brave New World of massive central bank balance sheets and the massive-er quantities of sovereign and corporate bonds that are priced off those balance sheet dynamics.

The crowding inherent in the accommodations we all have made to the Hollow Market — particularly our collective embrace of ETFs + index products and our collective tolerance for central bank magic spells — has the same enormous drawback that global crowding always has: it dramatically increases our collective risk. We don’t care about that collective risk today because we’re all so consumed by our idiosyncratic risks of not fitting into the modern market zeitgeist. I get that. There’s no career risk in collective risk. But as a thinking, feeling human being I am focused on the collective risk. And here’s specifically what I’m focused on.

First, the notion that ETFs and index products are somehow “passive” investments in the buy-and-hold sense of the word is just utterly and disastrously wrong. If you’ve gotten nothing else from Rusty Guinn’s brilliant Epsilon Theory notes, please get this: there’s nothing “passive” about ETFs and index products. They are, on the contrary, the very instantiation of active portfolio management, where investors are making an inherently and completely “active” decision on this sector versus that sector, this asset class versus that asset class, this geography or factor versus that geography or factor. What this means is that the big risk to market structure and the big potential for feeds-on-itself selling pressure during a market downturn isn’t “risk parity” or some other small-fry bogeyman de jour, it’s the active trading decisions of the holders of TRILLIONS of dollars’ worth of active trading instruments — ETFs and index products. There’s your bogeyman.

And the same thing goes for the $14+ TRILLION in central bank assets. These are not buy-and-hold portfolios. These are trading portfolios. I mean, even the act of maintaining these portfolios at their current levels, much less the $2 trillion per year current growth rate, is an active trading decision of massive proportions. Depending on the average duration of the bonds these banks hold, they will be forced to buy $1 to $2 trillion of new bonds each year just to replace what’s running off. Will central bankers jawbone their tapering and selling every which way to Sunday? Will they buy more if markets get really squirrely? Of course they will. Of course they will because … once more with feeling … these are trading portfolios!

Okay, Ben, so they’re trading portfolios. So what? The so what is that there’s one thing that central bankers are even more committed to than propping up financial asset prices, and that’s preventing wage inflation from getting a full head of steam. That’s because central bankers are, in fact, bankers, and bankers gotta serve somebody, too. Or as Zora Neale Hurston would say, their eyes are watching God. It’s just — and I don’t mean to get all Marxist here or anything subversive like that — but their eyes are watching Capital, not Labor. Central bankers think they’re on the side of the angels with this one, the big struggle between the Old God Capital and the Old God Labor. I mean, it’s their “mandate”, after all. Their Mandate of Heaven, so to speak. Who can argue with that?

I know it sounds ludicrous today to suggest that wage inflation might be gearing up to make a run, what with it holding at a very sticky 2.4% or thereabouts in the U.S., and Europe and Japan unable to sniff inflation despite all their central bank purchases (wait a second … is it possible that that all this balance sheet expansion is deflationary rather than inflationary? Nah, that’s crazy talk. Forget I even said it.). But I don’t think a new regime of wage inflation is ludicrous at all. In fact, I think it’s pretty darn inevitable with the current swing of the populist pendulum, and I think it’s not just inevitable in the U.S. but in China, as well. And when it happens, the Fed is going to be waaay behind the curve, or they will think they are, which is worse. So they will tighten. They will sell assets. Regardless of whether the market is down a little or a lot, the Fed will tighten and sell a lot more and a lot more quickly than people imagine, and that’s going to beget a lot more selling of … everything. Because we all gotta serve somebody.

You know, the first time I really thought about the Dylan lyrics was back in my headstrong younger days, when the notion of professional autonomy was pretty much my highest goal and I was particularly chafed at what I perceived at the time as the unjust limitations on the full exercise of my natural investment genius . The company I worked for provided a corporate shrink, and she was wonderfully insightful. Much more Wendy Rhoades than Dr. Gus, for any Billions fans out there. The most impactful observation, among many: “Ben, no matter who you are or what you do, if you stay in the investment business you gotta serve somebody. Maybe it’s not a portfolio manager or a senior partner. Maybe it’s your clients. Maybe it’s a Board. But you gotta serve somebody.” She wasn’t trying to talk me out of leaving. Which I did. She was trying to talk me into opening my eyes. Which I also did … kinda sorta. That’s the problem with youth. It’s wasted on the young. And I wasn’t that young.

