The Tells of Fiat News

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I was reminded of an old video this week (h/t author Robert Kroese) featuring two of the most creative people in America: Trey Parker and Matt Stone. They are, uh, pictured on the left and right above, respectively. The creators of South Park and Book of Mormon, Parker and Stone are famously irreverent, productive and capable of creating surprisingly incisive social commentary on 2-3 days’ notice. They have a lot to say about storytelling. At an NYU writing seminar back in 2014, they said a lot.

You can watch the video clip here, but a transcript of the key bit is below:

Trey Parker: Each individual scene has to work as a funny sketch. You don’t want one scene that’s just like, what was the point of that scene? We found out this really simple rule that maybe you guys have all heard before, but it took us a long time to learn it.

We can take these beats, which are basically the beats of your outline, and if the words ‘and then’ belong between those beats, you’re f***ed. Basically. You’ve got something pretty boring.

What should happen between every beat that you’ve written down, is either the word ‘therefore’ or ‘but’. So what I’m saying is that you come up with an idea, and it’s like ‘so this happens’ right? And then this happens,’ no no no no! It should be ‘this happens, and therefore this happens. But this happens, therefore this happens.’

Literally we’ll sometimes write it out to make sure we’re doing it.

We’ll have our beats, and we’ll say, ‘okay this happens, but then this happens’ and that effects this and that does to that, and that’s why you get a show that feels like this to that and this to that but this, here’s the complication, to that.

And there’s so many scripts that we read from new writers and things that we see …

Matt Stone: F*** that. I see movies, f*** man, you see movies where you’re just watching, and it’s like this happens and then this happens, and this happens — that’s when you’re in a movie and you’re going what the f*** am I watching this movie for?. It’s just like: this happened, and then this happened, and then this happens. That’s not a movie. That’s not a story. Like Trey says it’s those two, ‘but’, ‘because’, ‘therefore’ that gives you the causation between each beat, and that’s a story.

This is among the more concise, actionable advice I’ve seen about storytelling and writing, fields which tend to attract uselessly impractical or vague recommendations. But it is also a perfect illustration of how news is transformed into fiat news. News is and ought to be exactly the thing which Parker bemoans – a series of linked ‘and then’ statements. Holding multiple truths in our heads (#AND) in this way is powerful. It is also boring.

But more often than not, too many journalists, so many of whom entered the industry out of a desire to ‘change the world’, now approach a topic having already decided the ‘beat’ toward which they must steer the story. Ideas, principles and conclusions they consider self-evident, powerful or provocative. Important. Instead of descriptions of what took place, stories are connected with ‘but’, ‘because’ and ‘therefore.’

These are the mechanics of effective storytelling. These are the tells of Fiat News.

When you open news, get in the habit of searching for ‘because’, ‘but’, ‘therefore’ and ‘however.’ Search for ‘nonetheless’ and ‘as a result.’ More often than not, it will give you a sense of the underlying intent of the author outside of the facts being presented. 

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The Grammar of Risk

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Butch: Alright. I’ll jump first.

 Sundance: No.

Butch: Then you jump first.

Sundance: No, I said.

Butch: What’s the matter with you?!

Sundance: I can’t swim!

Butch: Are you crazy?! The fall will probably kill you!

Butch Cassidy and the Sundance Kid (1969)

Now, I’m going to love you
Till the heavens stop the rain
I’m going to love you
Till the stars fall from the sky for you and I. 

Touch Me, by the Doors (1969)
Not even the Gods above
Can separate the two of us
No, nothing can come between You and I

You & I, by One Direction (2013)
Oh yeah, well, I’d rather die
Without you and I.

You and I, by Lady Gaga (2011)
Ain’t nobody in the world but you and I.

You and I (Nobody in the World), by John Legend (2013)
Between you and I darlin’,
Nothin’ could get better baby.

Between You & I, by Jessica Simpson (2006)
As long as I got you
As long as I got me
As long as we got you and I.

You and I, Kenny Rogers (1983)

I saw a funny little poll earlier this week from Bloomberg Opinion writer Noah Smith. “Which do you think,” it asked, “is correct grammar?” It then provided readers with two options:

  • “Come with Bob and I”
  • “Come with Bob and me”

Nearly one-fifth of what one would presume is a reasonably literate bunch picked the wrong answer. But this error is unlike the many other common language gaffes. You know the ones I mean. They’re/their/there. It’s/its. These are the kind of mistakes that are usually the result of someone simply not knowing what’s correct. Or forgetting. Or not caring.

But “come with Bob and I” isn’t the result of ignorance or indifference. It is the result a lesson badly taught and badly learned.

You see, there is no more present problem for elementary and middle school English teachers than the rampant misuse of the objective first-person pronoun in a series. In other words, just about every kid in America grows up saying, “Me and my friends are going to the park!” I am not sure why it is that every school and in America is so laser-focused on this quirky usage, which is far too ubiquitous and colloquial at this point to stamp out.  Say it in a school in America, and it will be corrected. Every time. Which is probably fine, I guess.

And it would be fine, except that the lesson inevitably becomes part of a recurring lesson plan on using nouns and pronouns in a series. Students are hammered year after year with “Jack, Jill, and I” exercises that unintentionally reinforce the idea that what matters is using the first-person subjective/nominative when referring to yourself in a series, and to always put yourself last. The latter lesson is utter hogwash, and the former lesson is fine as far as it goes – that is, until it becomes clear that most young English speakers have internalized a non-existent relationship between series of nouns and the subjective/nominative ‘I’. That’s how we end up with the lyrics to all those songs that will now set your teeth on edge every time you hear them.

You’re welcome. Since I’m already wielding this power, you now also have the Kars-4-Kids jingle in your head.

The confusion about ‘I’ is also one of the clearest examples I know of to describe what happens when you learn or teach people the answers to questions, instead of the process by which they will find answers in the future.

By the way, Happy Black Monday anniversary. You know, the day that we read opinion and feature articles about what went wrong and what lessons we learned?

One or more of the pieces usually turns into a brief survey-of-crashes piece. Here’s an intro to those portfolio insurance products back in ’87. Here’s what LTCM did just a decade later. Here’s a summary of the 2007 quant meltdown. Here are the proximate causes of the Global Financial Crisis. After this, you will learn about the actions that investors took to ensure that those things couldn’t happen to their portfolios and strategies again. We introduced this new risk measure. We stopped buying this kind of product. We sold this fund that didn’t work right during the crash. We stopped trusting computer models to run our money. We fixed this faulty assumption in our model. Finally, you will learn about the scary parallels today. Program trading! Trade disputes with Asia! Risk-targeting asset allocation strategies built around correlation estimates!

If you don’t know what I’m talking about, stop and find a hedge fund that publishes stress tests with their quarterly fact card or investor deck. Talk to them about how those stress tests are conducted. Then come back to this note when your brain asks itself, ‘Wait, you mean they’re just telling me what their current positions would do if every asset performed exactly like it did in that event 30 years ago?’

These are answers. They aren’t just not useful. They have negative value. They make you see ghosts. They waste your time. They prevent you from taking what are perfectly prudent steps to diversify, hedge and get the right level of risk in your portfolios. So in celebration of this anniversary and the opportunities it affords to learn lessons badly, let me instead offer a heuristic and a process I learned from Brad Gilbert, Matt Strube and Todd Centurino, my friends and former colleagues on the hedge fund team at Texas Teachers. It has served me well.

Leverage

Illiquidity

Concentration

You can almost always get away with one. You can almost never get away with three. In a normal market you can handle two. In a bad market you can’t. I’ve been toying with adding Abstraction to my little list, but it’s tough to measure. This is the grammar of risk. These – not algorithms, not derivatives, not some specific mix of news events that matches a prior crisis, not some other lesson badly learned – are what will blow you up. 

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Investment Diligence and the Cornelius Effect

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Earlier this week Ben wrote a note about the Curse of Some Talent. There is a related idea that comes with a story. This is one of my favorite stories. It recounts a seminal event from the earliest days of Saturday Night Live.

The inaugural cast was a gifted one. If, like me, you weren’t there, it included John Belushi, Gilda Radner and Dan Aykroyd, among other generational talents. It also included Chevy Chase. His stint would be brief. After one full season in 1975 and a few episodes in the 1976 season, Chevy left the show. He claimed that he did so because his fiancée wasn’t willing to live in New York, which may have been true. The cast and many others, however, believed he left to quickly cash in on the platform and fame their young repertory company had provided him. He was a star, and they weren’t (yet). He was Chevy Chase, and they weren’t. And by all accounts, his behavior quickly started to reflect that belief.

And then, just as quickly, he was gone.

Chevy was replaced by a 26-year old actor named Bill Murray, only six years removed from having been arrested at O’Hare for possession of 10 pounds of marijuana. True to form, he was only caught because he made a joke about smuggling weed to the passenger sitting next to him.

Bill and Chevy overlapped a bit during Chevy’s transition, and did not get along. But John Belushi and Chevy really did not get along. And when Chevy came back to host the show in 1978, Bill, being the force of nature that he was, was enlisted by John and the rest of the cast to confront Chevy. The entire week of rehearsals was a mess of accusations and rancor. It escalated into insults, first about Murray’s complexion, and then about…well…Chevy’s prowess, to put it delicately. The confrontation culminated in a physical altercation at one of the final rehearsals. Upon being separated, a furious Murray pointed at Chevy and delivered the real pièce de résistance:

Medium Talent.

God, what an amazing line. It was the most cutting possible blow. Unanswerable. It wasn’t so absurdly critical that it could be brushed off as a mere insult. Instead, Murray found the thing that a star quickly elevated would most fear, and laid it bare for everyone to hear. To be fair, Cornelius Crane Chase is talented and funny. Far more, probably, than you or I. Do his natural gifts exceed those of 99% of Americans? 99.9%? 99.99%? Almost certainly. But at least in the opinion of his castmates, that wasn’t enough. And while I don’t know enough about the craft of comedy to issue my own opinion, I know enough to agree with Bill Murray, Jane Curtin and John Belushi on the subject.

Alas, the investment world, too, is cursed with the problem of Medium Talent.

I am an investor of Medium Talent. Ben is a Medium Talent. Most of the investors I’ve ever worked with were Medium Talents. Almost every fund manager I’ve ever invested with, and almost every analyst I’ve hired. Unlike Bill Murray, I don’t mean this as an insult. The term simply describes the reality in which, beyond some baseline threshold, further increases in talent, intelligence and skill are not the factors which influence outcomes. What’s more, it describes the basis on which our expectations for ourselves and others continue to rise despite the declining relevance of increases in those traits. Maybe this phenomenon already has a name. In honor of Chevy, however, let’s call it the Cornelius Effect. Here’s a No Talent sketch of what I mean:

The Cornelius Effect pervades the identification of talent across many – although certainly not all – fields. It is ubiquitous in financial markets. It governs how we hire analysts. It governs how we hire fund managers. It governs how we hire financial advisers. It governs how we invest in management teams.

If your organization is like any investment organization I have been a part of or have performed due diligence on, each of those talent identification processes can be distilled into a simple philosophy: hire or invest with the smartest-seeming person everyone seems to like. Oh, we almost always make some attempt to find useful proxies for these traits that permit us to feel like we’re evaluating some other characteristics as part of a targeted process. This is a cartoon. As an industry, we hire based on our perception of intelligence. Maybe you think you or your organization don’t do this. And maybe you really don’t. But I’d ask you to really think about your last few decisions before you draw that conclusion.

Up to a point, emphasizing intellectual talent is kind of what we should be doing. The work isn’t trivial, and simple measures of intelligence are still a far better indicator of outcome than the skill inventories so many HR departments emphasize. You know, the kinds that search for resume keywords of skills that the average human could pick up in a week or so? It is also certainly the case that there ARE some legitimate investment activities which require a bit more horsepower. But in context of the very high average intelligence of people in this industry, the threshold of intellect at which the traits we are seeking out should shift to traits related specifically to our process – or theirs – is low. Much lower than most people think. By and large, if you are hiring managers, advisers and staff by trying to find the smartest PM/FA/consultant/analyst you can find, this practice will lead you to constant surprise and disappointment.

I’ve got a lot more to say about how the Cornelius Effect ought to influence our diligence processes for these advisers and professionals, but all of these concepts orbit around the belief in emphasizing process over the idea that we’re going to find someone with the answers. When we are hiring, doing this requires us to have a clear-eyed view of the part of our process which we believe is truly value additive, and for which aspect of that process this individual would be responsible. When we are selecting a fund manager or adviser to work with, we must first develop a clear (or as clear as it is really possible to be in this muddy mess of markets) mental model of what it is about their process that should theoretically be capable of producing better outcomes. Our diligence questions then become less about ascertaining just how blindingly brilliant and knowledgeable they are, and more about judging whether they have the intellectual and temperamental traits necessary to execute that process.

The alternative is to be stuck with the constant disappointment of Medium Talent.

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Locusts’ Lament

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After publishing a few In Brief pieces featuring Quid-based narrative maps, we received a number of emails from subscribers asking us for analysis on other topics. 

For those who have read prior notes, you will know that what I usually find most interesting are areas in which otherwise similar topics or words engender very different sentiment and narratives, or in which different universes of authors, commenters and missionaries conjure up different narratives tailored to produce separate responses from distinct audiences. When one long-time reader expressed curiosity about narratives around private equity, I was intrigued. Its results surprised me. But it wasn’t until I checked it against a comparable topic that I found the narrative dimension I really wanted to explore.

First, let’s take a look at the narrative map – as usual, with major cluster names joyfully designated by me with both flippancy and bias – for private equity in 2018.

Like the historical treatment of the big tech stocks in media I highlighted last week, media treatment of private equity in 2018 has been glowing. Of the more than 3,100 news stories referencing private equity this year, the positive-to-negative sentiment ratio was nearly 16-to-1. What is more interesting, perhaps, is that a huge number of these stories are using very similar language, terminology and structure. Shown graphically, you see this as the almost non-existent distance between the various clusters. The stories about what allocators are doing are frequently also about dry powder, and frequently also about operational improvements and valuations. In rare cases, they spare a moment to reference the loss of generational businesses, factories, storefronts, high street shopping districts and jobs.

You would be forgiven – especially after the big tech piece – to question whether my priors about the infrequency of this kind of sentiment about financial topics are inaccurate. So let me show you another narrative map. This time? Hedge funds. Same period. Same sources.

Blech.

First, let’s talk about the sentiment. Remember how the ratio of positive-to-negative for private equity was nearly 16-to-1? For hedge fund stories, that ratio is about 0.3-to-1. In other words, that’s a 3-to-1 ratio in favor of articles written with negative language, terminology and structure. To be clear, some of that is going to be picked up in periods of bad performance just by factually representing that performance. But interestingly for 2018, hedge fund performance has not been especially bad relative to traditional assets or other alternatives. In fact, some hedge funds are having a decent year.

More importantly, the negative sentiment pervades the stories that cover hedge funds on just about every topic. The same glowing discussions of operational improvements by private equity are all about the uncomfortable language of shareholder activism when it comes to hedge funds. Basically the only clusters with non-toxic sentiment are (1) excited discussion of cryptocurrency fund launches and (2) exposés into how difficult it is to get hedge fund jobs.

Fascinatingly, as you see from the relatively distinct clusters, there isn’t a recurring narrative. Nothing that really creates strong links between all these articles, besides the idea that hedge funds are bad. It is simply a topic about which common knowledge is so strong that just about any pot shot will land. There’s no need for any art – just mail it in. Hedge funds are the range pickers at any driving range in America – an irresistible target, and one for which the attacker is unlikely to ever get anything more than the most perfunctory tsking from another golfer.

You won’t find me or Ben arguing that there isn’t truth in some of the stories. We’re on record, for example, opining that the most positively selected trait for hedge fund PM success is probably sociopathy. But the idea that every activist PM is Gordon Gekko and every MD at a buyout shop is Mother Theresa is pure narrative.

Ultimately, however, this is what the lazy, complacent cartoon formed around a view that has been correct for a very long time looks like. Lest we let all this discussion of narratives get in the way of the facts, let’s recall that hedge funds have had a very bad run of performance in almost every category in comparison to nearly any other alternative strategy or traditional asset class. On an absolute and on a risk-adjusted basis. Private equity has performed much better, and because it is usually treated as an either/or with hedge funds by financial and broad media who don’t really understand the very different roles they play in portfolios, some measure of difference in treatment is appropriate.

But there are still some lessons to be gained here:

  • Hedge fund managers: Start playing some metagame again, for God’s sake. Aren’t half of you supposed to be WSOP headliners?
  • Private equity fund managers: Yes, you’re very smart. Everybody says so. But if you care about the long-term integrity of your franchise and your investments, be especially cautious about believing your own bullshit right now.
  • Allocators to alternatives: I would be obsessively focused on finding hedge fund managers with process that has been resilient to the last 10 years, even if it hasn’t worked, and on private equity managers with humility and introspection about the sources of their success over the last 10 years.
  • Everyone: I would be cautious of consultants or advisers whom you observe painting either strategy with a broad brush today. If someone is pushing private equity to you aggressively as a panacea, or seems to constantly, strangely bring up vague criticisms of hedge funds, you’ve probably found the easy mark the missionaries were looking for. That is usually a good sign that this consultant or adviser is not the guy or gal YOU are looking for.

If you’ve got other topics you’d like us to examine under this lens, be sure to drop them into the comment section here.

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When Good Words Go Bad

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More than four years ago – when Epsilon Theory was still young – Ben wrote a marvelous note that discussed the importance of the meaning of words. Called The Name of the Rose (after the movie, the book and the Shakespearean reference, in that order, I think), Ben’s piece remains a must-read. It is the origin essay of our repeated encouragement to call things by their proper name.

