Investing with Icarus

The wind blows where it wishes, and you hear the sound of it, but cannot tell where it comes from and where it goes.

The Bible, John 3:8

As Narrative abstractions — cartoons — become our short-hand for things that used to have meaning, our models become more and more untethered from the reality they seek to reproduce. When wind becomes the thing-that-makes-the-leaves-move, then wind becomes a bear rubbing his back on the bark.

He that breaks a thing to find out what it is has left the path of wisdom.

The Lord of the Rings, J.R.R. Tolkien

Pursuing better returns by uncovering absolute truths about the companies and governments we invest in is not a serious enterprise in the face of markets rife with Narrative abstractions. It is a smiley-faced lie, a right-sounding idea that doesn’t work, and which we know doesn’t work. Selling the idea that it does to clients is the territory of the raccoon and the coyote. We can pursue it, or we can do the right things for ourselves and our clients. But not both.

Disneyland is presented as imaginary in order to make us believe that the rest is real, whereas all of Los Angeles and the America that surrounds it are no longer real, but belong to the hyperreal order and to the order of simulation. It is no longer a question of a false representation of reality (ideology) but of concealing the fact that the real is no longer real…

Simulacra and Simulation, Jean Baudrillard (1981)

How does Wall Street maintain the respectability of dishonest businesses? By declaring victory over straw men — active management is dead! Hedge funds lost the Buffett bet, beta won! Risk parity / vol-targeting / AI funds / quant funds are to blame! If you must sell that L.A. is real, you must create Disneyland.

“All right,” said Susan. “I’m not stupid. You’re saying humans need… fantasies to make life bearable.”

REALLY? AS IF IT WAS SOME KIND OF PINK PILL? NO. HUMANS NEED FANTASY TO BE HUMAN. TO BE THE PLACE WHERE THE FALLING ANGELS MEETS THE RISING APE.

“Tooth fairies? Hogfathers? Little—”

YES. AS PRACTICE. YOU HAVE TO START OUT LEARNING TO BELIEVE THE LITTLE LIES.

“So we can believe the big ones?”

YES. JUSTICE. MERCY. DUTY. THAT SORT OF THING.

“They’re not the same at all!”

YOU THINK SO? THEN TAKE THE UNIVERSE AND GRIND IT DOWN TO THE FINEST POWDER AND SIEVE IT THROUGH THE FINEST SIEVE AND THEN SHOW ME ONE ATOM OF JUSTICE, ONE MOLECULE OF MERCY. AND YET — Death waved a hand. AND YET YOU ACT AS IF THERE IS SOME IDEAL ORDER IN THE WORLD, AS IF THERE IS SOME…SOME RIGHTNESS IN THE UNIVERSE BY WHICH IT MAY BE JUDGED.

“Yes, but people have got to believe that, or what’s the point—”

MY POINT EXACTLY.

Hogfather, Terry Pratchett (1997)

So long as the government requires financial markets to act as a utility, and so long as it makes more sense for big tech companies to hire evangelists than CEOs — until the farmer comes out with his gun – we have only a few choices:

  1. We can be raccoons: We can recognize the overwhelming influence of abstractions and continue to sell products and ideas that don’t.
  2. We can be coyotes: We can recognize the overwhelming influence of abstractions and DESIGN new products and ideas that don’t.
  3. We can be victims: We can let the raccoons and coyotes run rampant over the farm.
  4. We can insulate: We can push back from the table and try to do the things that aren’t abstractions. Real things. Physical things. Things that put spendable currency in our accounts.
  5. We can engage: We can do our best to think about how to change our investment strategies and processes to respond to abstraction-driven markets.

These aren’t mutually exclusive, although only two are worthwhile. Ben’s DNA is long vol, so he wrote about how to insulate. My DNA is short vol. This note is first in a series on how to engage.

Speaking of DNA, there are few fields of study I find as thrilling as the intersection of anthropology and genetic geneaology. What I mean by that is how people lived, died and moved, and how their cultures and lineages moved with them. Yes, if kicking off notes with the old King James didn’t give you enough of a hint, I’m a big hit at parties.

Some of the appeal of genetic anthropology comes from the simple pleasures it offers, like the satisfaction of watching white supremacist idiots discover that they are mutts just like the rest of us.

The second appeal is the grand scale of ancestry and human movement, even over cosmologically infintestimal periods of time. This appeal is timeless. For example, in a legend common to three of the world’s great religions, God promises to multiply Abraham’s descendants as the stars of the heaven and as the sand on the seashore. It’s a pretty attractive promise, but temper your excitement — it was a reward for being a hair’s breadth away from murdering his son. The promises are poetic, of course, but the scope of the two is surprisingly different.

There are somewhere around 100 billion to one trillion stars in the Milky Way, an estimate which would vary based on how you estimated the galaxy’s total mass through the gravity it exerted and based on what you assumed was the average type of star. We’ve discovered a Wolf-Rayet star in the Magellanic Cloud with mass perhaps 300 times that of our sun, for example. It is so much larger than our sun that its surface would reach almost a third of the current distance to Mercury. Icarus wouldn’t stand a chance. On the other hand, we’ve discovered a red dwarf only 19 light-years away with less than 10% of the mass of the sun. But the 100 billion to one trillion range is a fair estimate. Earth has already seen 100 billion human lives. It will (hopefully) see its trillionth at some point between the year 2500 and 3000, if y’all could stop killing each other. Still, if you’re willing to ignore that we can see stars from other galaxies, too, I think we can prematurely give this one to Abraham.

As for the sand, there are about seven or eight quintillion grains on the earth. There’s just no way, even if Elon manages to get us off this planet before the next mass extinction event.