Well, I’m older now, I have my eyes wide open, and here’s how I think about this Truth with a capital T today. I am truly happy to serve the people I care about. In a business capacity, these are my partners and my clients. And yes, I know that my clients are often institutions, not natural persons, but Mitt Romney wasn’t completely wrong when he said that corporations were people, too. The point being that I’m NOT happy to serve an idea. I’m NOT happy to serve a market loa like Value Investing or Artificial Intelligence. I’m NOT happy to serve The Man or The Fed or The Party. I’m NOT happy to serve the interests of the Missionaries that barrage us with their Narratives day in and day out. As Vito Corleone put it, I refuse to be a fool dancing on the strings held by all of those big shots. And what makes my business world work is that the people I serve, my partners and my clients, give as good as they get and do not require me to serve another Master. That hasn’t always been the case in my professional career, and I’m sure it’s not the case for many people reading this note. But if I can give one piece of advice for how to make one’s way through this petty, accommodationist, transactional, voodoo wasp-infested world, it’s simply this: find your Tribe. Work with people who value you as an end in yourself, not as a caterpillar host for whatever voodoo wasp eggs — i.e., zombie-fying endoparasitoid IDEAS — they or others are looking to implant.

So yeah, I’m overweight and I need to get more sleep. I’m not happy about the market, and I’m anxious about living up to my obligations to my partners and clients. But I wake up every morning thinking independent thoughts about idiosyncratic risks. I’ve got a Tribe. I’m nobody’s horse. And that’s about as good as it gets here in the Hollow Market.

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Chili P is My Signature: Things that Don’t Matter #5

Jesse After His Chili P Phase

Walter: Did you learn nothing from my chemistry class?
Jesse: No. You flunked me, remember, you prick? Now let me tell you something else. This ain’t chemistry — this is art. Cooking is art. And the shit I cook is the bomb, so don’t be telling me…
Walter: The shit you cook is shit. I saw your setup. Ridiculous. You and I will not make garbage. We will produce a chemically pure and stable product that performs as advertised. No adulterants. No baby formula. No chili powder.
Jesse: No, no, chili P is my signature!
Walter: Not anymore.
Breaking Bad, Season 1, Episode 1

“There was only one decline in church attendance, and that was in the late 1960s, when the Vatican said it was not a sin to miss Mass. They said Catholics could act like Protestants, and so they did.“
— Rodney Stark, Ph.D.

She should have died hereafter;
There would have been a time for such a word.
To-morrow, and to-morrow, and to-morrow,
Creeps in this petty pace from day to day
To the last syllable of recorded time,
And all our yesterdays have lighted fools
The way to dusty death. Out, out, brief candle!
Life’s but a walking shadow, a poor player
That struts and frets his hour upon the stage
And then is heard no more: it is a tale
Told by an idiot, full of sound and fury,
Signifying nothing.
— William Shakespeare, Macbeth, Act 5, Scene 5

“I can’t do it if I think about it. I would fall down, especially if I’m wearing street shoes,” he said, laughing. “It wasn’t something I did because I wanted to. I didn’t even know I did that until someone showed me a video.”
— Fernando Valenzuela about his unique windup to the LA Times (2011)

Fernando-mania

Baseball was in the midst of a crisis in 1981.

In the years prior, competition for talent in larger markets had driven player salaries higher and higher. This caused owners to seek increasing restrictions on free agency. The players’ union went on strike in June, right in the middle of the season. Fans were furious, and mostly with the owners, as is the usual way of things. We still hate millionaires, of course, but we positively loathe billionaires. While the strike ended by the All-Star break in early August, work stoppages and disputes of this sort have often been the signposts of baseball’s long, slow march to obscurity against the rising juggernaut of American football and the sneaky, if uneven, popularity of basketball. It was not a riskless gamble for either party, and as future strikes taught us, the aftermath could have gone very badly.