Ben’s essay was also an early call to Clear Eyes and Full Hearts. Pursue with full hearts, he exhorts, communication with one another at the lowest possible level of abstraction. Walk with clear eyes, he cautions, knowing that those we encounter may communicate in heavily abstracted language, desiring to influence us to act against our best interests.

The complicating factor is that words also change meaning for innocent reasons. It’s something linguists call semantic shift. I don’t think it’s fair to ascribe ill intent to anyone for the fact that the last person who legitimately felt awe when he said awesome or awful was decades ago. We write about narrative, and so you, dear reader, should know that we are probably a bit wired to commit Type 1 errors on this topic. We are prone to occasionally see narrative and intent behind natural shifts in meaning. Mea culpa.

Even so, it can still be interesting to observe how words align with differences and changes in narratives among different participants in social, political and economic dialogue. For example, I’ve noticed anecdotally that the implication attached to a couple of words – acronyms, actually – seems to have changed a bit over the last year. So I took a closer look at it, and I think it’s true:

FANG and FAANG appear to be transitioning into pejorative terms.

Here’s why I think so.

First, a couple of Quid-based narrative maps. Each of these maps shows articles which referred to each of Facebook, Amazon, Netflix and Google, but did not use the term FANG or the Apple-inclusive FAANG. The map on the left is from all of 2017, and the chart on the right is since June of this year. The topics and their connectivity have changed. For one, these articles aren’t talking nearly as much about privacy, our trust in these companies or their reputation. Their sentiment, however, has remained very positive, and has even improved slightly. For every such article in 2017, there were five scored with positive sentiment for each negative one. In Q2 2018, that number was five-and-a-half.

Not much there.

Now take a look at the articles over the same periods which did use the terms FANG or FAANG. Like with the Fang-less group, we observe some shift in the major topics. In particular, Q2’s articles were far more likely than either the fang-less articles OR 2017 to start linking the concepts of privacy, reputation, valuation and what was going on in markets. More importantly, the sentiment of these articles declined by a lot. Articles referencing FANG/FAANG were just under twice as likely to be positive as negative in 2017. In the more recent period, more articles were negative than positive.

We have to acknowledge the obvious chicken-and-egg question here. Does the inclusion of the word FANG/FAANG in an article simply set it off as a piece that is likely to be from a markets-related publisher? Sure, although recall that the first set are articles that must reference ALL of the members of the group in the same article, so there is more overlap in sources than you might think. Does a bias toward markets-focused publishers mean that the negative sentiment shift is mostly representative of those articles covering weaker market performance of these stocks more than articles that are more generally about the companies and their products? In part, although it is worth noting that the ratio doesn’t change if you exclude the October stub period. More importantly, we don’t just observe that negative sentiment shift within stories about markets. The shift is taking place in articles about content, streaming and privacy. The shift is taking place in articles about the outlook for these companies that don’t really reference market activity.

What does all this mean?

  • I don’t think there’s enough to say it means that there’s a negative general narrative forming around the big tech companies.
  • I do think it is interesting to observe that as broader media seem to be developing fatigue and drifting away from any narrative about these companies that is linked to privacy, anti-trust and regulation, market-related news seems to be much more frequently integrating these concepts into the stories they are telling about price, valuation and market activity.
  • I do think it’s worth observing that FANG and FAANG have shifted to terms with negative meaning, even (in my opinion) beyond their relationship to market activity.
  • I don’t know if that’s part of bias or intent by any party to promote a narrative.
  • I do think that I would be asking “Why am I reading this NOW?” when I saw these terms used for the time being.
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Why Am I Reading This NOW? 10/12/2018 Edition

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In the spirit of Ben’s In Brief from last Sunday – Why Am I Reading This NOW? – I thought I would share a few others that popped up in my daily news routine today.

Uber CEO pulls out of Saudi conference after journalist’s disappearance – CNN – 10/12/2018

Richard Branson pulls out of $1bn investment talks with Saudi Arabia over missing journalist” – Independent – 10/12/2018

Report: Turkey has proof showing Saudi journalist Kashoggi was killed – CNBC – 10/12/2018

Silicon Valley’s Saudi Arabia Problem – NY Times (Opinion) – 10/12/2018

This story has been percolating a bit, and for good reason. Some of the implications of this situation are positively vile, and there’s no indication that any of this is ‘fake news.’ It is, frankly, far more encouraging than discouraging that prominent personalities and leaders are starting to take a stand on this kind of behavior from S.A. But if you’ve been paying any kind of attention to the Arabian Peninsula over the last few decades, shock and surprise at the murder of a journalist are, shall we say, odd reactions, if long overdue. So why am I reading this NOW?

Behind Market Turmoil, Potentially Good News” – WSJ – 10/12/2018
Interest rates are far below historical definitions of normal. Optimistic analysts believe the economy could have years left to run, and that the stock market selloff will prove to be a temporary bout of indigestion.

“Sector Focus” section of Barrons.com (10/12/2018)

There’s nothing wrong with the sentiment or content in the WSJ piece or the Barron’s section here. Most sell-offs do prove to be temporary. As a rule, most economic environments DO have years left to run. But announcing these truisms as ‘good news’ above the fold on the web edition? And sure, Delta hanging in there is an interesting story, and…yeah, I guess things could obviously be a lot worse. But why am I reading this NOW?

“Treasury Secretary Mnuchin describes Wall Street’s 2-Day plunge as a ‘natural correction:’ economic fundamentals strong” – Lead story on CNBC.com, Banner Headline on CNBC.com, Chyron on CNBC – 10/12/2018

I won’t insult your intelligence by even posing the question, y’all. They are clearly just interested in making sure you didn’t miss this important…news.

FOX News First Alert: Kanye-Trump meeting drives Hollywood crazy” – Fox News – 10/12/2018        

Analysis: Why Kanye’s lunch with Trump was a disaster” – CNN – 10/12/2018

“T.I. says his patience with Kanye is dead and gone” – CNN – 10/12/2018

Sometimes the question is ‘Why am I reading this at all?’

How the Red Sox Eliminated the Yankees, Inning by Inning” – NY Times – 10/10/2018

Why I am reading this NOW? Because the Yankees stink on ice. Thanks, Boston – shoot it, Houston Texas, go Astros!

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Complacency and Concern in Robo-Land

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Both Ben and I have had a lot of conversations about robo-advisors lately. I wrote an ET In Brief piece a few days ago to discuss some of my own thoughts about Vanguard moving into the periphery of the space. Robos have also come up in discussions with early-stage and VC investors, individual high net worth investors, traditional competitors and staff from the robo-advisors themselves.

The sentiment I’ve gotten from these discussions? Concern.

In some cases, that’s exactly what you’d expect. Traditional wirehouses and RIAs obviously dislike the model, because even if it isn’t directly competing away all that much business, it is starting to influence margins. But among fintech investors and company principals we have spoken to, the level of concern is similar, even if the issues are different. I am hearing about painful customer acquisition costs, rapidly accelerating competition eroding whatever margins there might have been, and a general sense of fear about what a real downturn in equity markets – if such a thing ever happens again – would do to a client base whose stickiness has yet to be proven.

Maybe I’m wrong, and maybe I’m projecting, but I haven’t had a positive conversation about robo-advisors with anyone in months.

So I thought it would be interesting to run the topic through Quid’s natural language processing engine, as Ben and I have been known to do from time to time. It clusters news stories from a wide range of sources around general themes based on various measures of similarity, links them to other nodes, and then qualifies the language to assign sentiment.

Below is the Quid map for Q2 and the beginning of October 2018 for robo-advisors. The boxed categories are mine.

My first observation is that when the financial and general media cover robo-advisors, the stories they tell cluster around one of two distinct Narratives:

  1. Robo-advisors are an exciting part of a machine-learning and AI-fueled set of innovations, including blockchain applications, that will revolutionize banking (the 3 clusters on the right).
  2. Robo-advisors are forever changing how financial services companies marry product, technology and advice (the 3 clusters on the left).

The only strong topical link between these two similar but clearly distinct Narratives? Millennials. C’mon.

My second observation, and probably the more important, is that the news treatment of robo-advisors isn’t just positive. It is incandescent. Of all the stories written, Quid’s engine categorizes fewer than 3% as carrying generally negative sentiment. That is very, very unusual for anything relating to financial services. In fact, I’m not really sure that I’ve ever seen it before.

I don’t have a strong take from this, other than to say that topics where different sources have vastly different perspectives tend to be the most interesting. It may also simply be the case that my anecdotal evidence is exactly that – just anecdotal, and not at all representative.

But I don’t think so.

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Et in Arcadia ego

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“And I said: Don’t you know that he said I will foller ye always even unto the end of the road…Neighbor, you caint get shed of him”

– Blood Meridian, by Cormac McCarthy

And rear a tomb, and write thereon this verse:

‘I, Daphnis in the woods, from hence in fame

Am to the stars exalted, guardian once

Of a fair flock, myself more fair than they.’

– Eclogues, No. V, by Virgil

There is a field at the end of a lane in Tennessee that sits long abandoned. A rusting livestock gate is held fast to the fence by heavy gauge wire, twisted by hand to keep it from swinging open. It may be that a caretaker once allowed sheep to graze here to keep the brambly bushes at bay. They have been absent for some time.

The name of the lane is Caldwell Cemetery Road. At its end is a graveyard of graveyards, a field of broken monuments and faded inscriptions set into soft Tennessee limestone. There are perhaps a dozen raised tombs besides. One hopes they are architectural and not sepulchral, because most are now little more than broken lean-tos, exposed on at least one side to the world and the elements. Far to the back of the burial ground, through tall weeds and bushes, a broken headstone lies on the grass. Rev. W. G. Guinn, it reads, born August 15, 1795. He was my fourth great-grandfather.

His son, one of the last of his short dozen children, died at 41. A few years later in 1892, that son’s wife dragged their seven children between the ages of 7 and 21 to Texas, where they became tenant farmers. It was a steep fall. You see, the Rev. William Guinn was an Important Man.

You would not go very wrong to say that the Methodist minister in the deep antebellum south was the most important man in town. While the Calvinists have since given way to the Baptists there, the swelling masses of pioneers and settlers who braved the Great Wagon Road through the Great Appalachian Valley of Virginia were, as a rule, Scots-Irish. Which meant that they were Presbyterian. Which meant that they were one camp meeting and a preacher on a horse away from being Methodists.

The preacher in a small town officiated marriages. He was the trusted arbiter of disputes. He was a voice of civil authority in letters to far-off politicians and governments. He blessed new homesites and new businesses. His church on Sunday would house the most concentrated version of a dispersed community. His home often served as the orphanage, homeless shelter and welfare office. All of this was true for the Rev. Guinn, beyond which he served as postmaster, justice of the peace and in many other roles over the course of his life. He may not have been the richest man in town. He may have been the most important.

And now his grave is forgotten and his monument broken, the fatal cracks no doubt caused by the fall of some ancient tree themselves already smoothed by rains and time. How long did it take for people to forget that they had even forgotten him? One generation? Two? Thirty years? Fifty?

There is a phrase I hear from time to time among investors and allocators: ‘our time horizon is infinite’. It is a phrase used to justify performance over other-than-infinite horizons, often very fairly. It is a belief used to justify illiquidity in investments, often very fairly. It is an expression sprinkled casually over all manner of short-termism and knee-jerk responses from boards, committees, bosses and constituencies. But within that truth, there is another that we should remember:

Your time horizon is not infinite. Your institution’s time horizon is not infinite.

To those who would roll their eyes and respond, “It might as well be. For all intents and purposes, it is effectively infinite,” please accept this amendment:

Your time horizon is not effectively infinite. Your institution’s time horizon is not effectively infinite.

‘Et in Arcadia ego’ is a stylization of a theme from Virgil’s Eclogues: even in Arcadia, there am I. The I, my friends, is death. Even in paradise, death is coming, and death is there. Even for our great institutions, for our university endowments and our great charitable foundations, death will come. This isn’t fatalistic. It isn’t morbid. It isn’t bearish. It can be bullish! It can be optimistic! Like a fire through the floor of a stagnant forest, the death that comes for these institutions may be their reformation into something newer and better. It may be great or small changes in the way society is ordered. It may be a change in their mission brought about by its achievement! One day we will conquer the diseases foundations have been established to research, and even that will be a death of a kind.

There are other deaths we cannot avoid. Smaller ones. Changes in governance. Changes in law. Changes in tax schemes. Changes in securities law and regulation. Changes in student loan markets. Changes in philanthropy and in centers of wealth. These are all a death for us as investors, because they may change what we ought to be doing, and because they may invalidate the strategies we employed before. Amid those deaths, we have one governing rule: 

Your time horizon is the shortest period over which you may be forced by circumstance, behavior, prudence, constituencies, governments or outside forces to sell what you own.

This may still be a very long time! And so it may be the case that this reality should have no influence on our portfolios. But it must have an influence on our frameworks, our process and our risk management. It should color our strategic asset allocation reviews, and it should be part of the language of our engagement with oversight boards and other constituencies.

If I may be permitted a post-script, it is my personal belief that it should have one more effect: Our great universities and grand foundations should be spending more of those endowments to better execute their missions today. A lot more. Et in Arcadia, ego.

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Punting and the Tyranny of Risk Memes

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Last Sunday, with just under six minutes remaining on the clock in overtime, the Dallas Cowboys faced a 4th down and 1 from their opponent’s 42-yard line. Jason Garrett, the Dallas coach, sent out his punting unit. In a matter of minutes, they would go on to lose to their in-state rival Houston Texans.

It was a monumentally and objectively bad coaching decision. It would have been a bad decision for any team in the league. It was an even worse decision for the Cowboys, a team with a quarterback/running back combination with a historical success rate of 94.7% converting 4th and 1 situations. As ESPN pointed out later that evening, that is a marginally higher success rate than the rate at which kickers have converted extra points since they were moved to the 15-yard line. If you are not a fan of American football, the extra point is typically regarded as a mere formality – an early chance to visit the restroom.

Because of their location on the field, the punt’s value was also lower. A punt into the end zone would cause a touchback and yield only 22 yards of field position. Because of this risk, punters in this situation are often accordingly more conservative, targeting higher punts that terminate around the 10-15 yard line to avoid the touchback. For the Cowboys on this day, a well-executed kick still netted only 32 yards of field position. In exchange for those 32 yards of field position, the coach of the Dallas Cowboys rejected a play which – for this team – had the success rate of an extra point, and which would have provided multiple additional opportunities to advance into scoring range. You could spend hours mining historical scenarios, splits and advanced statistics for some kind of support for the decision. You won’t find it.

The press conference that follows is inevitable and all too easy to predict. The coach will explain away the decision with the sort of milquetoast response we simultaneously demand and bemoan from entertainers. You know you will hear a variant of ‘We believed in our defense’. It’s a nonsense statement, of course, since the defense could just as easily make a stop at the 42-yard line if they failed to convert. You will hear an appeal to experience and being ‘on-the-ground.’ You will hear a plea that ‘every situation is different’ and a vague allusion to what was ‘unique about that situation’. But that isn’t the point. The point, like with so many memes and narratives, is to make us sit down and shut up. The meme used to produce this response was field position!

The coach who summons this meme wants to be seen as wise – a sage, prudent leader. And it works. Every time. No one ever got fired for punting for field position! Oh sure, the media and fans will criticize him for 3-4 days. It will get mentioned the following Sunday, and then never again.

Risk-related memes are everywhere in the investment industry, too. Like the memes in football, most are built on sage-sounding ideas.

The risk management! meme is probably the most popular. It shuts down discussion by subtly implying that others in the conversation are not sufficiently focused on prudently managing risk. If you want to get someone to stop arguing with you in an investment discussion, just imply that they aren’t being prudent. One senior investor at a prior stop in my career loved responding to well-considered investment recommendations from younger investors with some variant of, ‘It’s not about the doing all the good deals, but avoiding all the bad ones.’  It’s not that there isn’t some shred of truth in this. It’s that everyone in the room who hears this knows that the discussion is over, ended by someone who wasn’t prepared to discuss the actual merits of the investment.

Most others are built around the client’s best interest! meme. Want to get a sharp, ethical professional on your team to sit down and shut up? Imply he or she isn’t considering what is best for the client. It doesn’t have to be true. Once this meme enters the room, other discussions stop. Other considerations end. Don’t you care about the client? 

These memes are so powerful because our true obligations to prudently manage risks and act in clients’ best interests are so sacred. Like any other meme or narrative, they force us to take a side. To signal.

But make no mistake. When we take score – and we do – the institutions that allow executives and PMs to use risk memes to get staff to sit down and shut up will be the losers.

Every time. 

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Mailbag: Deadly. Holy. Rough. Immediate.

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A challenging question from reader David S. He quotes from and responds to an excerpt from Deadly. Holy. Rough. Immediate.

“Over very long periods, you will generally be paid based on the risks an average investor (including all of his liquidity sensitivities, his investment horizons, etc.) would be taking if he made that investment.” (from Deadly. Holy. Rough. Immediate.)

Isn’t this idea built on risk spreads, building up from the risk-free rate?  But in a world where central banks set risk-free rates for other reasons, is the concept of a risk-free rate even coherent?  In other words, does anyone really think Italian government debt is safer than U.S. government debt right now?

Again, it’s a useless theoretical question.  I think risk spreads work; will continue to work; and, even if I felt otherwise, I wouldn’t be foolish enough to try to predict the timing.  But how solid is the theoretical foundation on this one?

Over a sufficiently long horizon, I’d say it’s about a 6 out of 10 (which is about as good as it gets in this game).

There are probably more finance papers on the topic of the relationship between risk and return, or premia for the fancy among us, than any other. Many of them are purely empirical (e.g. what are the long-term Sharpe ratios of different asset classes over various horizons?). Many are purely theoretical (e.g. how should markets with mostly rational actors function to price risk?). Some are a bit of both (e.g. how much of variability in stock prices is driven by changes in expectations vs. changes in discount rates?). Even as a Hayekian who thinks that prices separate us from Communists and the animals, I’m kind of with you. To practitioners, the explanations and frameworks offered by these papers are often unsatisfying.

Over many very long horizons, the data will show you that the Sharpe ratios of major asset classes are similar. In other words, the relationship between the variability in price and long-term returns above a risk-free rate appears to be pretty consistent across assets. You’ll hear this factoid a lot in defense of the idea that long-term risk-adjusted returns of assets should be comparable if investors are at all rational. But this is one of those cases where I think we’ve got to be a little bit skeptical of a surprisingly geometric cow. One exaggerated example?

Commodities.

Their long-run Sharpe ratio is not far off from those of financial assets (this obviously depends on horizon – you’ve, uh, gotta go back for this one). But any sort of attempt to build a theory about why our return expectations for commodities should have anything to do with how volatile their prices are ends up looking like a dog chasing its tail. The practitioner sees this, because he sees how much of a commodity’s price changes are directly driven by non-economic actors, substitutability, seasonality, weather, extraction costs, storage costs, hedgers, etc. Plus, y’know, supply and demand.

This is part of the reason why many practitioners do NOT treat commodities – and this includes things like Bitcoin and other cryptocurrencies, by the way – as investable asset classes. We may have some expectation of their rise, but it is hard to determine in any meaningful theoretical way why we should expect to be paid with returns in any proportion to the risks we are taking on by owning them. Incidentally, I don’t think you need to believe there is a commodity risk premium to justify holding commodities in a portfolio. I would say the same thing about cryptocurrencies if I believed there was a state of the world in which they wouldn’t be treated as a highly correlated speculative asset in any kind of sell-off event for risky assets.

This isn’t just a commodity phenomenon. To David’s point, I think it is obvious that there is a portion of the risk we take in owning financial assets – stocks, bonds and other claims on cash flows – that we probably ought not to expect to be paid for either, or at least for which the smooth, ‘rational actor’ transmission mechanism between risk and the price demanded for it is perhaps not-so-smooth. Low-vol phenomenon, anyone? A half dozen other premia? But prices for financial assets are also hilariously overdetermined. That means that if we line up all the things that influence those prices, we will explain them many times over. It’s a topic that occupies the entire lives and careers of people smarter and more dedicated to the subject than I am, so I hesitate to give it the short shrift I am here. But in the interest of responding somewhat substantively, let me tell you in short what I think:

  • I think that the risk differences caused by placement in capital structure and leverage should have a pretty strong long-term relationship with return, because they describe an actual cash flow waterfall connected to economic reality. This is why I feel confident that I’m going to be paid some spread – even if it isn’t completely proportionate – for risks I take by owning risky financial assets.
  • I think that the risk differences caused by country and currency have a weaker relationship with return. You’ll be able to find examples where this isn’t true, but in general, capital markets still exhibit very local characteristics. Assuming that the differences in realized risk between markets in two countries will give us reliable information about how participants in those markets are pricing their relative risk may be pretty unrealistic.

In practice, I think that the first bullet alone is powerful enough to make it a foundational principle of portfolio construction. Perhaps the most important. I also think it is strong enough that it matters even if you think that a significant portion of price variability and movement is driven by abstraction, game-playing and narrative.

P.S. Folks, if you’re thinking about writing me that volatility isn’t risk, please don’t.

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Surprisingly Geometric

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“For pigs, the ideal was a football shape. Cows were rectangular, and sheep tended towards oblong.” – Ron Broglio, as told to Anne Ewbank

I came across a delightful piece in the marvelous Atlas Obscura this weekend (h/t to a similarly delightful thread on this topic from @ZeenaStarbuck). Written by Anne Ewbank back in 2017, the piece is all about livestock – and livestock art – in late 18th and early 19th Century England. It’s also a charming illustration of Narrative at work.

You see, the ultimate status symbol to a gentleman farmer in the early 19th Century wasn’t a framed photo in the subject’s 54th Street office of him sitting, wearing a John Deere vest and John Deere hat, on a perfectly clean John Deere tractor that is three or four series too large for his property. It was a painting of his cow. And in a perfect world, this painting would tell the story of a very large, very rectangular, surprisingly geometric cow. An absolute unit, if I may use the expression.

The prevalence of this art form raises a question: in what proportions is fat, rectangular cow art the result of (1) 19th century cows being more muscular and more rectangular, (2) 19th century dilettante farmers instructing artists to display exaggerated muscles and geometry, and/or (3) 19th century British artists being a bit shit?

It’s hard to know for sure. But the unrealistic body image foisted on this poor sheep, made manifest in a couple body parts I’ll leave you to identify, leads me to believe that our second reason above probably bears the lion’s share of responsibility. It was mostly story-telling.

But the things that were happening to cows, sheep and other increasingly geometric animals in the real world still played an important role in the storytelling process. Incremental improvements in certain desirable (I guess?) features through selective breeding permitted ever more fantastical imaginings of just where a sheep might develop a bulging new fat deposit. Those fantasies, in turn, were used as models in the breeding and improving of yet more animals. This bears a lot of similarity to how Ben characterizes bull markets as “climbing a wall of worry.” It’s an expression which describes how investors create artificial hurdles to pretend that they are performing critical analysis, but then construct ever more ridiculous extrapolations when those largely meaningless hurdles are miraculously scaled. Yes, but have you seen their growth in pro forma adjusted EBITDA per pixel?

In other words, beware the sheep with legs too skinny to support its body weight, and beware small truths used in service of big lies.

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The Power of ‘AND’, and the Walmartization of Advice

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Growing up in the beautiful swamp that is Brazoria County, Texas, you learned quickly that you took entertainment where you could get it. I’m not saying that it was boring, but having fun did require a certain amount of creativity. Some of the kids, by which I mean the ones who weren’t the drum major of the band and a member of the madrigal singing ensemble – y’know, cool kids – were rumored to collect in the fields owned by absentee cattle ranchers for pasture parties. I did not get invited to these parties. I’m not convinced they really existed.

The rest of us? Yeah, we hung out at the mall. Oh. Late Millennial readers, a ‘mall’ was a large structure which housed a variety of different stores, pretzel restaurants and a kiosk that offered, but to my knowledge never actually sold, small bits of ice cream flash frozen with liquid nitrogen.  Gen Z readers, a ‘store’ is like Amazon, but…anyway, the problem was that around 9PM, the mall closed. But there was a place, a magical place, which never closed. A place where the small town Texas kids who didn’t drink and were too awkward for words could go at any hour to have slightly-above-replacement levels of fun.

Walmart.

I don’t have to defend myself to you, and I won’t. I have an affection for Walmart. Even beyond my affection for the place, I think it has probably done more than any one other company to improve the quality of life of the everyday American. Walmart, along with generally free trade, have allowed the average lower and middle class American to enjoy technology, home amenities, foods and conveniences that we could only have dreamt of 50 years ago.

If you’ve got a “yeah, but” forming in your head, save it. I know what Walmart has done to many small businesses that offered a valuable niche service. God, I desperately miss having a small town butcher. I also know that a job at Walmart probably doesn’t offer the quality of life that most people imagined for themselves. If we’re going to survive the widening gyre, however, there’s a trick we have to learn.

We’ve got to learn to say ANDa heck of a lot more.

Yes, Walmart has improved the tangible quality of life for hundreds of millions AND I’m not sure any of that made us happier AND I’m not completely sure how to balance those things, which is why I’d prefer to let the market do so. We must be able to hold multiple truths in our head at once. The second ‘BUT’ and ‘OR’ escape our lips, we implicitly insert beliefs about the relationship between those facts, and about the weighing of those facts. We will have to do that at some point if we’re ever going to come to conclusions about things, but when we’re exploring questions – and when we are engaging with people about ideas – we ought to stick with ‘AND’.

So here are a few finance ‘ANDS’ for you: I think Vanguard may have done more for the average person than any financial institution in the last several hundred years AND I think that their aggressive move into financial advice will be a net good AND I think that it will lead to harm for many individual investors.

If you don’t know what I’m talking about, it’s this: Vanguard believes the next step in making investing work for normal people is making financial planning and advice less expensive. This is self-evidently true. The less investors pay, the more they keep. But it’s a bit more complicated than that.

There is a big difference between a fund manager and your financial adviser. For the average investor, the specific stocks and funds in a portfolio really don’t – and shouldn’t – matter that much. John Bogle realized this and changed the world. On the other hand, for the average investor, the decisions made with a financial planner and adviser matter a LOT.

Does that mean you should pay a lot for them? No, not necessarily. A lot of the decisions that matter a great deal have perfectly reasonable answers that are generalizable – by which I mean applicable to a lot of people based on shared traits – with just a little bit of information about the client. How much risk to take. What the diversification should look like. How liquid the portfolio should be. How to adjust allocations over time to reflect changing life circumstances. If someone tells you that you need to pay a lot for their advice on these topics, they are misleading you.

But here’s the thing: none of those topics are why you hire a financial adviser. You hire a financial adviser to keep you from doing something stupid. You hire a financial adviser to tell you the truth about that stock you’re thinking about buying with a huge chunk of your assets that they don’t manage. You hire a financial adviser to tell you ‘No’ when you call in to ‘place an order’ to a discretionary account that doesn’t take orders but the industry still kind of allows to take orders. You hire a financial adviser to keep you from endlessly tweaking to find the next big thing. You hire a financial adviser to keep you sane, and to keep you from firing them so that you can do something stupid, like sell, generate capital gains and go to cash after a 30% drawdown in the stock market.

Vanguard, Schwab, and many of the others are wisely expanding their advice models to include humans capable of doing these things. That’s a good thing. Not because the humans will add any valuable investment insight (sorry), but because most of us need both technological and human algorithms to manage our behavior. A lot of people will find that person at one of those institutions – which is great! Do it! AND I worry that a lot of investors are going to be drawn to these robo-plus-a-call-center solutions instead of pursuing a relationship with whichever adviser is going to keep them from hitting sell, sell, sell or buy, buy, buy at exactly the wrong time, even if it costs 30 or 40bps more.

For better or worse, we are entering the Walmartization of Advice. I know that sounds bad, but that’s only because you don’t like Walmart as much as I do. I say it with equal parts admiration and concern. 

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Deadly. Holy. Rough. Immediate.

Stephen Fry and Mark Rylance engaging in Immediate Theatre
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Baron Von Swieten: Mozart, music is not the issue here.  No one doubts your talent.  It is your judgment of literature that’s in question. Even with the politics taken out, this thing would still remain a vulgar farce.  Why waste your spirit on such rubbish?  Surely you can choose more elevated themes?

Mozart: Elevated?  What does that mean?  Elevated!  The only thing a man should elevate is – oh, excuse me.  I’m sorry.  I’m stupid.  But I am fed up to the teeth with elevated things!  Old dead legends!  How can we go on forever writing about gods and legends?

Von Swieten: Because they do.  They go on forever – at least what they represent.  The eternal in us, not the ephemeral. Opera is here to ennoble us.  You and me, just as much as His Majesty.

Kapellmeister Bonno: Bello!  Bello, Barone.  Veramente.

Mozart: Oh, bello, bello, bello!  Come on now, be honest.  Wouldn’t you all rather listen to your hairdressers than Hercules?  Or Horatius?  Or Orpheus?  All those old bores! People so lofty they sound as if they shit marble!

— Amadeus (1984)

A man walks across this empty space whilst someone else is watching him, and this is all that is needed for an act of theatre to be engaged.

— The Empty Space, by Peter Brook (1968)

We were going to send you all a survey, you know.

One month ago, Ben and I were feverishly preparing for next week’s launch. We had an exchange over email about the details of a survey we were going to include with Ben’s essay from early September. The idea was to ask our subscribers what they wanted from a subscription to Epsilon Theory. With that survey, we would also include a request for some demographic information. Income, gender, region, questions about what kinds of decisions you make at your place of employment. Things that would help us sell better, more valuable ads on the website.

Honestly, we already had a pretty good idea what we wanted to deliver through our subscriptions. What we were after was the data. We still kind of want it. We’re still probably going to ask for it some day. But there was an epiphany moment for both of us, I think, when we realized that if we were going to do that kind of thing, we should do it by telling our readers exactly what we were asking for and why. Instead, we were working up some thinly veiled artifice, creating some cartoon in which we’d leverage our goodwill to make our friends pretend they didn’t know what we were doing. What a contradiction it would have been, to launch our vision to help investors and citizens cut through abstractions and to become more honest participants in financial and political markets, by sending out a survey requesting a bunch of personal information under the auspices of interest in the things you care about.

Ben’s fond of quoting Whitman to those who call him out for contradicting what he has written in prior pieces – “Very well then I contradict myself. I am large, I contain multitudes.” We do contain multitudes. You contain multitudes. It is inevitable, when we write so much about the perils of abstraction, that we should begin to regard it as an evil.  It isn’t. Memes are self-sustaining ideas that live in the human brain, and they reflect both the good and bad about us. We celebrate Narrative when it is marshaled for positive change. We respect it when it is cleverly applied. We fear it when it is used to stir up fear and division. We loathe it when it seeks to control and direct our lives through nudges under the guise of libertarian paternalism. Language is always an abstraction from some true meaning, or at least from true intent. Consider even my little confession about the survey – was my intent to tell you an honest story in good faith? Or were the words just a convenient mechanism to convey my true intent – that I wish you to see us as honest voices in a wilderness of conflicted Wall Street advice?

There are thousands upon thousands of books from thousands of authors over thousands of years discussing philosophy of language and meaning, from Socrates to Bertrand Russell. It’s not that we think we’ve discovered something new here. It’s that we think we’ve got something to say about how things that are new – always-on news, social media and the class-free global connectivity of the internet – allow each of us to conjure those primal forces to wield the kind of influence that Wittgenstein could never have dreamed of. To stoke the kind of belief in our company’s stock that could endure multiple CFO resignations, multiple SEC investigations and a bizarre public attempt at an MBO. To bring down tyrants and sexual abusers. To solidify our political tribe at the expense of national unity. To sell shoes. To sell football. To increase confidence in financial markets and the collective belief in the political will of authorities to prevent their decline.

For well-intentioned citizens, all this requires a great deal of us. It requires us to have clear eyes when others are leaning on Narrative abstractions to produce a response from us. It requires us to decide how to discern their intent. It requires us to be more mindful of our own ability to manipulate the judgments of others, and to hold ourselves accountable for our intent in doing so. It’s not the kind of thing that political science, business or economic programs really cover. That’s because this isn’t really about politics or economics.

There is, however, a field for which these questions have been the stock-in-trade for 2,500 years. Its lessons are invaluable to anyone who would navigate Narrative-driven political and financial markets. One of its finest books – and a short read, at that – is my first recommendation for anyone who is looking to understand management, communication and civics. The book is called The Empty Space. It’s about theatre.

Deadly Theatre

“Over the centuries the Orphic Rites turned into the Gala Performance – slowly and imperceptibly the wine was adulterated drop by drop.” – Peter Brook

Peter Brook’s 175-page masterpiece seeks to categorize and define the ways in which theatre – which he defines as ‘a man walking across an empty space whilst someone else is watching him’ – is performed. In all, Brook identifies four varieties of theatre: deadly, holy, rough and immediate. Each of them is a pitch-perfect description of the ways in which any performative use of language interacts with an audience, whether it’s a theatre troupe performing a play, a politician giving a policy speech or a CEO discussing earnings.

Brook’s definition of Deadly Theatre will be familiar to anyone who goes to see the theatre from time to time. Frankly, it would be familiar to anyone who has an idea in their head of what a play or opera looks like, because Deadly Theatre is by definition the Common Knowledge about what theatre is. Deadly Theatre is every heavily affected To Be or Not to Be speech. It is every spear-toting, blonde-braided Brünnhilde in an absurdly contoured half-breastplate. It is the understudy of the nth Broadway casting of Alexander Hamilton, watching YouTube videos of Lin-Manuel Miranda from a Crown Heights apartment, desperately trying to recreate the mix of charismatic bravado, ambition and self-consciousness audiences remember from the original character.

Deadly Theatre is a performance that is so deeply abstracted from its source material that it has become painfully, obviously artificial to anyone who is paying attention. A stylish disaster, it looks right, but feels wrong to even the most untrained eye. All that we call political correctness falls into this category. We remember what it is like to be offended. We remember, or think we remember someone telling us about what battles for social justice in the 60s and 70s felt like, or maybe we saw it in a documentary. Then we go through the motions, performing the rituals of offense as best we can remember them. Our friends play the roles of heroes rallying to the defense of the offended.

The parallels with demonstrations of patriotic correctness are no accident, for they are Deadly Theatre, too. We witnessed love of country and acts of service by statesmen and warriors in the past, and instead of studying and internalizing the source of their passions, we perform the outward rituals we remember. The flags. The speeches. The lapel pins. That Lee Greenwood song – you know, the one he wrote before he adapted it to “God Bless You, Canada” for profitable distribution in the Canadian market. Like political correctness, each individual’s actions may stem from good intentions, but empty ritual is still empty ritual.

As investors, once we start looking for it, we realize that Deadly Theatre is all around us. There is the fussy baroque opera of operational due diligence on fund managers. Oh, it’s a flurry of busy-looking activity – the checklists, the ‘process’, the consultant grades – when no manager hiring decision in 10 years has been influenced by this activity, outside of the results of references and background checks. And yet, we – or more accurately, our clients – would take offense at its absence.

There is the big, bombastic, pyrotechnics- and celebrity cameo-laden Broadway show, which is the consultant-led strategic asset allocation review conducted by every institutional asset owner in the world every five years or so. Here are 300 pages of research from our 150 Ivy League-trained analysts telling you why we’ve modified our 10-year assumption for “Emerging Markets” returns by 50 basis points. In the end, because we’ve also modified our volatility assumption and currency expectations, it all comes out as kind of a wash, so we’re not actually recommending any changes. But don’t you feel better, safer after this whole experience?