But not this time. You see, baseball had a secret weapon to quickly bring fans back after the 1981 strike: a “short fat dark guy with a bad haircut.” His name was Fernando Valenzuela.

Fernando was an anomaly in another long, slow march — that of baseball’s transition from a pastime to something more clinical, more analytical, more athletic. We were at a midpoint in the shift from the everyman-made-myth that was Babe Ruth or the straight-from-the-storybook folk hero like Joe DiMaggio to the brilliant, polished finished products of baseball academies today. Only a few years after 1981, we would see the birth of the new generation of uberathletes in Bo Jackson, a man who many still consider among the most gifted natural athletes in history. Only a decade earlier, the top prospect in baseball was one Greg Luzinski. The two weighed about the same. Their body composition was just a little bit different.

Fernando was certainly a physical throwback of the Luzinski variety, but so much more. He was a little pudgy. His hair was, long, shaggy and unkempt. More to the point, everything he did was inefficient, out of line with trends in the league. His windup was long and tortured, with a high leg kick that reached shoulder level in his early years and chest level in his older, slightly chubbier years. It featured an unnecessary vertical jerk of his glove straight upward near the end, and most uniquely, a glance to the heavens that became a signature of Fernando-mania. To stretch the inefficiency to its natural limits, his most effective pitch was a filthy screwball, a pitch that had been popular for decades but had already significantly waned by the early 1980s. Fathers and coaches taught their sons that it would hurt their arms (which a properly thrown screwball does not do), and by the late 1990s the pitch that ran inside on same-handed batters was all but extinct, except in Japan, where a very similar pitch called the shuuto continued to find adherents.

There were many reasons he captured the national imagination. He was a gifted Mexican pitcher in Los Angeles, a city full of baseball-obsessed Mexican-Americans and migrant workers. He was also truly marvelous as a 20-year old rookie in 1981. His stretch of eight games between April 9th and May 14th still ranks as one of the most dominant in history. Eight wins. Eight complete games. Five shutouts. Sixty-eight strikeouts. And that was how he started his career!(1)

But more than anything, I think, it was the pageantry and the spectacle of it all. The chubby, mop-top everyman who came out of nowhere with a corny sense of humor, who threw from a windup out of a cartoon, who threw a pitch that nobody else threw anymore. It was inefficient and ornamental and just so unnecessary — and we loved it. I still do. It was even how I was taught to pitch growing up. My father told me and instructed me to throw with “reckless abandon”, and so in my windup I would rotate my hips and point my left toe at second base before kicking it in a 180-degree arc at a shoulder level, nearly falling to the ground from the violent shift in weight after every pitch.

Alas, the efficiency buffs who disdained such extravagances were and are mostly right. While Valenzuela had a long and decent career, the greatest pitchers of the modern era — Roger Clemens, Pedro Martinez and especially Greg Maddux — all thrived on efficient mechanics and a focus on a smaller number of high quality pitches.(2) While a screwball is nice, and in many ways unique, it also isn’t particularly effective as a strikeout pitch in comparison to pitches with more vertical movement like, say, curveballs, split-finger fastballs or change-ups, or pitches that can accommodate lateral movement AND velocity, like sliders and cut-fastballs.

There’s a lesson in this.

As humans, especially humans in an increasingly crowded world where we can be instantly connected to billions of other people, the urge to stand out, to carve out a different path, can be irresistible. This influences our behavior in a couple of ways. First, it drives us to cynicism. Think back on the #covfefe absurdity. If you’re active on social media, by the time you thought of a funny #covfefe joke, your feed was probably already filled with an equal number of posts that decided that the meme was over, using the opportunity to skewer the latecomers to the game. Those, too, were late to the real game, which had by that time transitioned to new ironic uses of the nonsense word. A clever idea that is shared by too many quickly becomes an idea worthy of derision. And so the equilibrium — or at least the dominant game theory strategy — is to be immediately critical of everything.