There is the complex pageantry of pre-Stanislavski Russian theatre that is sell-side stock research. It is produced with flourishes of language, and the patina of knowing expertise. It is consumed by those who say “they don’t use it” to clients and “I only use it to see what others are thinking” to peers, when the way buy-side analysts really consume it is to copy the assumptions into a spreadsheet model, read about the company for a few days, and think really hard about what kind of twist on a ‘key assumption’ sounds like it would appeal to the portfolio manager. Yet all of these forms must be observed.

And these forms don’t emerge out of nothing. They are imitations of something which was once new and real before it was replaced by convention. Some of us remember doing these things when they mattered, or we remember how some professor who did them once described them to us.

To the Citizen and to the truth-seeking investor, Deadly Theatre is moribund. Worthless. To be observed but rejected wherever it manifests. To be ruthlessly rooted out of our own behavior.

Holy Theatre

“A false symbol is soft and vague; a true symbol is hard and clear. When we say ‘symbolic’ we often mean something drearily obscure: a true symbol is specific, it is the only form a certain truth can take.” – Peter Brook

Holy Theatre is theatre in which those parts of life which escape our senses become manifest. In other words, it is the theatre of true memes, the heuristics and recognized patterns that exert irresistible influence on eusocial animals in a culture that has survived for millenia on the basis of those heuristics and recognized patterns.

It is also, as Brook writes, the true dream behind the debased ideals of the Deadly Theatre. Deadly Theatre succumbs to the belief that somewhere, someone has found out and defined how a play should be done, and that we ought to replicate it. Holy Theatre, on the other hand, recognizes that reproducing the words and motions of a magnificient play at a different place and time will not faithfully reproduce its meaning.

Most of what we call ‘Narrative’ in these pages is Deadly Theatre. It is useful to recognize it, and at times it may be necessary to exploit the behaviors it engenders, but it is a primary source of abstraction in our personal, political and professional lives. As Ben has written, however, memes are often the building blocks of Narrative. Our natural vulnerability to memes lays the groundwork for a Narrative’s spread. So it is that much of Narrative is Holy Theatre. Its informational content is contained in the feelings, emotions, attachments and aversions that it evokes, rather than the meaning of its words. It emphasizes Truth over truth, which makes it a dangerous weapon (for good or ill).

Like anything that we describe by saying “you know it when you see it”, Holy Theatre is hard to describe in words. Except for Ben, who wrote at length about it some weeks ago, in an essay called Notes from a Birmingham Museum:

What makes the museum so effective in communicating a difficult story well? Just that. They present it as a story, as a narrative. Not a cartoon story of Superheroes, although it’s impossible to avoid some degree of hagiography when it comes to this stuff, and not a cartoon story of Social Justice™, either, although here, too, it’s impossible to eliminate completely the heavy-handed nudging of the Smileyface State. No, it’s mostly a story of … people. Of the actual lives of actual people. It’s immersive and it’s real. It creates a compelling narrative arc, but not in a way that feels scripted or forced.

The Birmingham Museum is Holy Theatre. The Julius Caesar production Ben mentioned in Always Go to the Funeral was Holy Theatre. Yet Holy, in the sense we mean here, should not be universally understood to mean ‘good’ like it did in Ben’s note. Just as Holy Theatre may be comedy or tragedy, its manifestations in political and financial markets may be directed toward good or bad ends. George Bush standing on the mound at Yankee Stadium in a FDNY jacket to deliver the first pitch after 9/11 is Holy Theatre, but so is Hitler delivering the Nuremberg Address in 1938. Enemy! is a meme of Holy Theatre, a spell cast by good and evil men alike, and a key source of our present political division. The Hero! meme of Holy Theatre induces us to seek out those who hold themselves out saviors, some of whom truly are, but most of whom are not. The Wizard! meme stokes our passion for genius, for those capable of making deflation or SEC investigations into an MBO-by-Twitter go away with a few magic words.

To the Citizen and to the truth-seeking investor, Holy Theatre should be consumed with eyes wide open. Open to the beauty that only its deep connections with our nature are capable of invoking. Open to see the way in which others who would manipulate us would use it to further their own ends.

Rough Theatre

“They analyzed the sounds made by clarinets, flutes, violins, and found that each note contained a remarkably high proportion of plain noise: actual scraping, or the mixture of heavy breathing with wind on wood. From a purist point of view this was just dirt, but the composers soon found themselves compelled to make synthetic dirt – to ‘humanize’ their compositions.” – Peter Brook

While all theatre – and indeed, any interaction relying on language – is inherently performative and full of abstraction from true meaning, not all of it is grand and reliant on meme in the way that Deadly and Holy Theatre are. Much of theatre is a joy not because it meets some deep-seated intrinsic longing, but because it meets us where we really are. Physically, emotionally, plainly. Brook calls this Rough Theatre.

Its definition will vary by individual. To Brook, it is salt, sweat, noise, smell: the theatre that’s not in a theatre, the theatre on carts, on wagons, on trestles, audiences standing, drinking, sitting round tables. To me, Rough Theatre is a minor league baseball game. It is a marathon session of D&D. It is a midnight showing of Henry V at the New Globe in Southwark in the rain, teeth chattering with other patrons as Hal strides into the audience to clap hands on strangers’ shoulders and deliver a shouted St. Crispin’s Day speech. It’s a no-BS financial advisor boldly telling prospects that she has no idea where the market is going, and that any FA who tells you that they do is a liar. Anywhere the play is play.

The Rough Theatre is not Truth, but truth. The stories it tells can be direct, foul-mouthed and profane.  While it is still subject to the kind of silly exaggerations of Deadly Theatre, there is no malice or attempt to summon memes for some lofty purpose. There may still be abstractions in the performance, but they are of the kind that exist in all language. The aim is authenticity.

And sure, authenticity! itself can be a meme, like an ‘artisanally crafted’ turkey sandwich at a Panera store. But that’s not what I’m talking about here. When I say authentic, I am talking about performances which are delivered in a language, at a place, and at a time that serves the audience, and not the speaker. Rough Theatre in our social and political lives doesn’t really scale, because it is nearly impossible to speak authentically to a big, broad audience. In its native environment among small groups, it is honest advice freely given, without calculation about how it will serve our reputations or our metagame. It is bad news delivered swiftly. It is self-deprecation and lack of pretense.

To the Citizen and the truth-seeking Investor, Rough Theatre is a necessary part our language. Sometimes small-t truth from a trusted friend or adviser is the only thing that can dispel the fear, anger, overexuberance and other emotions conjured by a parade of pompous Truths from Missionaries.

Immediate Theatre

“In the Russian tradition of Stanislavsky, the actor says, ‘I will tell you a story about me.’ In the German tradition of Brecht, the actor says, ‘I will tell you a story about them.’ In the Vietnamese tradition, the actor says, ‘You and I will tell each other a story about all of us.’” – Le Hun

Theatre of the first three varieties has one universal trait: its performers have a meaning in mind before the curtain goes up. That meaning – even in Rough Theatre, seeking to avoid affectation – has been meticulously planned for months. Imagine, if you will, the preparation for a typical play: dramaturgs cut scripts to a director’s specificiations, but also based on their training and experience. Actors memorize their lines, practicing them alone before they later rehearse them with the other actors. Costume and set designers begin their work as well, attempting to reflect the director’s intent, but also their own vision and ingenuity. Director and choreographer set the blocking before a single actor steps on the stage.

Before the first performance, each component of such a production represents an abstracted version of a director’s abstracted vision of what words and instructions on a page written years ago might have meant to a very specific troupe of actors. But even more, each component is necessarily abstracted from the unknowable environment in which the play will be presented on one night or another. The fourth type of theatre, which Brook calls Immediate Theatre – is a response to this problem. Immediate Theatre is dynamic theatre – responsive to time, responsive to venue, and most importantly, responsive to the audience.

It is impossibly tricky to pull off. As any improvisational musician will tell you, your understanding of the underlying chord structure and rhythm of the music must be greater, not less, if you intend to make up the melody as you go. As any portfolio manager keen on making large, seemingly idiosyncratic bets will tell you, it takes more of an understanding of risk and interrelationships between positions to navigate that kind of strategy, not less. So it is that Immediate Theatre requires a near-perfect understanding of the source material, of the other actors, of the meaning embedded in the play, to be capable of responsiveness and adaptation to setting and time, much less to the audience. When this works together, it is magical, if ephemeral. A moment that cannot be recaptured.

In the practical, non-stage versions of the three other kinds of theatre we practice, we engage with society and other people with some objective in mind. Perhaps we wish for them to feel a certain way about us, to see us as kind, or intelligent or credible. Perhaps we wish for them and their influence to diminish. Perhaps we wish for them to select us, to do business with us, to hire us. Every aspect of these interactions is theatre, and in pursuing these objectives, in using language as abstractions of some ulterior intent, we perform a role to an audience. Sometimes that’s the way it has to be.

But there is a beauty to choosing to tell a story about all of us instead of a story about ourselves. That’s what Immediate Theatre is. That’s also what we mean by finding your pack – people whose aims you make part of your own, and whose intentions you trust implicitly. Maybe that pack is your family, your friends, your neighbors. If you’re a financial advisor or investor, I hope it includes your clients. If you become an ET subscriber when we outline how you can do that next week, I hope it includes some like minds you find in some of our interactive features. With these people, we can speak as directly as language allows without fear. We can put words to our intents, as best we are able, and trust that they will be heard.

Even outside of our narrow networks of trust and shared aims, there is still room for incorporating the authenticity of Rough Theatre and the dynamism of the Immediate. The citizen and the fiduciary can still reject the monologues of the Holy Theatre and theatrics of the Deadly in favor of a more direct objective in our performative use of language: to understand and to be understood.

It is our hope that Epsilon Theory can play a small role in keeping this ethic alive. In the meantime, Narrative – both Deadly and Holy – surrounds us, and we will continue to point it out where it exists. Celebrating it, when we think it serves some good purpose. Subjecting it to derision when it is a tool of manipulation and power. Indeed, this is the underlying truth in the multitudes contained in all of us and all our contradictions. It is why we write to be wise as serpents and harmless as doves. It is why we write to act boldly but hold loosely. It is why we write to identify a strong set of core beliefs, yet to subject all else to harsh, regular scrutiny.

Ironically, all of this talk has me in a bit of a theatrical mood, so I hope you’ll forgive me (Socrates wouldn’t) one last bit of Holiness from Lord Tennyson, which I think a rather succinct expression of the full hearts with which we carry our vision for this new venture:

It may be we shall touch the Happy Isles,

And see the great Achilles, whom we knew.

Tho’ much is taken, much abides; and tho’

We are not now that strength which in old days

Moved earth and heaven, that which we are, we are;

One equal temper of heroic hearts,

Made weak by time and fate, but strong in will

To strive, to seek, to find, and not to yield.

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Notes From the Road: Roadkill

Get well soon balloon
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Most species do their own evolving, making it up as they go along, which is the way Nature intended. And this is all very natural and organic and in tune with mysterious cycles of the cosmos, which believes that there’s nothing like millions of years of really frustrating trial and error to give a species moral fiber and, in some cases, backbone.

This is probably fine from the species’ point of view, but from the perspective of the actual individuals involved it can be a real pig, or at least a small pink root-eating reptile that might one day evolve into a real pig.

— Reaper Man by Terry Pratchett (1991)


This is Part 2 of the multi-part Notes from the Road series, introduced with Bayes and the Boreen. The Series explores how popular, otherwise adaptive methods we use to develop theories about political and financial markets based on priors and lived experience can subject us to unexpected new risks. The series tells the story of a range of journeys in history, sports, the arts and nature to illustrate the sources of those risks.


If, as Ben has written, memes are self-sustaining ideas that live in the human brain, I think there’s one that may predate all of the rest: Only the strong survive!

It’s a dumb meme about how we think evolution works that has spread, ironically, because of the way evolution actually works. Despite growth in scientific literacy, the popular conception of evolution continues to celebrate the idea that better/stronger/smarter things will prosper, and worse/weaker/dumber things will fail. The reality is much less sexy. Evolution is the process whereby nature necessarily favors traits which improve the ability of an organism to suvive until it reproduces. The idea that we are successful because of objectively superior traits – because only the strong survive! – is an idea perfectly adapted to the human ego. But on almost no dimension would we have judged our mammal ancestors superior to the dinosaurs they outlasted. But outlast they did, because – by sheer luck – their traits were better adapted to a post-Chicxulub state of the world.

That last observation is an important one. When we consider evolution as it truly is, we still usually focus on the organism, or in an Epsilon Theory context, the idea or the investment strategy in isolation. An individual organism mutates a new trait, which either makes it more or less well-adapted to the current environment. If more, then over time the trait is more likely to propagate. If less, then organisms carrying the trait will probably die along with it.  But for all the value that there is in constant improvement of our processes and philosophies in similar ways, the survival of a species or idea isn’t just a function of its own changing traits – it’s a function of the changing states of the world and the people in it.

For our investment principles and strategies, like any organism, observing that evolution is both a function of the traits of our ideas AND changes in the state of the world reveals two types of risks to our models and frameworks for understanding it:

  • Type 1 – The False Positive: We think and act like our principles are based on immutable laws of nature. They aren’t, and we get a rude shock when the world changes.
  • Type 2The False Negative: We believe that principles others believe are immutable laws are only representative of some temporary state of the world. We try to predict the change in the world, and it never happens. We waste returns, fees and client goodwill in the process.

Evolution is a painful journey for the individual. There’s not much solace in our failures becoming Harvard Business School case studies that help the species – or other investors. We must find some kind of middle ground between allowing ourselves to become speedbumps to a change in the state of the world on the one hand, or victims to the coyotes who would tell us “This Time It’s Different” about every bit of normal variability in the world on the other. We have to find that middle ground in our non-investing lives, too. Which of our heuristics and principles for evaluating life decisions are objectively true, or are at least true enough? Which are adaptations to our past environments and experiences, and will those be relevant to our new situation? When we make big life decisions, are the priors we rely on, well…reliable?  In the end, we muddle through, and more often than not, make it up as we go along.

Incidentally, that’s exactly what I’m doing. Next week, it’ll be 27 hours with a 2- and 3-year old in a blue pickup on the 1,712 miles of Dwight D. Eisenhower’s asphalt dream between old home and new. In honor of this journey, since we’re talking about growth, evolution and risk, and since I’m moving up to a part of the country where I won’t be able to talk about this sort of thing in polite company any more, I figure it’s as good a time as any to write about roadkill. And that’s saying something, because it’s always a good time to write about roadkill.

Full disclosure. If you’ve read this far, you’ve read the word ‘roadkill’ five times: once in Ben’s email, once at the top of this essay, twice in the prior paragraph and once in this sentence. You clicked on it, and I kind of feel like you’re already in for at least a penny here. But if you were squeamish about Ben’s disgusting tick infestation picture from a couple months ago, this one may not be for you.


Profiles in Roadkill: Dasypus Novemcinctus

Now that we’ve gotten all that out of the way, we can start talking vehicular critterslaughter. Allow me to introduce you to someone special.  This handsome fellow on the left is a nine-banded armadillo – one of the three state mammals of Texas, because unlike the boring-ass state you live in, Texas gets THREE state mammals. Take that, James Madison and your exquisitely reasoned Federalist Paper 62. Armadillos are remarkable little creatures who followed an unusual and narrow genetic path that has produced some of the strangest land mammals alive today. In addition to its signature armor plating, the armadillo reproduces from an egg which separates into four parts after fertilization. That means that nearly all litters consist of 4 identical creatures of the same sex. What’s more, the implantation of that fertilized egg is typically delayed by the mother by several months to better align with the spring season. Very handy, that.

The armadillo can inflate its intestines to float. It can hold its breath for six minutes to submerge. And that armor really is as tough as we think it is. Tough enough to defeat a .38 revolver. Like its closest cousins, the anteater and tree sloth, the armadillo is a marvel of specialized adaptations. One of evolution’s many weird, slimy miracles.

Also, when an armadillo sees headlights, it gets so terrified that it jumps straight up in the air and gets slammed by a car that would otherwise have passed right over it.


Profiles in Roadkill: Odocoileus virginianus

The armadillo, however, probably isn’t the animal most people (outside of Texas, anyway) think of when they think of victims of automobile-related critter flattenings. In honor of the trek we will take through the beautiful and too-unfairly-maligned state of Mississippi (which is also probably better than your state since it has two state land mammals), it is time we recognize the famousest of roadkill, the white-tailed deer. So common is the sad sight of one of these beautiful creatures along US highways that it causes the otherwise stonehearted, rage-filled American motorist to descend into our country’s unique style of gallows humor. Get well soon, gross deer. Get well soon.

Like the armadillo, evolution has gifted the white-tailed deer with extreme traits that are well-adapted to the challenges it faced during its emergence as a species. First, it is a remarkable jumper. While deer fences tend to be around eight feet tall, the average individual can actually jump somewhat higher than that, in some cases as much as 12 or even 15 feet. Somewhat less when it needs to jump forward and not just up.

Second, probably because of the adaptive benefits of a better field of vision for spotting predators, deer’s eyes are positioned closer to the sides of their head than the front. That means that deer, like many other prey animals, sacrifice binocular vision and depth perception to, you know, get eaten less by things behind them and to their sides. The downside is that it is more difficult for deer to judge distance and the depth of objects in front of them. Incidentally, in addition to being particularly stupid, this is one of the reasons why white-tails don’t always jump over fences they almost certainly could – poor depth perception means that they can’t be sure if they’re going to clear it.

Third, whether because of the need to manage temperatures and heat, to avoid predators, or other reasons they keep to themselves, thank you very much, white-tailed deer are crepuscular, which means they are most active in the twilight hours of dawn and dusk. That adaptation means that their vision is attuned to modest levels of light.