It also makes us inexorably prone to affectation. We must add our own signature, that thing that distinguishes us or our product; the figurative chili-powder-in-the-meth of whatever our form of productive output happens to be.  Since we are all writers of one sort or another now, we feel this acutely in how we communicate. When part of what you want to be is authentic in your communication, our introspection becomes a very meta thing — we can talk ourselves into circles about whether we’re being authentic or trying inauthentically to appear authentic. But we’re always selling, and while our need for a unique message has exaggerated this tendency, at its core it clearly isn’t a novel impulse. People have been selling narratives forever. But if there’s a lesson in Epsilon Theory, surely it is that successful investors will be those who recognize, survive and maybe even capitalize on narrative-driven markets — not necessarily those whose success is only a function of their ability to push substance-less narratives of their own.

Perhaps most perniciously, our urge to stand out is also an urge to belong to a Tribe — to find that small niche of other humans that afford us some measure of human interaction while still permitting us to define ourselves as a Thing Set Apart. The screwball, the chili powder, the fancy windup, the obscure quotes about Catholicism from sociology Ph.D.s in your investing think-piece — instead of a barbaric yawp, it becomes a signal to your tribe. When pressed, our willingness to rip off the steering wheel and adopt a competitive strategy becomes dominant, a necessity. Lingering in the back of our heads as we go all-in on our tribe is the knowledge that our tribal leaders, no matter who they are, will sell us down the river every time.

In our investing lives, when we build portfolios, we know full well how many options our clients or constituents have, so these three competing impulses drive our behaviors: cynicism, affectation and tribalism. The cynical, nihilistic impulse shouts at us that nothing matters enough to justify risking being fired, and so we end up choosing the solution that looks most like what everyone else has done. That’s the ultimate equilibrium play we’re all headed toward anyway, right? The affectation impulse requires that we add a little something to distinguish us from our peers. A dash of chili powder. A screwball here or there, or an outlandish delivery to delight and astonish. Our tribal impulse compels us toward the right-sounding idea that makes us part of a group (I’m looking at you, Bogleheads). More frequently, we’re motivated by a combination of all three of these things in one convoluted, ennui-laden bit of arbitrary decision-making.

The real kick in the teeth of all this is that many of the things we are compelled to do by these impulses are actually good and important things, even Things that Matter. But because of the complex rationale by which we arrive at them (and other biases besides), we often implement the decisions at such a halfhearted scale that they become irrelevant. In other, worse cases, the decisions function like the tinkering we discussed in And They Did Live by Watchfires, potentially creating portfolio damage in service of a more compelling marketing message or to satisfy one of these impulses. In both cases, these flourishes and tilts are too often full of sound and fury, signifying nothing.

Too Little of a Good Thing

What, exactly, are we talking about? Well, how about value investing, for starters?

I think this one pops up most often as a form of the tribal impulse, although clearly many advisors and allocators use it as a way to add a dash of differentiation as well. Now, most of us are believers in at least a few investing tribes, each with its own taxonomy, rituals, acolytes and list of other tribes we’re supposed to hate in order to belong. But none can boast the membership rolls of the Value Tribe (except maybe the Momentum Tribe or the Passive Tribe). And for good reason! Unlike most investment strategies and approaches devised, buying things that are less expensive and buying things that have recently gone up in price can both be defended empirically and arrived at deductively based on observations of human behavior. The cases where science is really being applied to investing are very, very rare, and this is one of them. Rather than pour more ink into something I rather suppose everyone reading this believes to one extent or another, I’d instead direct you to read the splendid gospel from brothers Asness, Moskowitz and Pedersen on the subject. Or, you know, if you’re convinced non-linearities within a population’s conditioning to sustained depressing corporate results and lower levels of expected growth mean that such observations are only useful for analysis of the actions of an individual human and can’t possibly be generalized or synthesized into a hypothesis underpinning the existence of the value premium as an expression of market behavior, then don’t read it. Radical freedom!

What is shocking is how ubiquitous this belief is when I talk to investors, and how little investors demonstrate that belief in their portfolios. We adhere to the tribe’s religion, but now that it’s not a sin to skip out, we only attend its church on Christmas and Easter. And maybe after we did something bad for which we need to atone.

Value is the more socially acceptable tribe (let’s be honest, momentum has always had a bit of a culty, San Diego vibe), so let’s use that as our case study. Since I’m worried I’m leaving out those for whom cynicism is the chosen neurosis, let’s use robo-advisors to illustrate that case study. They’re instructive as a general case as well, since they, by definition, seek to be an industry-standard approach at a lower price point. Now, of the two most well-advertised robos, one — Wealthfront — mostly ignores value except in context of income generation. The other — Betterment — embraces it in a pretty significant way. I went to their very fine website and asked WOPR what a handsome young investment writer ought to invest in to retire around 2045. Here is what they recommended:

Source: Betterment 2017. For illustrative purposes only.

Pretty vanilla, but then, that’s kind of the idea of the robo-advisor. But I see a lot of registered investment advisors and this is also straight out of their playbook. It’s tough to find an anchor for the question “I know I want/need value, but how much?” As a result, one of the most common landing spots I see is exactly what our robot overlords have recommended: half of our large cap equities in core, and the other half in value. We signal/yawp a bit further: we can probably also afford to do it in the smaller chunks of the portfolios, too. Lets just do all of our small cap and mid cap equities in a value flavor. As for international and emerging equities, we don’t want to scare the client with any more line items or pie slices invested in foreign markets than we need, so let’s just do one big core allocation there.

I’m putting words in a lot of our mouths here, but if you’re an advisor or investor who works with clients and this line of thinking doesn’t feel familiar to you, I’d really like to hear about it. Because this is exactly the kind of rule of thumb I see driving portfolio decisions with so many allocators that I speak to. But how do we actually get to a portfolio like this? If you think there’s a realistic optimization or non-rule-of-thumb-driven investment process that’s going to get you here, let’s disabuse ourselves of that notion.

Could plugging historical volatility figures and capital markets expectations into a mean/variance optimizer get you to this split on value vs. core? In short? No. No, we know that this is an impossible optimizer solution because the diversification potential at the portfolio level — what we call the Free Lunch Effect in this piece — would continue to rise as we allocated more and more of our large cap allocation to a value style (and less and less to core). In other words, while the intuition might be that having both a core and value allocation is more diversifying (more pie slices!), that just isn’t true. In a purely quantitative sense, you’d be most diversified at the portfolio level with no core allocation at all!

Free Lunch Effect of Various Allocations to Large Cap Value vs. Large Cap Core in Example Portfolio

Source: Salient 2017. For illustrative purposes only.

If your instinct is to say that doesn’t look like much diversification, however, you’d be right as well. Swinging our large cap portfolio from no value to nothing but value reduces our portfolio risk by around 8bp without reducing return (i.e., the Free Lunch). That’s not nothing, but it’s damn near. The reason is that the difference between the Russell 1000 Value Index and the Russell 1000 Index or the S&P 500, or the difference between your average large cap value mutual fund and your average large cap blend mutual fund, is not a whole lot in context of how most things within a diversified portfolio interact. Said another way, the correlation is low, but the volatility is even lower, which means it has very little capacity to impact the portfolio. Take a look below at how much that value spread contributes to portfolio volatility. The below is presented in context of total portfolio volatility, so you should read this as “If I invested all 32% of the large cap portion of this portfolio in a value index and none in a core index, the value vs. core spread itself would account for about 0.1% of portfolio volatility.”

Percentage of Portfolio Volatility Contributed by LC Value-Core Spread

Source: Salient 2017. For illustrative purposes only.