Like the armadillo, the combination of these natural talents has done wonders for making white-tailed deer one of the most successful and widely distributed mammal species in the world.

It also means that when a deer leaps into a road, it spots your distant car in its remarkable peripheral vision, turns its head, is blinded by your headlights because of the attunement of the rods in its eyes to take in more light, and because of its lousy visual acuity and depth perception, can’t make out the closing distance of your vehicle until it’s too late, at which time it leans upon its remarkable leaping abilities so that it can take out your windshield because screw you AND your Volvo.


Profiles in Roadkill: Sciurus carolinensis

Although the deer is the most iconic roadkill animal, it’s not the most common. The most common is the state mammal of one of the most beautiful states in our fair union, but one that admittedly only manages to have a single state mammal, so take my kind words about its trees, mountains and coastlines for the damning faint praise that they are. It’s your time to shine, Interstate 85 and North Carolina.

The 1993 data from an ongoing survey of roadkill (weirdly created for schools as a testing ground for teaching the scientific method) reported just over 750 squirrels in its sample. If anyone is curious, there were only 308 raccoons and 4 coyotes. The noble possum comes in second, at 348. Squirrels are the undisputed kings of roadkill, and yes, the extremely disappointing state mammal of the State of North Carolina. By the way, this really IS disappointing, because North Carolina could have selected one of its many legitimately interesting and endangered/threatened species, like the Carolina Northern Flying Squirrel. The state is also one of the last homes east of the Mississippi for the Townsend’s big-eared bat, which adapted a whispered form of echolocation that probably serves as a countermeasure to the active sonar jamming skills of its primary prey – moths.

Now, obviously some of the reason so many squirrels become double-thumps in the road is because – despite my efforts as a kid with a BB-gun – there are a lot of squirrels. But that’s kind of the point. There are a lot of squirrels because squirrels are a very successful species. Part of why they are a very successful species is because they are very successful at avoiding predation, mostly by hawks and other birds with a taste for tree-rat.  Part of the reason they are so successful at avoiding predation is that they adapted an instinctive tendency to run in seemingly random zig-zag motions that involve unpredictable changes in both speed and direction. Very good defense against a hawk flying at high speed toward a fixed point.

Not so much against a speeding teenager driving his mom’s Yukon.


All three of these animals are incredibly successful and still growing their geographic footprint. All three are incredibly well-adapted to the challenges that they faced over the course of their evolution. All three are well-prepared for the challenges they face in most of their daily lives. All three get dead real quick when their evolutionary strengths are transformed into circumstantial weaknesses.

Part of the reason I wrote this, the second note in this series, was to make you look at that hilarious and morbid roadside pizza party deer. That and to pursue some tortured analogy to compare you, dear reader, to roadkill. But there’s an important investment lesson here, too: Survival is the only way we measure the success of an adaptation, and the species that treats past adaptations as timeless and universal – as laws of physics – will go extinct.  

The trick is in knowing what, among all the things we do as investors, reflects timeless and universal principles, and what reflects our adaptation to states of the world which will change. It’s not always easy to tell the difference.

Timeless and Universal Principles

For my part, I think timeless and universal principles of investing must be either tautologies or generalized reflections of human behavior. Heuristics which are based on states of the world (e.g. I like this asset class because it is cheap, I favor this sector because of its growth characteristics, I’m concerned about this country because of higher-than-usual geopolitical risk) don’t really fit. Philosophies which are driven by views on the superiority of certain constructs (e.g. asset classes, instruments, etc.) are similarly ephemeral. I think there are really four timeless and universal principles, and we’ve written about each before:

  1. Over very long periods, you will generally be paid based on the risks an average investor (including all of his liquidity sensitivities, his investment horizons, etc.) would be taking if he made that investment [1]. – Whom Fortune Favors
  2. We must be supremely confident that we have information about the returns on various investments to justify decisions which reduce the diversity of our sources of return.You Still Have Made a Choice
  3. Humans have evolved to demonstrate preferences for certain types of investments and returns. Those preferences – and the fact that other humans will shrewdly seek to exploit those preferences – will influence returns.The Myth of Market In Itself
  4. Taxes, fees and transaction costs will reduce returns.Wall Street’s Merry Pranks

I think it’s a good framework. You may not, in which case you should replace it with what you think these rules are. Or y’know, by sending me an email telling me how stupid I am. Both are fine. But identifying these rules means acknowledging that all of our other philosophies are either successful adaptations OR new things we’re trying out because we are guessing they will be better suited for some future state of the world. After all, if we’re going to update our Bayesian estimates, we’ve got to have some kind of experiment.

It isn’t hard to identify beliefs and strategies that look well-adapted over the last decade, by which I mean investment strategies whose reputations have survived. Structurally owning more assets in U.S. financial markets looks well-adapted during this age of the world. So has owning more stocks in technology companies. Believing that there is no need for an investor to have a financial adviser seems like a very well-adapted trait. Aversion to any strategies which try to pick which securities will outperform. Keeping things simple with a 60/40 portfolio of stocks and bonds. Leveraged strategies. Aversion to, skepticism about and usually derisive attitudes towards hedge funds. Those of us who saw what worked in 2009 and 2010 and stuck with it as the new normal probably have a pretty confident assessment of some of our adaptations. More than a few of us and our clients have adopted some of the above as heuristics – our rules of thumb around which we generalize our investment beliefs into process.

What does treating well-adapted-looking traits like permanent states of the world look like? Below is one innocuous-looking example from social media marketing. I’ve removed any author’s name to protect the innocent.

There are good principles in here. But look at these more closely to see temporarily well-adapted traits creep in. A decade of dominance from US stock markets and low volatility has created a world of investors who now think that saying “keep things simple” and “avoid excessive diversification”, which are smart-sounding dog whistles for “just buy US large cap ETFs”, is timeless and universal advice. It’s not. And it’s going to get a lot of investors hurt.

Unfortunately, the memeability of common sense! advice like this is is exactly how an adapted trait evolves into a species-defining characteristic. Survival and reproduction. And then extinction.

Identifying the line between timeless principles and adaptations gets even harder over very long periods. 30 years. 50 years. Owning more bonds than our timeless principles might otherwise recommend. Relying on those same bonds to be diversifying against stocks. Knowing that commodities are not really investable, that real assets should just be a personal asset. Trusting that risky assets will always generate positive returns over a long enough horizon. As periods get longer, our confidence that our heuristics are not situational adaptations, but timeless and universal principles, grows.

All of this is Roadkill thinking. Oh, we may not get run over right away. It may never happen – during our investment lifetimes, anyway. We may go quietly in our sleep like so many armadillos, convinced that we adapted to survive cars just because we never got run over. But believing that the strategies we developed are timeless and universal strategies just because they’ve worked for us during our careers so far, or because they have worked for others for what feels like a very long period of time, is Roadkill thinking.

This first kind of Roadkill thinking is of the Type 1 error variety I mentioned earlier – false positives when identifying timeless and universal truths about markets.

Type 2 errors in Roadkill thinking are usually the more pernicious. It’s easy to think that the solution to our fears that an investment environment may be changing is to be creative, to throw a bunch of ideas at the wall, because that’s what we think adaptation looks like. And it is, in a way. But while adaptation through (mostly) random mutation works at the species level, at the individual level, it is literally murder. If our adaptive strategy is trying to time the turn in value or the market top, we will probably fail individually. If our adaptive strategy is to hold a quarter of our portfolio in cryptocurrencies to insulate us against what’s next, we will probably fail individually. If our adaptive strategy is to drain the swamp by…sorry, lost my train of thought, there. And sure, our failures will inform and improve the odds of success of other investors at large. A fat lot of good that does us. There’s a reason why coyotes with no skin in the game are so drawn to fields where they can promise disruption, new ideas, and high risk/high reward opportunities: because they share in all the upside of the aggregate while subjecting us to the risk of individual ruin along the way.

What does matter is that pursuit of these strategies often comes at the explicit or implicit expense of the ideas that really are permanent. We have finite dollars and finite attention, and our attempts to do something about environments that confuse us are usually distractions. In the same way that we’re probably all Coyotes from time to time, I think we’ve got a lot of Roadkill in us, too. I certainly do, anyway. There’s no extricating it from our nature, but as with so many things, simply acknowledging it goes a long way toward being mindful of its influence:

  1. Roadkill doesn’t know what its timeless and universal investment principles are.
  2. Roadkill doesn’t discern between temporarily effective adaptations and timeless principles.
  3. Roadkill randomly tries new adaptations even when they violate timeless and universal principles.

If we would not be Roadkill – or worse, food for coyotes – we would do well to subject our priors to constant challenge. What assumptions are we making about our investments, intentionally or unintentionally? What priors are built into our portfolio construction and investment selection methodologies? Are they always true, or maybe artifacts of an environment or industry convention?

For my part, were I sitting on an investment committee during a period of slowing in population growth, after a sustained long-term rally in multiple types of risk assets, following an extended period of falling interest rates, in the face of historically significant household and government debt, with increasing abstraction sitting between valuations and value, I would hold very loosely to all but my core principles. During every regular review, I would subject my conventions – sectors, style definitions, benchmarks, asset class definitions, risk measurement methodologies, and the like – to scrutiny.

More to the point, when we write about Narrative, we write in part because we believe that Common Knowledge about investment strategies and investable assets is part of what makes them work. This is our theory, and not a fact, but I think that Narrative analysis can inform earlier, less individually risky attempts at adaptation as environments change. Big if true. And I think it is.

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We had a little fun at North Carolina’s expense, but it’s a wonderful state and a wonderful place with a lot of people that are hurting – and will be hurting – for a long time. From my experience with Hurricane Harvey in Houston, there are few organizations that do as much good as the United Way. If you can, consider giving now to the United Way of Coastal Carolina. Or if you want to make amends for laughing at the balloon deer, the Outer Banks SPCA and the Dare County Animal Shelter will be in desperate need of help over the next few weeks.


[1] This is, incidentally, why I am not one of those who thinks that volatility is a terrible ex ante way of thinking about risk. If price sensitivity matters to individual investors – and it does – it matters to how the return investors will demand for taking that risk, even if that perception is completely irrational and they should be thinking about “permanent impairments to capital” or some other phrase that has survived because it sounds clever in marketing materials. My experience with investor behavior also tells me that unrealized returns often become realized when they’re big, negative numbers.


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They Don’t Think It Be Like It Is, But It Do

Oscar Gamble
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They don’t think it be like it is, but it do.

– Oscar Gamble (1949 – 2018)

I’ve always loved this beautiful line from Oscar Gamble – who, sadly, passed away earlier this year. I referenced it in the first of my Things that Matter series last year, a note called Whom Fortune Favors.  The gist of it is: when we are active in a specialized field for a very long time, or when we have a highly technical understanding of a narrow field, we often miss what should be obvious truths about that subject staring us in the face.

Read moreThey Don’t Think It Be Like It Is, But It Do

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Notes from the Road: Bayes and the Boreen

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I believe in American exceptionalism. Unironically. Still.

Millions of men and women over many centuries uprooted themselves from established lives of plenty and poverty alike. They bought passage or sold a portion of their futures for passage under indentures. They crossed the perilous Atlantic – and later, the Pacific – to start new lives as strangers in a strange land. Others were stripped of their freedom and sent here against their will. When they or their descendants were finally freed, a generation of millions were forced to start new lives among those who had enslaved them, who had thought them less than human.

Read moreNotes from the Road: Bayes and the Boreen

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It Was You, Charley

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Charley: Look, kid, I— how much you weigh, son? When you weighed one hundred and sixty-eight pounds, you were beautiful. You coulda been another Billy Conn, and that skunk we got you for a manager, he brought you along too fast.

Terry: It wasn’t him, Charley, it was you. Remember that night in the Garden you came down to my dressing room and you said, “Kid, this ain’t your night. We’re going for the price on Wilson.” You remember that? “This ain’t your night!” My night! I coulda taken Wilson apart! So what happens? He gets the title shot outdoors on the ballpark and what do I get? A one-way ticket to Palookaville. You was my brother, Charley. You shoulda looked out for me a little bit. You shoulda taken care of me just a little bit so I wouldn’t have to take them dives for the short-end money.

Charley: Oh, I had some bets down for you. You saw some money.

Terry: You don’t understand! I coulda had class. I coulda been a contender. I coulda been somebody, instead of a bum, which is what I am. Let’s face it. It was you, Charley.

— On the Waterfront (1954)

Read moreIt Was You, Charley

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Mental Toughness!

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There are three nevers in fashion design. Never confuse fad with fashion. Never forget it’s your name on every label. And, when showing your lines to the press, never let them see you sweat.

— Donna Karan, GilletteDry Idea” advertisement (1984)

I’d come so VERY close to getting her to go in for treatment (to the same place Catherine Zeta-Jones went for her successful bipolar treatment program). I’d spoken with them on the phone (not telling them exactly who the patient would be). They agreed to fly in and talk with her and take her with them to the treatment center.

She was all set to go — but then chickened out by morning. I even said I (would) go with her and be a ‘patient’ too (she liked that idea). That seemed to make her more comfortable, and we’d get sooo close to packing her bags, but — in the end, the ‘image’ of her brand (happy-go-lucky Kate Spade) was more important for her to keep up. She was definitely worried about what people would say if they found out.

— Reta Saffo (Sister of Kate Spade), The Kansas City Star, “Kate Spade Suffered Years of Mental Illness” (2018)

At the beginning of my career, it was very hard to go up. Now, it’s very hard to stay on top. You have to stay there, and I want to stay there so badly. I’m still standing.

— Gianni Versace, The New York Times, “Gianni Versace, 50, the Designer who Infused Fashion with Life and Art” (1997)

If you know me at all, you know that I am not a fashionable person.

I did, however, develop a brief fascination with fashion in the mid-2000s. My first boss was a notable banker to investment firms by the name of Roberto de Guardiola, and at the time he lived in a beautiful townhome on E. 64th Street. Roberto was an intimidating, old school banker. Gold glasses, suspenders, Southampton estate, Turnbull & Asser — the whole package. Like many peers of his vintage, he wanted printed models and presentations hand-delivered to his home. Unlike many peers of his vintage, he was home a lot, because that’s where his kids were. Something I admired a great deal about him.

No, in case you’re wondering, the fascination with fashion wasn’t the result of the resemblance this story has to a similar scene in The Devil Wears Prada, although the reality was very much like that. I got buzzed in and left the papers on a table in the anteroom, which had a separate set of doors to the imposing empty black marble foyer. It was unthinkable that I would even try that second set of doors.

The fascination came from the neighbors. You see, Roberto lived across the street from the Versace mansion, and it was for sale. I think Thomas Sandell ended up buying it. Being a curious young lad, I went back to my 420-square-foot studio and researched the property and its prior owner. Being an uncultured hick from the sticks, when I read about Gianni and Donatella Versace, I was learning about them for the first time. The rise, the flamboyance, the murder. New York was already impossibly glamorous and ridiculous to me. This just put it over the top.

It had never really occurred to me before, but the more I read, the more I came to the conclusion that fashion must be the most mentally exhausting white-collar job in the world. Its very name tells you why. The industry is change, and as much as its practitioners will talk about timeless design and bucking trends, there is an incessance to the demands it places on designers and creatives. There is always a new season. Always a new thing. And it’s always better to decide what that new thing will be than to be the one responding to it. There’s another job that looks a lot like this: The life of a professional chef.

I don’t know why Kate Spade committed suicide this week.

I don’t know why Anthony Bourdain did the same.

In Tony’s case, it happened only today. We know very little, other than that he was apparently found by the remarkable Eric Ripert, chef of what I think is still the best restaurant in New York (Le Bernardin). We know more about Kate. But we don’t know how — even if — the unique pressures of fashion directly influenced or triggered the depression that it seems plagued her for years. When I read her sister’s account of the failed attempts to get help for Kate, it hit me pretty hard. She confessed to her sister how concerned she was that people would react badly if they discovered she had sought professional help for mental illness. More tellingly, she expressed her concern that it would damage the brand that was Kate Spade, which for those of you unfamiliar with the brand, is fresh, bright, young, colorful and, as she put it to her sister, happy-go-lucky.

The people who loved her tried to help, but in the end it seems she suffered in silence.

Surviving Markets

If you’re reading this note, you are probably familiar with another “what have you done for me lately” industry. Like those who choose to be a fashion designer or chef, the people who choose finance and investing as a profession are a motley crew. But they also have some things in common. Most are very smart. Most want to make a lot of money. Nearly all are very driven to succeed, by which I mean to grow in responsibility and reputation. Outside of that, you’ll find all kinds. The empathetic, the selfish, conscientious and socially clueless alike find homes in our industry.

Intelligence and drive are found in abundance. But success in finance requires something else that is in somewhat shorter supply: mental toughness. Resilience. When I say that it comes in short supply, I perhaps understate the matter. Every person employed at a high level in finance would be better at their jobs if they were mentally tougher. More able to endure changes of fortune. More resistant to our biologically adapted fight-or-flight responses to stress and perceived danger.

Well, almost everyone. Ben and I are fond of observing that so many of the very successful people in our industry are high-functioning sociopaths. Given that I’m writing about mental illness, I should probably be less reckless in throwing out pseudo-clinical terms, especially in a pejorative way, but I hope you have enough grace to understand what I’m trying to say. At a minimum, accept my contention that a less emotional response to the day-to-day changes in the value of an investment portfolio is an asset of immense value.

This is true in almost every job in this industry. The executive assistant to a high-powered investment banker or investment executive hears unspeakable horrors. He’s the first one to learn about the layoffs, the employee being disciplined. He’s the one who must endure the rapidly changing moods of someone who must grapple with every hard reality of running a business. What is he called upon to do? To be even. Calm. To ensure that meetings still happen and that people still make their flights when the shit is hitting the fan. Mental toughness.

It’s demanded of the salesperson who walks into yet another office that forgot about the meeting. Four people show up for your pitch because, well, you brought breakfast, and they feel like they have to be polite before their “hard stop” in 20 minutes (who has a meeting that starts at 9:10 AM?). But no decision-makers in the room. The lady who scheduled the meeting isn’t there, and you passed up another meeting because of that 10% weight in her model where’s she’s looking to swap out managers. Quarter’s almost up and you’re halfway to your sales targets. What’s your spouse going to say? Time to stop daydreaming and calmly, respectfully, helpfully answer that question from the young kid that you already anwered. Mental toughness.

The advisor working with clients endures this daily. Why are we still holding this value fund / low vol fund / quality fund / hedged strategy when it has underperformed the S&P 500 by so much, they ask? Do you remind them of your last conversation, where you agreed that this holding was a long-term position motivated by their portfolio risk appetite? Are you serving them better by pushing back on specious arguments, or is the customer always right? They seem furious, and a sense of justice and righteous anger is rising up in you as they express it. You suppress it. You empathize. Your mind is racing. What is the right thing to say to help them understand how to resist emotional investment decisions without being condescending? Mental toughness.

In investment roles, the need for a short memory, for the ability to come in the next day unchanged and unperturbed by the prior day, seems almost self-evident. And yet, you feel the weeks of things not working weighing you down. You don’t get this market. You’ve progressed from doubting the sanity of other investors, to doubting your process, to doubting yourself. My process says max long here. Am I really willing to go all-in? Maybe I should just pull things in for a bit. But is that what my investors expect? What if they see through me here? Mental Toughness.

Our industry recruits and trains people to be mentally tough, because those who cannot achieve some growth in this trait must choose between charlatanry or failure.

There’s no getting around this. We are fiduciaries. This is how it must be.

But there is a problem. Because we require mental toughness of the people we hire and promote within our organizations, we have allowed the emergence of a meme of mental toughness! Friends, there is a vast gulf between mental toughness and mental toughness!

The Mental Toughness! Meme

When we emphasize traits of mental toughness in our employees and the people we hire, we recognize their importance to the roles we serve as fiduciaries. After all, for so many of us, the value that we add is almost wholly the result of our role in preventing the layperson from investing emotionally. But when we do so, we must recognize that we create an incentive to signal that toughness. This is where things go off the rails.

Mental toughness looks like the ability to shrug off rough days in the market without questioning fundamental investment beliefs. It looks like the ability to maintain composure under withering fire from an angry client. It means continuing to work through a model when your intentionally iterated circular reference sends a cascade of errors with a change of a cell that requires you to delete multiple ranges and re-enter the formula… if you could only find which ranges to delete.

But it’s tough to show those things to the people who need to see us doing the right things to promote us. To pay us more money. To empower us with more responsibilities. And so instead of pressing on with personal growth in our temperament that is so critical to success in this fickle industry, we see in mental toughness! all the trappings of credibility, but with a quicker payoff.

Mental toughness! looks like never showing weakness to anyone. It means believing that complaining or venting concerns to a confidant is never appropriate. It’s telling ourselves that a lot of other people with tougher jobs would be happy to take our place, to get paid what we get paid, so we should just suck it up and deal with it. It’s an unwillingness to talk to anyone about doubts we have about our skills and decisions we made. It’s putting in facetime, and no vacation time and always-on mobile phones because it’s so damned important that we show our commitment to the job even when we’re wiped out and barely have enough to give to the people who love us.

It’s an unwillingness to talk to a trained professional about real mental health problems because we’re worried that it would make us look like we lacked real mental toughness. It’s being worried about what doing so would do to our brand.  

How Do We Destroy the Meme?

Fixing this is tricky.

The importance of the traits that cause investment professionals to feel like they must signal mental toughness! is real. Those traits are not a meme. We can’t change this, because then we’d cease to serve our main function to our clients and, well, society, which is already a narrow enough matter as it is, not to put too fine a point on it.

We also can’t solve it through rhetoric or words. Look, I love it as much as anyone else when a celebrity comes out and tweets that there’s no shame in acknowledging mental health issues, and that if anyone needs help they should call this number. They’re trying to help how they can, and that’s not nothing. But saying that there should be no stigma attached to mental illness is not the same as destigmatizing mental illness. The only way to destigmatize it in our industry, I think, is for people who have reached senior positions and meaningful success in our industry to talk about it. Openly. Bluntly.

Remember in my last note how I told you we were going to lose so much we’d get sick of losing? Let me take another L.

I mentioned in that note that I was a dumb kid. That’s true in more ways than one. I married my college sweetheart when I was 21 years old. We moved to New York and were just miserable. There’s nothing special or noteworthy about my dumb story, except that it’s my dumb story. In under three years, we were divorced. As with any such story, there are a million details, and you and I are not good enough friends for me to tell you all of them. But I was devastated.

Compounding is the most powerful force in the universe, to be sure, and nothing compounds like shame. And God, was I ashamed. I was ashamed about the marriage ending, and the way it ended, of course. I was more ashamed at being stupid enough to get myself into that situation, and not being able to salvage it. I was ashamed at what people would say and think about me. He was married for what, two years? He got married right out of college? I thought he was smart? I was most ashamed that I’d become so petty and superficial that I felt worse about what people would say rather than the thing itself. It’s a recursive, ugly cycle of shame, all the way down.

I drank too much. I self-medicated. I felt ashamed about that. I poured myself into my work and sought to attach my identity to it. I felt ashamed about that. A naïve and gentle person by nature, I became vindictive and angry. Unfair. Nobody made me act that way. It was all me. I felt ashamed about that. I started to think that maybe that was who I was, and that was the first time my thoughts really started going to really bad places. Alright, no euphemisms. There were times where I was convinced in my heart of hearts that the world would be a less crappy place if I weren’t in it. I let my mind wander briefly to how I might make that happen. Then I would feel ashamed about that, too, and try to fall asleep. But mostly I just lied there in bed.

In the mornings I felt like an anchor was dragging me down into my bed. Weekdays, weekends, it didn’t matter. I didn’t want anyone to see me like that. Vanity again. Shame. One day I boarded the 1 train going up to my place on 157th street, and somewhere around Columbia University, maybe 110th or 116th, I just couldn’t take it. All the people. My skin felt like I’d walked into a spider web in the dark. I had to get off. I was dead sober, but I have no memory of getting home.

It’s weird to write about this. Part of the reason is that there were maybe a half-dozen people in the world who knew any of this before today. Only two who knew it all. Now there are thousands. It’s also weird because this was 10 years ago, and my life today is a blessed, healthy one. Seriously, I live a damned good life. Oh, there are days when the black dog comes stalking, when the pull of that anchor is firm, but with help I’ve found ways of coping, of thriving. For me, getting that help meant talking to a professional. Once. Honestly, it didn’t help, directly anyway. But the act of making a call, setting it up, taking the train there and saying the words out loud made all the difference. There is no one-size-fits-all to this, because everyone’s battle is different. Anthony Bourdain was as open a book as you can be about his daily struggles, and for him, it seems, they never went away.

Maybe there’s some part of this story that seems familiar to you. And maybe not. But if you’re running or managing an investment firm of any size, I can guarantee you that it will be familiar to someone on your team, or to someone who wants to work for you. Here’s the important part of my story for you: if you ask anyone who has worked with me or for me who they’d pick to be the least likely to lose his head in a crisis, I know what they’d say. If you asked them who would be the least likely to succumb to giddiness and lack of discipline in the good times, I know how they’d answer that, too. Mental Toughness is NOT Mental Toughness! If you’re running an investment firm, it’s important that your staff know that signaling their toughness isn’t necessary. Real mental toughness is.

If my story is more personal, I won’t tell you all the well-intentioned but unhelpful things that people tell you. But I do hope you’ll take this to heart: asking for help does not signal a flaw in your mental toughness. It doesn’t mean you can’t be an exceptional investor. It doesn’t mean you’re going to slow down your professional growth. It doesn’t mean you won’t be the superstar you’ve planned on being, with the trajectory you daydream about. It really doesn’t.

Some of you are hesitant to say what you’re going through is a mental health issue. You’re not sure if you’re just stressed, or frustrated, or sad. And that’s OK. Still, talk to someone. You aren’t respecting anyone by trying to make the problems you’re fighting through smaller than they feel to you. Even so, somebody will invariably give you the old wise Persian proverb that Abraham Lincoln used to greatest effect:

It is said an Eastern monarch once charged his wise men to invent him a sentence, to be ever in view, and which should be true and appropriate in all times and situations. They presented him the words: “And this, too, shall pass away.”” How much it expresses! How chastening in the hour of pride! How consoling in the depths of affliction!

This too shall pass — it’s a great expression, really, and a sort of memento mori. If I can be forgiven for ending an uncharacteristically serious note with a bit of lightness, however, I think there’s only one response to that counsel. You have my full permission to give Marcus Vindictus’s response to the insistent “Remember, thou art mortal” refrains from the court spokesman from History of the World, Part 1: “Oh, blow it out your ass!”

It doesn’t always pass. When it doesn’t, please ask for help.

If your boss is worth anything, he or she will know that the mental toughness! meme that makes us afraid to ask doesn’t have a damned thing to do with your mental toughness in the job.

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The Acrobat and the Fly

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No, nothing makes sense, nothing seems to fit
I know you’d hit out if you only knew who to hit
And I’d join the movement
If there was one I could believe in.
Yeah, I’d break bread and wine
If there was a church I could receive in,
Cause I need it now
To take the cup
To fill it up, to drink it slow
I can’t let you go
And I must be an acrobat
To talk like this and act like that,
And you can dream, so dream out loud,
And don’t let the bastards grind you down.

— U2, Achtung Baby, “Acrobat” (1991)

It’s no secret that a conscience can sometimes be a pest
It’s no secret ambition bites the nails of success
Every artist is a cannibal, every poet is a thief
All kill their inspiration and sing about their grief
Over love
A man will rise
A man will fall
From the sheer face of love
Like a fly from a wall
It’s no secret at all

— U2, Achtung Baby, “The Fly” (1991)


Maybe because of their popular appeal, or the fact that our society can’t abide a person like Bono with unapologetic earnestness about his beliefs, or because of the band’s retreat into musical weirdness and emergence into arena bombast, U2 has been treated rather uncharitably by modern commentators. But at their best, U2 were mesmerizing. Stylistically, I prefer Unforgettable Fire or War, and for sheer songwriting genius, Joshua Tree remains one of the greatest albums ever recorded.

But where art about making art (e.g., La La Land, Birdman) can sometimes veer toward self-indulgence, Achtung Baby reaches a different kind of peak. It is raw and self-critical, with no attempt at final redemption. I mean, it is melodramatic as all hell, which is kind of the concept of the whole album, but if its arc carries any absolution for the artist, it is that hypocrisy is the universal result of art and not some unique moral failing. Every artist is a cannibal, every poet is a thief.

But in the end, neither the artist’s cannibalism nor the poet’s thievery invalidate their art. You can dream, so dream out loud, and don’t let the bastards grind you down. There’s a narrow lesson in this that goes like, “You can still read Ender’s Game even though Orson Scott Card once ate a Chick-fil-A sandwich.” But there’s a bigger lesson, too: if you go around looking for hypocrisy in your enemies, you’ll always find it. Doing so will always feel good. Doing so will rarely get you closer to truth, beauty or love.


I was recently explaining to a friend and former colleague what I write about on Epsilon Theory. They asked me if it was a behavioral investing blog, and I wasn’t sure how to answer.

In a sense, yes, of course Epsilon Theory is a behavioral investing blog. We believe that humans and the stories they tell heavily influence, and sometimes determine asset prices. And we write about that. But when most people say “behavioral economics” or discuss investment strategies that account for investor behaviors, what they usually mean is “cognitive biases.”  Yes, we write about those things, too.

But except in the way that all human activities are influenced bv the way that our brains evolved to process information, Epsilon Theory isn’t really about cognitive biases. That isn’t because we don’t believe in those biases. Quite the contrary. Instead, it is a recognition that our biased brains are riding on meat puppets that spend most of their time interacting with other meat puppets. Our brains are rarely tasked with drawing conclusions from raw data. Most of the things that matter to us and our lives are social. That means that the stimuli that reach us, the basis for our judgments and opinions, are usually the outputs of other compromised brains, processed through established cultural and social structures.

It is intuitive that understanding and mastering our own biases should mean not only being aware of innate evolutionary impulses, but also understanding how they manifest in social behavior. This is what Ben meant when he wrote about acknowledging our own vulnerabilities to the introduction of memes and Narrative in This is Why We Can’t Have Nice Things. We like to think that we operate from internally coherent, epistemologically sound ethical, social and political frameworks. You don’t. I don’t. We don’t. We’re making it up as we go along and we all know it.

It is rarely possible to divorce ourselves completely from the ways in which our human brains are wired to respond to society that is increasingly aware of the ways in which other human brains are wired to respond. We cannot pretend that it doesn’t change anything that companies like Tesla and Salesforce now seek to foster rabid audiences and stabilize their stock price through targeted social media engagement strategies — what we write about on these pages as Missionary activity. We cannot pretend that it doesn’t change the priors that drive how we build investment portfolios that standing governments consider markets to be utilities for maintaining public order and assent, and actively employ communications strategies to establish Narrative around fiscal, monetary and trade policy.

And so it is that in our investing lives, and in our public, political lives, it is very difficult to refuse to play the game. Ours is a Narrative-driven world, and surviving in it means doing more than understanding how our biology predisposes us to cognitive biases. It means understanding how our engagement with social structures and with one another creates new biases and pitfalls altogether, a kind of special susceptibility to brutal logical fallacies. Many of these are so-called ecological fallacies, discussed in an ET note from 2013 that still reads very well.

Ben wrote recently that the memeification of information — the transformation of Emails into Emails! or Lyme disease into Lyme disease! — is a big part of why we can’t have nice things. I want to suggest to you that it is possible to have nice things again. Real conversations with other people that result in real outcomes. Perhaps even a move back in the direction of Cooperative Games from the Competitive Game we are in today. I argued in my essay from last August that this would require a critical mass of well-intentioned people willing to give up on, to lose, non-existential battles. I also warned that you wouldn’t like my advice. In the interest of providing you with yet more unsolicited advice that you won’t like, allow me to outline the four Competitive Game equilibrium-enforcing strategies I think we must give up if we’re going to make ourselves and our thinking less vulnerable to memes, abstractions, tribalism and Narrative.

Know in advance that in a Competitive Game, each of these four is a dominant strategy. To wit:

  • The People Who Disagree with Me are Hypocrites
  • The People Who Disagree with Me are Stupid
  • The People Who Disagree with Me are Evil
  • The People Who Disagree with Me are Controlled

If you give up using these strategies as I will recommend to you, you will lose. You will lose credibility. You will lose standing. You will lose popularity. People will believe you are losing arguments. People will believe you are less intelligent. People may believe you are less committed to ethics, morality and justice.

Wondering where you can sign up yet? Good. We’re going to lose so much, you’re going to be so sick and tired of #losing.

You’re Too Biased to Measure the Impact of Hypocrisy on Credibility

Before we get too far, however, let’s get one thing out of the way: the people who disagree with you really are hypocrites.

I don’t know the people who disagree with you and I don’t need to know. Hypocrisy has been the human condition since Adam proclaimed his holiness by blaming the apple eating on his wife (I mean, it was kind of her fault, if you think about it). But the game of find-the-hypocrite isn’t really about finding gaps between the behaviors people condemn in others and the actions those people take themselves. We all know those exist, and I hope you came here for meatier arguments than, “We’re all hypocrites, so live and let live, amirite?” No, the game is about how we go about quantifying that gap. Who is the bigger fraud, the bigger phony? It’s also about why we seek out hypocrisy in others.

You might think that this strategy would be played out by first looking for the worst actions and then aligning them with incongruous statements of condemnation. Turns out that isn’t exactly the case. Four Yale researchers in psychology published a fascinating study in 2017 on this topic. It’s a well-written, very digestible bit of research based on cleverly formulated questions. A rarity for such papers, I recommend reading the whole thing. It holds a few interesting insights:

  • People attribute more moral value to condemnations of bad acts than to claims of good acts.
  • People will forgive admitted actions that don’t jive with values, but they won’t forgive bad acts that conflict with condemnations of bad acts.

In other words, what people hate about hypocrisy isn’t the immoral act, or even the gap between values and actions. It’s the intentionally false signal from moralizing about the act. And while the paper doesn’t suggest this directly, it is my belief that this aversion is one reason why excessively strong signaling or moral condemnation, when coupled with even suspicions that someone may be acting in conflict with those signals, is so distasteful to many of us. You’ve heard of virtue signaling, I presume.

The gulf between a false signal and simple conflict between values and action may seem like a distinction without a difference, but it isn’t. It matters that our anger about hypocrisy is not the response to a moral failure, but to a failure in ideological signaling. That means that it is an opportunity to assault the credibility of those signaling.

It just so happens, of course, that credibility is one of the most important social signals we send, and one of the ones that matters most in Narrative-driven political, financial and other social and civic markets. The mechanisms of credibility within social capital are so pivotal to influence, wealth generation, capital formation, new lead generation and popularity in general that signaling “I am a credible person” becomes for many of us an objective unto itself. We may complain about Missionaries and their attempts to influence us, but we would all be Missionaries in a heartbeat if we could. For those who have read my piece exhorting us to Make America Good Again (and to stop worrying about being great), you won’t be surprised to learn where I come out on this issue. Those who have built on the sands of cringeworthy credibility signaling may come to a different conclusion.

One of our most potent weapons for winning the credibility game — or so we perceive — is seeking out and identifying hypocrisy in others. We are attracted to assaulting hypocrisy for two reasons. First, it acts as a credibility signal for us. It tells others that we are players in the great game. It tells others that we care about logical consistency and other Good Things. Second, it acts as a credibility reducer for our opponent. It challenges and reduces their believability and standing, and seeks to insinuate that they care less about intellectual honesty and logical and moral consistency. In effect, it is a force multiplier for our arguments, because once we establish that another party has made hypocritical statements, we can summon that spectre again and again to relieve us of the need to dispute further arguments on their merits.