Fellow tribesmen, does this reflect your conviction in value as a source of return? Some of you may quibble, “Well, this is just in some weird risk space. I think about my portfolios in terms of return.” Fine, I guess, but that just tells the same story. Consider how most value indices are constructed, which is to say a capitalization weighted splitting of “above average” vs. “below average” stocks on some measure (e.g., Russell) or multiple measures (e.g., MSCI) of value. We may have in our heads some of the excellent research on the value premium, but those are almost always expressed as regression alphas or as spread between high and low quintiles or deciles (Fama/French) or tertiles (Asness et al). In most cases they are also based on long/short or market neutral portfolios, or using methodologies that directly or indirectly size positions based on the strength of the value signal rather than the market capitalization of the stock. There are strategies based on these approaches that do capitalize on the long-term edge of behavioral factors like value. But that’s not really what you’re getting when you buy most of these indices or the many products based on them.(3)

So what are you getting? For long-only stock indices globally, probably around 80bp(4) and that assumes no erosion in the premium vs. long-term average. Most other research echoes this – the top 5 value-weighted deciles of Fama/French get you about 1.1% annualized over the average since 1972, and comparable amounts if you go back even further. Using the former figure, if you swung from 0% value to 32% value in your expression of your large cap allocation — frankly a pretty huge move for most investors and allocators — we’re talking about a 26bp difference in expected portfolio returns. Again, not nothing, but if our portfolio return expectations are, say, 8%, that’s a 3.2% contributor to our portfolio returns under fairly extreme assumptions.

Does this reflect your conviction in value as a source of return? No matter how we slice it, the ways we implement even fundamental, widely understood and generally well-supported sources of return like value seem to be a bit long on the sound and fury, but unable to really drive portfolio risk or return. Why is this so hard? Why do we end up with arbitrary solutions like splitting an asset class between core and value exposure like some sort of half-hearted genuflection in the general direction of value?

Because we have no anchor. We believe in value, but deep down we struggle to make it tangible. We don’t know how much of it we have, we don’t even know how much of it we want. We struggle even to define what “how much” means, and so we end up picking some amount that will allow us to sound sage and measured to the people who put their trust in us to sound sage and measured.

I’m going to spend a good bit of time talking about how I think about the powerful diversifying and return-amplifying role of behavioral sources of return like value as we transition our series to the Things that Matter, so I’ll beg both your patience and indulgence for leaving this as a bit of a resolutionless diatribe. I’ll also beg your pardon if it looks like I’ve been excessively critical of the fine folks who put together the portfolio that has been our case study. In truth, that portfolio goes much further along the path than most.

The point is that for various behavioral reasons, our style tilts like value, momentum or quality occupy a significant amount of our time, marketing and conversations with clients, and — by and large — signify practically nothing in terms of portfolio results. In case I wasn’t clear, yes, I am saying that value investing — at least the way most of us pursue it — doesn’t matter.

The Magically Disappearing Diversifier

The time we spend fussing around with miniscule style tilts, however, often pales in comparison to the labor we sink into our flourishes in alternatives, especially hedge funds. Some of this time is well-spent, and well-constructed hedge fund allocations can play an important role in a portfolio. When I’m asked to look at investors’ hedge fund portfolios, there are usually two warning signs to me that the portfolios are serving a signaling/tribal purpose and not some real portfolio objective:

  1. Low volatility hedge funds inside of high volatility portfolios that aren’t using leverage
  2. Hedge fund portfolios replacing Treasury or fixed income allocations

Because of the general sexiness (still, after all these years!) of hedge fund allocations to many clients or constituents, the first category tends to be the result of our affectation impulse. We want to add that low-vol, market-neutral hedge fund, or the fixed income RV fund that might have been taking some real risk back in 2006 when they could lever it up a bajillion times, not because of some worthwhile portfolio construction insight, but perhaps because it allows us to sell the notion that we are smart enough to understand the strategies and important enough to have access to them. Not everyone can get you that Chili P, after all. In some cases, sure — we are signaling to others that we are also part of that smart and sophisticated enough crowd that invests in things like this. In the institutional world, where it’s more perfunctory to do this, it’s probably closer to cynicism: “Look, I know I’m going to have a portfolio of low-vol hedge funds, so let’s just get this over with.”