There’s just one problem with this: we are hopelessly prone to bias in our assessments of others’ hypocrisy. Why? Because our anger about hypocrisy doesn’t begin with systematic, objective observation of moral failures or flawed reasoning under our value system. It begins with our selective observation of moral, philosophical or intellectual condemnations made by others — and guess what? We tend to pay a little more attention when someone condemns someone we like or something we believe in. In other words, when someone expresses a criticism of us, our friends, our allies and their behaviors or actions, we are simultaneously inspired to diminish that person’s credibility to protect our ego, and to search for actions that conflict with their condemnation. It’s like handing a three-year old a club and telling him that other boy over there took his favorite toy.

It’s an overwhelming bias that seems so obvious and non-partisan in its pervasiveness when you step back to view it with as much dispassion as any of us can muster. It’s why the political right quickly finds every example of a preening Hollywood numbskull moralizing about some progressive social justice issue right before they end up in TMZ for abetting the abuse of young actors and actresses.  It’s why the political left is lying in wait for any Bible-thumping family values Republican politician to get caught in an ethics scandal. It’s why there are millions of people still penning gotcha pieces on the hypocrisy of Bill Clinton supporters who criticized the moral failings of Donald Trump and why millions of people are still writing pieces on the hypocrisy of Donald Trump supporters who had criticized the moral failings of Bill Clinton. Claims of hypocrisy aren’t about morality. Claims of hypocrisy are about ideology.

But Hypocrisy! the meme isn’t about either of those things. It’s about credibility. And Hypocrisy! the meme is warm, wet garbage. In those rare moments when we are honest with ourselves, we know that the reason we accuse others of hypocrisy rarely has anything to do with a good-faith belief that it justifies devaluation of their opinions or arguments which would often stand on their own merits. Likewise, research tells us it has next to nothing to do with any moral objection on our part. No, we do it because we know that those we disagree with will use this same technique at every opportunity to devalue us and those we agree with. We know that not responding in kind makes us vulnerable.

I saw a lovely anecdote recently from Ethics and Public Policy Center fellow Pascal-Emmanuel Gobry recently, which expresses a similar idea somewhat more succinctly:

My high school best friend’s dad was one of the most talented jazz guitarists of his generation. When my friend was a kid, he asked his dad if he could teach him to play guitar. The dad was of course thrilled. “I’d love nothing more in the world, he said. But first, you’ll have to learn music notation and music theory and chords. Then I’ll teach you to play.”

My friend, being a wiseass, retorted, “Paul McCartney never learned any of that stuff, and it didn’t stop him.” My friend’s dad, being a wise man, replied, “Yeah, but you’re not Paul McCartney.”

Yeah, in the Bible Jesus calls people broods of vipers and whitewashed tombs. And Paul, and the Prophets, and saints, used salty language. Yes, there are times when such language is called for. But the reality of original sin means the odds of you using this language out of pride overwhelm the odds of using it because of the necessities of speaking love in truth.

You’re not Paul McCartney.

Whatever social structure or biological impulse evolved in us to make us respond the way we do to hypocrisy makes us uniquely unsuited to routinely rely on our detection of it as an indicator of anything other than our own bias. Neither you nor I are Paul McCartney (unless you are Paul McCartney, in which case, hello, thank you for reading and what is the weird chord in the second half of the third verse of “Let It Be” when you sing “Mother Mary” because I’ve been trying to figure out what’s happening there for 20 years).

I should be clear about the narrow point I am making, and the point I am certainly not making. From a moral and ethical perspective, there is no particular reason why being biased should prevent us from holding one another accountable for dishonesty, hypocrisy and other flaws. If we only spoke up about injustice and error when we had no dog in the fight, we would comprise an ugly society indeed. But I hope that you can see the difference between the impact of bias on the justifiable use of it as an argumentation technique and the justifiable reference to it in good faith efforts to improve our own behavior or of those who we love, trust and want to grow us with as humans.

Being a Hypocrite Doesn’t Make You Wrong

Even if we can play a mean left-handed bass and believe that we are capable of being even-handed in using accusations of hypocrisy as an element of our political and social engagement, it doesn’t take long to recognize that doing so is frequently counterproductive to the whole point of that engagement in the first place. It’s pretty simple. If what you care about is being considered right and winning those arguments, then the hypocrisy! meme is the right tool for the job. If your objective is to get to a better policy or portfolio outcome, then it isn’t.

The next time you’re looking to bring this tool out in an argument or disagreement, ask yourself: does this person’s false signaling really devalue the argument he or she is making? The data he or she is using to support it? Or is it just a tool I would use to discredit this person so that I don’t have to bother with the whole debate? It’s a bad, biased heuristic.

Consider Warren Buffett, the investing world’s moralizer-in-chief. Here he is on leverage.

Once having profited from its wonders, very few people retreat to more conservative practices. And as we all learned in third grade — and some relearned in 2008 — any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero. History tells us that leverage all too often produces zeroes, even when it is employed by very smart people.

Here he is in 2003 on derivatives:

No matter how financially sophisticated you are, you can’t possibly learn from reading the disclosure documents of a derivatives-intensive company what risks lurk in its positions. Indeed, the more you know about derivatives, the less you will feel you can learn from the disclosures normally proffered you. In Darwin’s words, “Ignorance more frequently begets confidence than does knowledge.”

Guess who sold protection on a bunch of munis starting in 2007, not entirely different in scope, although admittedly in scale, from similar trades that sunk AIG around the same time? Guess who, according to research from AQR, has historically generated his returns through effective leverage of 1.6-to-1?

For someone like me, who is convinced that randomness would almost certainly produce a Buffett or two through sheer chance rather than skill, applying the hypocrisy! meme is tempting. I am envious of his reputation, and I hold the good-faith belief that people who follow what Buffett does are focusing on things that don’t matter. I believe that the people who follow what he says about index funds place too much emphasis on costs and too little emphasis on getting the right level and sources of investment risk. It is so easy for me to justify why it isn’t just correct, it’s the right and moral thing to do to throw this guy under the bus for hypocrisy, to try to reduce his influence.

Except he really is an incredibly thoughtful investor with innumerable traits I wish I had, wisdom our world would be worse without, and perhaps the keenest insight into the role of temperament in the success of the investor we’ve seen in the last 50 years. The Competitive Game strategy says to seek to diminish him — to make ourselves the Fly. To kill our inspiration to sing about our grief.

But that’s just the meme talking. The fact that Buffett’s views on leverage and derivatives are insanely hypocritical don’t change the fact that he has a tremendous amount of investment wisdom to share.

Letting Ourselves Off the Hook

Maybe the worst harm this tick has in store for us, however, is the doubt it sows in us. You and I are both hypocrites. There’s a fine balance between internalizing the moral importance of honesty, consistency and forthrightness on the one hand, and not internalizing the hypocrisy! meme in ways that would cause us not to champion causes and values we believe in simply because we know we can’t live up to them on the other. This is a real danger.

In many cases, our hypocrisy is just growth. When I was 23, I put myself at odds with some genuinely nice and thoughtful people I worked with and for. Why? Because I was an arrogant ass who knew that no one could build and code a model as quickly and efficiently as I could, and because I knew that my skills in this area were creating all the company’s value. Except that wasn’t true. Of course it wasn’t true. I was a stupid kid with no concept of the value of different people and skills. Should I let this moral failure keep me from teaching young analysts today that modeling is a commodity skill? That their real value in an organization will come from cultivating trust, honing temperament, identifying business drivers that matter and becoming better communicators?

In some cases, what looks like hypocrisy is just the reality of a world of contradictions. I’ve written and, yes, moralized about the things investors waste time on, and the things they should focus on more. In these pages, I’ve condemned bad behaviors, like focusing too much time on picking stocks, on picking funds, on fees over other costs. And yet, like many who agree with me on these topics, I still spend far too much time doing each. I’ve spent days trying to figure out if my largely systematic framework for selecting U.S. stocks for our wealth management business is missing something on consumer brands. I’ve spent more time thinking about General Mills and Colgate-Palmolive than I have about things that I know will have greater long-term impact on financial markets and investor outcomes. But I know that these things are important to my clients, too. I know that it matters to them to understand what they own, and why, in a very qualitative sense. And if it matters to them, it matters to me. The hypocrisy that seems so clear in others is not always so cut and dry when we apply it to ourselves with all the details. Our life and work are complicated.

We are complicated, too. Today I relish the trappings of my Texas identity, but it wasn’t always that way. It took me five seconds to decide where I would go to college when the opportunity to escape a small town in southeast Texas presented itself more than 20 years ago. While I can’t imagine harboring that sentiment now, there’s a part of me that can’t figure how much of that refound identity is affectation, a resistance to things I didn’t like about living in the northeast, or an authentic expression of my values. We’re all complicated, conflicted, growing and changing, and there’s no nobility in allowing the hypocrisy! meme to cause us to withdraw from figuring out our own small issues, or helping our communities and societies figure out the big issues.

This isn’t some weird attempt to present hypocrisy as moral, or something we should be more or less prone to forgive or criticize. None of that. It’s awful and you should stamp it out wherever you see it whenever you have the standing with someone to be influential. It is about how you will respond to the tick, the meta-meme of hypocrisy! that seeks to shut off people you would learn from, deepen your falsely held belief in your tribe’s moral superiority, and short-circuit your own brilliance out of false-humble feelings driven by knowledge of your own hypocrisy.


Now because by reason of those daily sins of which I have spoken, it is necessary for you to say, in that daily prayer of cleansing as it were, “Forgive us our debts, as we also forgive our debtors;” what will ye do? Ye have enemies. For who can live on this earth without them? Take heed to yourselves, love them. In no way can thine enemy so hurt thee by his violence, as thou dost hurt thyself if thou love him not… In this he is as thou art: thou hast a soul, and so hath he. Thou hast a body, and so hath he. He is of the same substance as thou art; ye were made both out of the same earth, and quickened by the same Lord. In all this he is as thou art. Acknowledge in him then thy brother.

— Saint Augustine of Hippo, St. Matthew’s Gospel, “Sermon on the Lord’s Prayer”


The most painful realization of all in a world awash with Narrative, of course, is that the people who disagree with us are not especially hypocritical or contradictory. It is that they are our brother. Our sister. Made out of the same earth. And probably every bit as smart, upstanding, independent-minded and, yes, flawed as we are.

When we stop telling lies about why we disagree and start telling this truth, we can grapple with the uncomfortable fact that our brothers and sisters saw the same facts and came to different conclusions. As Narratives force us into ever narrower bands of acceptable views on markets and politics, the speech we must tolerate becomes more uncomfortable, and will feel more extreme. It will also feel more contradictory. Friends, if you would end the Competitive Game, if you would triumph over tribalism, you must learn to tolerate some hypocrisy — in yourself and in others. You must embrace the Acrobat and not the Fly. How?

Dream out loud, and don’t let the bastards grind you down.

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The Many Moods of Macro

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I think the original version of this gag is from a Far Side comic in reference to Irish setters, although I’ve omitted it out of respect for Gary Larson’s wishes. Truth be told, I always felt that Old English Sheepdogs would have had a better case for “creature who looks more or less the same regardless of circumstance” than setters. I guess this is one of those things that is infinitely transferable to whatever kind of dog you had growing up.

Unless your childhood dog was a global macro portfolio manager, however, I suspect the rather monotonic flavor of their returns has puzzled you from time to time. For all its inputs, for all its data packaged together from far-flung corners of the globe, all synthesized into sensible and well-researched models, the typical macro fund’s positioning and success is heavily reliant on a small number of influential drivers and environments.

On the surface that’s not necessarily a bad thing, unless you’re paying a ton for it, which you probably are, even in 2018. After all, repeatability and persistent premia are not bugs, but features that we seek out from systematic investing. But for investors in systematic tactical strategies and global macro hedge funds, the expectation of persistent novel sources of return should be scrutinized. In a Three-Body Market, they should be doubted.

A horse having a wolf as a powerful and dangerous enemy lived in constant fear of his life. Being driven to desperation, it occurred to him to seek a strong ally. Whereupon he approached a man, and offered an alliance, pointing out that the wolf was likewise an enemy of the man. The man accepted the partnership at once and offered to kill the wolf immediately, if his new partner would only co-operate by placing his greater speed at the man’s disposal. The horse was willing, and allowed the man to place bridle and saddle upon him. The man mounted, hunted down the wolf, and killed him. The horse, joyful and relieved, thanked the man, and said: ‘Now that our enemy is dead, remove your bridle and saddle and restore my freedom.’ Whereupon the man laughed loudly and replied, ‘Never!’ and applied the spurs with a will.

— Isaac Asimov, Foundation (1951)

At their core, most macro models are central banking models and macro managers are carry investors. They willingly tied themselves to success in predicting bank actions, and in so doing had a wonderful stretch of good returns and low correlations with stocks. Now that predicting bank action will increasingly require short carry positioning, and now that betting on uncoordinated action has gotten tougher, they’re feeling the spurs. This is your choice, too: buck the rider or feel the spurs.


The impulse to find a “a man who can make a plan work”, from F.A. Hayek’s brilliant Road to Serfdom cartoons, is not just a political one, but infects the way we make decisions as investors. We make portfolio plans ourselves, with our committees or with our advisors, and they…rarely turn out exactly like we wanted.

We never have the best possible portfolio we could have had. There is no decision structure that won’t yield questions of the, “Well, why weren’t we 100% in U.S. growth stocks the last three years?” ilk from our clients. More often, we made some real mistakes. We misread the risk environment and weren’t fully invested for our clients. Knowing we shouldn’t, we gave up on a value strategy in a 7-year drawdown right before sentiment turned. We sold bonds ahead of what we thought were inevitable rate hikes and were wrong for five years.

We know we need to fix these kinds of errors.  Too often our solution is to find the team with a model that understands “how all this madness fits together” and can exploit it for us. That’s the allure of systematic macro and tactical asset allocation. It’s well-intended. It’s also a path paved with peril.


This is Part 1 of the multi-part Three-Body Alpha series, introduced in the recent Investing with Icarus note. The Series seeks to explore how the increasing transformation of fundamental and economic data into abstractions may influence strategies for investing — and how it should influence investors accessing them. 

After Ben wrote The Three-Body Problem, and then again with The Icarus Moment, I suspect I reacted like many other readers. I didn’t have to predict whether I thought asset prices were increasingly driven by abstractions or higher degree derivatives of economic and fundamental data, as Ben argued. I was observing it. But between those observations and the related belief that most alpha-oriented strategies have been forced into deeper levels of the Keynesian Newspaper Beauty Contest — that we are increasingly in the business of predicting what others are predicting others are predicting rather than the impact of changes in real economic facts — I have the same questions: How should this impact our strategies? Our portfolios? The questions we ask our advisers and fund managers?

These questions only matter if this whole state of affairs persists, of course. If there’s a hypothetical criticism you could level at the framework Ben and I are working from, it is that the Narrative-driven market isn’t really a thing, that it’s just a label we are throwing on a period of temporary loopiness created by central bank-driven hyperliquidity. A period that appears to be ending. If you think this is the case, then we’re the guys in burlap sacks on the street corner shouting, “This Time It’s Different” right before things go back to normal. I’m empathetic to the view. I mean, I think the view is wrong, but I’ve heard that people are comforted when you tell them you’re empathetic to their view.

I think it’s wrong because we aren’t just observing this in financial markets. We are observing polarization and quantization — rounding words and numbers to their nearest analog — in nearly every human social sphere. Our media-connected Panopticon converts every uttered word into a loaded ideological message, in which every action is a symbol in service to a Narrative. Yes, central bankers were the original missionaries in our little history, but CEOs, financial media, crypto-experts, senators, regulators, traders and other power brokers are all wise to the game now. So, if you want to tell me we will see a return to a market in which the transmission of economic data and fundamental characteristics of issuers manifests in asset prices over some meaningfully investable period of time, fine. But you’ll have to tell me why you think that’s going to happen in politics, culture and media, too.

The painful Catch-22 for the investment advice industry is that people expect times of uncertainty to be the opportunity for advisers to prove themselves. When I talk to financial advisers and RIAs in times of perceived dislocation in asset prices, they want to know whether they ought to transition some of their stock portfolio to hedge funds. They want to know if now is the time to allocate to long/short equity managers. They want to find someone who can steer exposure to take advantage of dispersion when the dislocation corrects. When geopolitical volatility doesn’t manifest in market risk, the conversation is similar. Investors want a macro strategist with a model that answers how it all fits together. Maybe it’s as simple as adding a tactical asset allocation overlay through one of the big turnkey platforms, or maybe it’s hiring a systematic global macro hedge fund. There’s finally dispersion again, and the beta rally is over — now go be tactical and find alpha!

Want to know why Ben’s notes Tell My Horse and Three-Body Problem each yielded more emails from fund managers, CIOs, pension executives and investment professionals than many notes combined? Because they don’t know exactly what to tell their clients who are looking for macro guidance. Because not only is this environment not turning out to be a goldilocks regime for tactical, cross-asset, alpha-seeking managers, it’s becoming an environment in which even the things that used to work aren’t working for them. At all.  Nowhere is that truer than in strategies sitting at the confluence of what in our framework we are calling Systematic strategies operating Economic models. Don’t believe me? Here’s the very long-cycle trend, seen through the lens of the HFRI Macro: Systematic Diversified Index.

Source: eVestment April 2018. An investor cannot invest directly in an index. For illustrative purposes only.

The systematic universe has a lot of trend-following funds. Many of those have performed quite poorly. But that isn’t all that’s happening here. Even the broader Global Macro category, represented here by the HFRI Macro (Total) Index, looks similar. We could similarly split the systematic category into those focused only on trend-following and those that are not, and it would tell the same story.