For many clients and plans — specifically those where assets and liabilities are mostly in line and the portfolio can be positioned conservatively, say <10% long-term volatility — that’s completely fine. But for more aggressive allocations, there is going to be so much equity risk, so much volatility throughout the portfolio, that the notion that these portfolios will serve any diversification role whatsoever is absurd. They’re just taking down risk, and almost certainly portfolio expected returns along with it. Unless you feel supremely confident that you’ve got a manager, maybe a high frequency or quality stat arb fund, that can run at a 2 or 3 Sharpe, it is almost impossible to justify a place for a <4% volatility hedge fund in a >10% target risk portfolio. They just won’t move the needle, and there are better ways to improve portfolio diversification, returns or risk-adjusted returns.

The second category starts to veer out of “Things that Don’t Matter” territory into “Things that Do Matter, but in a Bad Way.” More and more over the last two years, as I’ve talked to investors their primary concern isn’t equity valuations, global demographics, policy-controlled markets, deflationary pressures, competitive currency crises, protectionism, or even fees! It’s their bond portfolio. The bleeding hedge fund industry has been looking for a hook since their lousy 2008 and their lousier 2009, and by God, they found it: sell hedge funds against bond portfolios! Absolute return is basically just like an income stream! There seems to be such a strong consensus for this that it may have become that cynical equilibrium.

No. Just no.

It’s impossible to overstate the importance of a bond/deflation allocation for almost any portfolio. This is an environment that prevails with meaningful frequency that has allowed the strong performance of one asset historically: bonds, especially government bonds (I see you with your hands raised in the back, CTAs, but I’m not taking questions until the end). The absolute last thing any allocator should be thinking about if they have any interest in maintaining a diversified portfolio, is reducing their strategic allocation to bonds. I’ll be the first to admit that when inflationary regimes do arrive, they can be long and persistent, during which the ability of duration to diversify has historically been squashed. The negative correlation we assume for bonds today is by no means static or certain, which is one of the reason I favor using more adaptive asset allocation schemes like risk parity that will dynamically reflect those changes in relationship. But even in that context, the dominance and ubiquity of equity-like sources of risk means that almost every investor I see is still probably vastly underweight duration.

Now many of us do have leverage limitations that start to create constraints, and so I won’t dismiss that there are scenarios where that constraint forces a rational investor not to maximize risk-adjusted returns, but absolute returns. I’m also willing to consider that on a more tactical basis, you may be smarter than I am, and have a better sense of the near-term direction of bond markets. In those cases, reducing bond exposure, potentially in favor of absolute return allocations, may be the right call. But if you have the ability to invest in higher volatility risk parity and managed futures, or if you have a mandate to run with some measure of true or derivatives-induced leverage, my strong suspicion is that you’ll find no cause to sell your bond portfolios in favor of absolute return.

Ultimately, it’s hard to be too prescriptive about all this, because our constraints and objective functions really may be quite different. To me, that means that the solution here isn’t to advise you to do this or not to do that, except to recommend this:

Make an honest assessment of your portfolio, of the tilts you’ve put on, and each of your allocations. Do they all matter? Are you including them because of a good faith and supportable belief that they will move the portfolio closer to its objective?

If we don’t feel confident that the answer is yes, it’s time to question whether we’re being influenced by the sorts of behavioral impulses that drive us elsewhere in our lives: cynicism, affectation and tribalism. In the end, the answer may be that we will continue to do those things because they feel right to us and our clients. And that may be just fine. A little bit of marketing isn’t a sin, and if your processes that have served you well over a career of investing are expressed in context of a particular posture, there’s a lot to be said for not fixing what ain’t broken. There’s nothing wrong with an impressive-looking windup, after all, until it adversely impacts the velocity and control of our pitches.

What is a sin, however, is when a half-hearted value tilt causes us to be comfortable not taking advantage of the full potential of the value premium in our portfolios. When the desire to get cute with low-vol hedge funds causes us to undershoot our portfolio risk and return targets. Perhaps most of all, when we spend our most precious resource — time — designing these affectations. We will be most successful when we reserve our resources and focus for the Things that Matter.