Source: eVestment April 2018. An investor cannot invest directly in an index. For illustrative purposes only.

What do we mean by “Econometric GTAA”?

The investment industry loves to obfuscate, and terminology can be a bear. Let’s cut through it.

In Hedge Fund Land, “Macro” — represented in the second chart above — is a term of art. Jargon. It refers to a universe of hedge funds, usually self-labeled, that pursue strategies that mostly allocate across and between different broadly defined assets. The term “Systematic Macro” simply refers to those which do so on a mostly systematic basis. By systematic, I mean that the trades are typically generated based on a system rather than determined by a human. That means different things for different funds, and many will have individual sleeves of the portfolio or elements of the portfolio’s construction that still come under human scrutiny. But in general, these funds trade based on generalized ideas and principles memorialized in code.

Depending on who you are talking to, you will also hear strategists, fund managers or consultants talk about “GTAA”, or Global Tactical Asset Allocation strategies. When a fund manager calls a strategy that allocates across assets GTAA instead of Macro, he usually means that he is willing to sell it to you for a lower price, often means that his trades will be confined to a defined, larger set of simple long and short expressions on broad asset classes, and sometimes means that he will have a general bias toward being long financial markets exposure. This is part of the universe I’m writing about here.

There’s a third category of strategies which are not precisely a sub-set of Systematic Macro, but at least occupy a big, overlapping part of the Venn diagram: Managed Futures and CTAs. This, again, is where terminology gets confusing. Managed Futures and CTAs are technically a structural category, by which I mean that they aren’t so much defined by what they do as by what they are. Because futures contracts were originally an instrument devised to trade commodities more efficiently, this industry and its structures formed around strategies for trading futures contracts on those commodities — which makes sense, since CTA stands for “Commodity Trading Advisor.” Over time, as extraordinarily liquid futures contracts became available in equities and interest rate markets, the CTA structures were able to accommodate strategies that looked almost exactly like what we’d see in a global macro hedge fund. But, as I noted in my quip above, this part of the universe tends to trade more often based on price trends, rather than what’s going on in the economy or in companies and other issuers.

So, we have three heavily overlapping Venn diagrams — Systematic Macro, GTAA and Managed Futures. But this piece is about strategies I’m labeling as Econometric GTAA. What do I mean? I mean strategies which trade long and short across a broad range of markets based on computer models driven by (and sometimes predicting the trajectory of and rates of change in) inflation, interest rates, asset flows, economic growth, corporate margins and earnings more broadly, tax rates, trade policy, balance of payments, and trade deficits, etc. These strategies will find their way into your portfolios in many ways. If you buy a Global Macro hedge fund, you will probably get a lot of this. If you hire a Managed Futures fund, you may get some of this, although as I mentioned, it is more likely to be driven by trend-following. If you buy a Multi-Strategy hedge fund, you will probably get a lot of this. But this isn’t just hedge funds. If you buy a “rotation” or “tactical” strategy from an ETF strategist or Tactical Asset Management Plan (TAMP), you will probably get a lot of this. If you hire a financial adviser from an institution with a home office that recommends asset allocation models, you are probably getting some muted flavors of this. So what do these strategies look like?

What Econometric GTAA Models Look Like

When you hire a “tactical” advisor or portfolio manager, while there is a huge amount of surface-level diversity, what you’re usually getting is some subset of the below:

Illustration of Typical Tactical Asset Allocation Framework

Source: Epsilon Theory April 2018. For illustrative purposes only.

The basic framework here takes in some combination of what I’m calling Econometric Data, Market Data and Sentiment. The mix may differ dramatically. In the case of Managed Futures strategies, many ETF strategists and “Tactical Allocation” funds, and others that call themselves Systematic Macro, models may skew entirely toward Market Data. They may even emphasize price movements above just about every other kind of input. This piece isn’t about those funds, and it isn’t about those strategies. It’s a big topic that deserves its own note, because most of the off-the-shelf model portfolios-in-a-box, ETF-based strategies, sector-rotation strategies and tactical allocation funds rely almost entirely on models driven by Market Data alone, usually simple valuation and momentum models.

But what we’re focused on is that top half — the Econometric Data. The approach that managers and strategists will take to incorporate these data will differ. In some cases, strategies will impute a direct transmission engine between econometric data and (implied) expected asset prices, and their desired position. For example, a strategy may be something as simple as rank-ordering countries by their short-term interest rates, buying the ones with higher rates and shorting the ones with lower rates. There are all sorts of implicit views this expresses on investor asset pricing behavior and risk, but the explicit mechanism for establishing positions connects relative interest rates to relative asset price returns over some period of time. This is what the illustration refers to as Implicit Price Behavior models — “Certain values of variable X will more often than not result in changes in the prices of asset price Y.”

In other cases, one or more (usually more) bits of data will be incorporated with economic logic into an interim model. That interim model will typically represent a more explicit simulation of the behavior of another actor or actor(s). For example, rather than estimate a simple relationship between, say, changes in consensus inflation expectations and whether inflation-linked bonds will outperform nominal bonds, many Econometric GTAA strategies will take in GDP growth, earnings growth, balance of payments, wage growth, producer price momentum, corporate margin and money supply data to predict the pressures on central banks to make changes in interest rate policy. That output would then influence views and positioning on a range of assets.

As with the bulk of tactical asset allocation strategies, ETF models, etc. mentioned earlier, the influence of these interim models or even many of the direct transmission models of Econometric Data to positions is often presented in context of valuation of the underlying assets, and momentum of the price of the underlying asset and/or the model’s signal itself. In other words, a fund may predict the pressure on a central bank to act, but it may be the momentum or change in that variable which produces a tradable signal. Alternatively, a trade may be conditioned on some valuation or momentum state, or even by the state of another interim model (i.e. “We trade when we have confirmation between our geopolitical framework and recent price action.”).

The types of positions these models establish will differ as well. For most strategies — especially those that fancy the GTAA moniker — the views tend to be long/short, and usually asset class neutral. For example, a model might pair a 5% long or overweight position in US stocks with a 5% short or underweight position in, say, German stocks. For others, the views might compare assets with cash. In other words, the models decide whether to have market exposure at all. This question of “directionality” is a big one. It’s one that tends to exaggerate differentness among practitioners of these strategies and pigeon-hole the emphasis of more risk-focused managers into a smaller number of relative value trades between assets.

But What is It, Really?

So with all these inputs, with all this diversity, we have our pick of a lot of interesting multi-asset and macro strategists with a lot of interesting different models, right?

Meh, not so much.

We don’t claim to have some secret sauce for analyzing drivers of fund performance. Most approaches are pretty well-trod ground at this point, although I was tempted to measure facial width-to-height ratios just for fun. But no, we’re simple — boring multi-factor regressions against some basic style and market factors. Fortunately, as is often the case, simplicity tells most of the story. Of the 74 funds in the HFRI Systematic Macro universe, 60 have positive, statistically significant betas to interest rates. Around 40 have betas higher than 1.0. These are betas in a multi-factor context that includes a range of market and traditional style factors. To be fair, many of these funds are implemented through futures or with market neutral positioning that allows them to earn cash returns, but this is a small portion of this effect. In the end, you are roughly three times more likely to run into a Systematic Macro fund with returns that look like a levered bet on interest rate-sensitive instruments than one that neutralized (read: hedged) the aggregate systematic influence of rates on its risk profile over time.

Source: Epsilon Theory, HFR, eVestment April 2018. An investor cannot invest directly in an index. For illustrative purposes only.

I don’t think this is an artifact or false positive from the data. Anecdotally, as I’ll argue, I think that many systematic macro funds really do execute strategies that are structurally biased toward being long bonds. But they also have a related bias. They like to own things where you collect a payment from someone else to own it. That someone else may be an issuer, a government or a hedger. Across macro funds, GTAA strategies and model portfolios, the only strategy that is as common as trend-following and a bond bias — systematic ones in particular — is buying higher yielding assets and selling lower yielding assets. We call these “carry trades”. Below are the significant betas (above and beyond the relationship to bonds) of each of the 74 funds to our measure of multi-asset carry trading. Most are positive, only a couple are negative, and the rest are largely positive but not significant after accounting for the existing carry component in their interest rate exposure.

Source: Epsilon Theory, HFR, eVestment April 2018. An investor cannot invest directly in an index. For illustrative purposes only.

Systematic Macro and Econometric GTAA funds have other systematic exposures as well, including a general bias toward short exposure in commodities, and a long bias toward equities, and these aren’t just present in the trend funds that have had those exposures because they have worked. They are common throughout.

If you talked about this with your tactical guy/gal or macro strategist, I know what he’s going to tell you, because it’s what they tell me, too. “There may be some of this, but we’re not directional. We may be long, we may be short, and we have a lot of other trades and signals.” I think you’ll find that this is sometimes completely true. For example, Bridgewater’s Pure Alpha strategy is consistently neutral to most market factors, although if you looked deeper into carry trades, you’d find a pretty persistent positioning in favor of higher yielding currencies. But generally speaking, your manager is telling you a half truth — literally. Across this universe, using static exposure to the most basic of market factors (stocks, bonds, commodities and currencies), you can explain around half of the variability in returns.  That’s not the problem, except that you’re paying them 1.5-and-20 for something you can and should get much cheaper. The problem is that after you take out the 50% you can explain with market factors, the hand-waving, black box, smoke-and-mirrors half they’re trying to sell you as their edge is a tire fire.

I mean, gods, look at this mess. Over the last five years, you would have gotten a positive Sharpe Ratio on whatever these guys did that wasn’t static long exposure to financial markets from only 23 of the 74 funds. Believe your model-driven macro guy when he tells you he isn’t only directionally long rates, -carry and trend-following. But be skeptical when he tells you that you ought to have a positive return expectation on whatever the other stuff he’s doing is.

Source: Epsilon Theory, HFR, eVestment April 2018. An investor cannot invest directly in an index. For illustrative purposes only.

The Many Moods of Macro

So how should we feel about the non-tire fire half of these returns — by which I mean the rates and carry half?

As I’ve alluded to above, the first mood of macro has always been betting on the behavior of central banks. There are a variety of reasons for that, but the first is that Systematic Macro, like other hedge fund strategies — and systematic ones in particular — is drawn to trades, strategies and markets with lower natural volatility. That means, generally, that positioning driven by the models will emphasize either directional exposure to lower volatility asset classes like bonds, or relative value trades (i.e. going long one asset and short a similar one). Importantly, it also means that the models will favor what they perceive as loosely correlated trades or positions. If you have better-than-random confidence in what central banks are likely to do, you have a full range of options to implement those views with characteristics that are attractive to a manager seeking to sell itself as limiting downside with significant uncorrelated upside. The other reason that funds were so fond of strategies reliant on their central bank behavioral models, of course, is that the models themselves were historically pretty effective.

But there’s another, more important reason for the attachment to central bank-driven econometric models. While most trades with significant upside potential and convexity require you to pay a premium — or be “short carry” — during the bond bull run of the last 30 years, a macro manager with a decent prediction model for the behaviors of central bank actions could put on trades with convex characteristics that paid him a positive carry over almost all of this three-decade span. For example, a prediction of a future rate cut would not only get the benefit of the signal but would also receive the term premium in an upward sloping rates curve, a premium that can be significant even in the front end of the curve.  Not only that, because central banks in different countries pursued frequently divergent policies with explicitly different inputs and aims, that manager could put on multiple such trades. And what’s more, these positions were uncorrelated to most portfolios’ primary sources of risk — we were living in a golden age!

This preference for long carry positioning is itself, I think, the second constant mood of macro. While it has historically manifested in part as a willingness to carry a directionally long bias in bonds, it also manifests in a preference for anything that pays you more to own it than something else. In Systematic Macro funds, you will see this in models which — from a variety of econometric inputs — ended up with a consistent preference for higher carry currencies, especially certain emerging markets currencies. The underlying model mechanics might differ. For example, the “emerging markets balance sheet quality” thinkpiece was a staple of the mid-2000s. The story went that the higher yields you earned for owning — I don’t know, Turkish lira — were compensation for perceived risk, but that the econometric support for fiscal stability and quality meant that the real risk of permanent capital loss was far lower. There are a hundred models with rationale like this that all lead to a pronounced bias toward carry.

The third ubiquitous mood of macro is pro-trend, and in particular, medium-to-long-term trend following. I’ve noted that much of the Systematic Macro universe overlaps with Managed Futures and CTAs that have made trend-following their bread and butter, but even among Econometric GTAA strategies, it is quite common to use trends and momentum to drive positions or to condition other models. It is, perhaps, even more common to measure trends in the econometric variables as strategies or factors of their own. Systematic models will also be driven toward pro-momentum stances by their risk management techniques. Because positive returning assets are generally lower volatility assets, things that have done well will tend to score well when the portfolios are being built, even if there is no explicit model saying, “Buy stuff that’s going up!” Beyond that, because many of these funds added implicit or explicit stop-loss logic in 2009, even among funds I would qualitatively (and subjectively) describe as following Econometric GTAA strategies, you can frequently explain much of the variation in returns with price momentum across asset classes of various horizons.

All of this is, incidentally, also why so many of your discretionary macro managers have spent the last two decades trotting out their Eurodollar guys to meet with you. They’re the guys who got paid to bet on central bank actions with diversifying, pro-momentum, carry-paying trades.

Systematic Macro in Three-Body Markets

Now, I don’t have much to say about whether I think that carry trades and momentum trades will work — or at least I don’t have much to say in this note. Suffice it to say that there are good behavioral and empirical reasons to think that they are persistent premia that compensate investors for bearing a certain type of risk, and also good reasons to think that may manifest somewhat differently in markets driven by Narrative abstractions. These are topics for another note.

But I do think it is clear that Econometric GTAA strategies have struggled mightily to adapt to a Narrative-driven market with everything else they are doing. When I have met with strategists and macro funds over the last few years, their language has been static. They walk me through the economic nonsense of negative interest rates and the upside asymmetry created by the zero barrier. They describe how relative growth rates, debt levels, deficits and trade balances cannot possibly support the relative yields of Treasuries and Bunds. They present compelling cases for curve trades between European markets that should converge given influences on ECB asset purchases, or for relative outperformance of this equity market over that because of the extension of corporate margins beyond some historical threshold for some historically long period of time. In other words, the Explicit Behavior models from the illustrated earlier in this note are running through the old motions on what central banks, asset owners and governments are going to do, and none of them are working.

It’s not as if managers and strategists haven’t tried to adapt to a world in which these trade drivers are subsumed into central bank communications strategy and the utilitization of markets by political figures. But when the models driving your trading are built to understand the cost and transmission mechanisms of capital, and your asset prices are driven by how investors think other investors are responding to a stronger adverb in front of a maybe hawkish adjective, it’s got to be more than just adapting and updating your models. It’s recognizing that over an expanded time horizon, asset prices are being driven by a wholly separate set of variables.

What worries me more than anything, however, is that the ability of GTAA and macro strategies to access the moods that may still work (mostly models that end up looking like carry trades) may be limited by their construction and their design in the emerging environment. As macro and GTAA strategists adapt to rising interest rates and inflation, I think you’re going to see some of their models under strain. They will be under strain because their central bank behavior models will be shouting “short rates”, but their DNA, their risk management framework, and maybe even explicit pro-carry models — will be screaming “God, that short looks expensive. Are you sure?” This dependency — implied already in the assessment of sensitivity to bond markets — is real. Since 2000, the average Global Macro hedge fund has generated roughly 2.4x its average return in months where the discount rate was reduced, with almost no advantage during periods with a rising discount rate. I think we may be entering an environment in which the only things that have really worked for these funds get lost in the wash. In their place, I think investors can expect to get weaker, lower Sharpe strategies based on Market Data-driven positioning. A lot of momentum and value, and not much novel insight — in many cases, a very expensive balanced market portfolio with a value overlay.

What do I do if I’m an allocator?

  • I don’t put all my trust in a macro strategist or tactical manager’s econometric models to ‘figure this all out’.
  • I probably own fewer of these funds and have less of my portfolio invested in them in the aggregate.
  • I ask for a manager’s rates and FX attribution. If it’s positive for most of the 2000s and starts to sour and turn over in, say, 2013-2014 and hasn’t recovered, I take the plastic binding rings out and file the pitchbook away in that special Iron Mountain filing cabinet in the print room. You know, the one with the lock on it that the guy comes for every couple weeks?
  • I challenge my macro PMs to explain how their models might approach rates and FX trading differently when rates are rising and if central bank policy remains largely coordinated. If they say, “We’re not directional and have always been agnostic on long or short positions, so it wouldn’t be any different,” I do my most exaggerated eye roll, put my chin on my fist, bat my eyelashes and give ‘em my best ca. 1991 Glamour-Shots-at-the-mall smile until they tell the truth.
  • I actively seek out managers who are incorporating and increasing the role of sentiment analysis, investor asset flows, market structure and Narrative, and reducing the role of econometric models, whether explicitly or through a systematic process for rotating capital between models (or turning off models whose alpha has evaporated).
  • I actively seek out managers who have actually figured out multiple robust models for trading commodities effectively other than trend-following models.
  • I continue to invest with managers accessing Systematic Macro’s traditional moods, but I’m only willing to pay what those replicable strategies are worth.
  • I look for managers who act boldly but hold their views loosely — in a word, humility.

The last goes for you and me, too. We must be humble about our ability to make good predictions about asset prices and returns. In a Three-Body Market, we should be even more humble than usual. But blindly handing over the reins of our asset allocation decisions to impressive people who claim to have developed the one model that will unravel this market’s mysteries is not an act of humility. It’s the very same act of expedience that caused so many of these managers to saddle themselves and their strategies to central banks, and it is the reason they’re feeling the spurs today. Buck it — or feel the spurs yourself.

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