(1) Please – no letters about his relief starts in 1980. If MLB called him a rookie, imma call him a rookie.

(2) Probably the only exception in this conversation is Randy Johnson, who, while mostly vanilla in his mechanics, would probably get feedback from a coach today about his arm angle, his hip rotation and a whole bunch of other things that didn’t keep him from striking out almost 5,000 batters.

(3) As much as marketing professionals at some of the firms with products in this area would like to disagree and call their own product substantially different, they all just operate on a continuum expressed by the shifting of weightings toward cheaper stocks. Moving from left to right as we exaggerate the weighting scheme toward value, the continuum basically looks like this: Value Indices -> Fundamental Indexing -> Long-Only Quant Equity -> Factor Portfolios

(4) Simplistically, we’re just averaging the P2 and half of the P3 returns from the Individual Stock Portfolios Panel of Value and Momentum Everywhere, less the average of the full universe. An imperfect approach, but in broad strokes it replicates the general half growth/half value methodology for the construction of most indices in the space.


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Quantum Supremacy, Correlating Unemployment, and Buddhists with Attitude (by Silly Rabbit)

Quantum supremacy

As Ben and I have discussed before on an Epsilon Theory podcast, my view is that quantum computing is going to be truly, truly transformational by “redefining intractable”, as 1Qbit say, over the coming years. My conviction around quantum continues to grow and — to put a pretty big stake in the ground — I believe, at this point, the only open questions are: Which approach will dominate, and how long exactly until we get quantum machines which work on a broad set of real-world questions? I’ve long been a big fan of the applied, real-world progress D-wave have made, and Rigetti too. However, the “majors” like IBM are also making substantial progress towards true “quantum supremacy” with R&D intensive approaches, while other pieces of the ecosystem, such as the ability to “certify quantum states“, continue to fall into place. In the meantime, here is a wonderful cartoon explainer on quantum computing by Scott Aaronson and Zach Weinersmith.

What web searches correlate to unemployment

Well, in order to get the answer to that question you will have to follow this link (and be prepared to blush). The findings were generated by Seth Stephens-Davidowitz using Google Correlate. “Frequently, the value of Big Data is not its size; it’s that it can offer you new kinds of information to study — information that had never previously been collected”, says Stephens-Davidowitz.

Using verbal and nonverbal behaviors to measure completeness, confidence and accuracy

I recently came across Mitra Capital in Boston who have an interesting strategy of “using verbal indicators to judge the completeness and reliability of messages, to form predictions about company performance (via) analysis of management commentary from quarterly earnings calls and investor conferences based on a proprietary and proven framework with roots in the Central Intelligence Agency” with the underlying tech/methodology based on BIA. They’re running a relatively small fund ($53m AUM in Q1 2017) and have returned an average of 8.5% for the past four years (including a +43% year, and a -12.5% year). Neat NLP approach, although these returns imply more of a “feature than a product” (i.e., a valuable sub-system addition to a larger system, rather than a stand-alone system.) But, hey, I said the same thing about Instagram.

Buddhists with attitude / Backtesting: Methodology with a fragility problem

Probably (hopefully!) anyone reading Epsilon Theory has already read Antifragile by Nassim Nicholas Taleb. Many things which could and have been said about this book, but the most important one to highlight for my narrow, domain application is the massively important distinction (although rarely talked about facet) of machine learning/big compute approaches vs. regression-driven back test approaches. Key distinction is a simple one: Does your system gain from exposure to randomness and stress (within bounds) and improve the longer it exists and the more events it is exposed to OR does it perform less well with stress, and decay with time. Antifragile machine learning systems are profoundly different to the fragile fitting of models.

And finally, since I have already invoked Taleb, and if for no other reason that the line “If someone wonders who are the Stoics I’d say Buddhists with an attitude problem”, here is Taleb’s Commencement address to American University of Beirut last year.

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