Interestingly, if you look backward, that isn’t quite true. When it comes to lineage, exponential math doesn’t always work going forward. One couple dies without any offspring, while another has a dozen children. But it always works going backward. Everyone has two parents and four grandparents. Based on most of those traditions holding that Abraham lived around 2,000 BC, we can estimate that the average living person has about 1.5 quindecillion ancestors from that time. Given that there were only about 72 million people alive at the time, that means that each of those individuals, on average, shows up in your family tree about 20 duodecillion times. That’s a 20 with 39 zeros. Congratulations! Math is amazing, and you are inbred.

The third appeal is that the really interesting findings are new. Very new. Anthropologists, of course, have theorized about the propagation and spread of cultures through comparative review of ancient art, tools, jewelry, burial sites and artifacts for centuries. Linguists can lean on anthropological techniques, but can also compare similar or derived grammar, vocabulary, and the like to identify how languages originated and spread. Maybe even some sense of where they came from. DNA has been used to develop and cultivate theories about human migrations and the spread of cultures for a shorter time, but in earnest starting in the late 1990s into the early 2000s. These studies have principally relied on the DNA of living individuals. Scientists examine current populations and theorize how ancient populations would have had to migrate to create the current distribution of various genetic admixtures — archetypes of varying compositions that can be generalized, like “Near Eastern Farmers.”

But in the last five years, the real excitement has been in the enrichment and analysis of ancient DNA. That means that, instead of just looking at modern populations and developing models to predict how they may have gotten there, we instead may look at the actual DNA of people who lived and died in some place in the distant past. We don’t have to guess how people moved and where they came from based on second-hand sources, like the DNA of people living in the same place thousands of years later, or on the pottery that they left behind.

We can know the truth.

Desperate for Wind

The allure of a fundamental truth is powerful. It’s the draw of science, and it’s a good thing. Understanding the true physical properties of materials and substances, for example, is the foundation of just about every good thing in our world. I mean, except for justice, mercy, duty, that sort of thing. We have the food we eat because those who went before discovered human chemical and enzymatic processes for digestion, and learned the mineral, chemical, water and solar needs for the plants that would be digestible. We have the devices we carry in our pockets because many thousands of researchers, designers and other scientists discovered the electrical conductivity of copper, the thermal conductivity of aluminum, the fracture toughness of various types of glass and a million other things.

I grew up around this kind of thinking. My dad worked for the Dow Chemical Company for some 40 years. Most of that time he spent as a maintenance engineer, an expert in predicting and accounting for the potential failure of devices and equipment used in the production (mostly) of polyethylene. His professional life’s work was perfecting the process of root-cause analysis. There may not be anyone in the world who knows more about how and why a furnace in a light hydrocarbons facility might fail. It may sound hyperspecialized, but that kind of laser-focused search for truth is something I took and take a lot of pride in.

Investors are hungry for that kind of clarity about markets. But it doesn’t exist. In The Myth of Market In-Itself, I wrote about investors’ vain obsession with finding root causes in media, economic news and Ks and Qs. Ben recently wrote about it pseudo-pseudonymously as Neb Tnuh, mourning the conversion of Real Things into cartoons, crude abstractions that investors are forced to treat like the authentic article:

Do I invest on the basis of reality, meaning the fact that wage inflation is, in fact, picking up in a remarkably steady fashion in the real economy? Or do I invest on the basis of Narrative abstractions that I can anticipate being presented and represented to markets at regularly scheduled moments of theater? Because the investment strategy for the one is almost diametrically opposed to the investment strategy for the other.

Like many Epsilon Theory readers, I am Neb Tnuh. Like Neb, I want to evaluate businesses and governments again. I want to understand their business models, evaluate their prospects against their competitors and subtitutes, quantify the return I can expect and the return I ought to demand for the risk, and seek out investment opportunities where the former exceeds the latter. I want this. But like everything else in life, wanting something to be possible doesn’t make it so.

It also doesn’t make it noble. Arch-raccoon James Altucher fancies himself Neb Tnuh, too:

“But business is just a vehicle for transforming the ideas in your head into something real, something tangible, that actually improves the lives of others. To create something unique and beautiful and valuable is very hard. It’s very special to do. It doesn’t happen fast.”
― James Altucher

And sure, there are ways to pull away from the table. There are ways to be short abstractions, like Neb recommends. Before he wrote The Icarus Moment, he wrote Hobson’s Choice, which described some of the few ways that all the Neb Tnuhs out there can reject the false choice between investing on the basis of a reality that is decoupled from risk and return, or not investing at all. These are strategies to insulate against Narrative abstractions, and I think they should be larger parts of almost every investor’s portfolio. Am I being explicit and actionable enough here? I’m talking about more real assets.

But a strategy which only insulates isn’t practical. It’s not practical for asset owners with boards, or actuarial returns, or a need to hit traditional benchmarks. It’s not practical for individuals who may not have the luxury, wealth or flexibility to, oh, I don’t know, buy an airport or 3,000 acres of northern red oak forests in Georgia. It probably isn’t desirable either. First, that level of underdiversification implies an extreme difference in return expectation, and I’m not going to leave that free lunch on the table. Neither should you. Second, the raison d’etre of turning the market into a utility, of propagating central bank missionaries and evangelist CEOs is the belief that those behaviors are at least somewhat predictable. If we’re not applying that in some measure to the rest of our portfolios, we’ve probably left something else on the table.

And so, unless we would be victims of the coyotes and raccoons who would sell us their own panaceas to this investing environment, we must engage with Narrative-driven markets. But it is hard. It is hard because the nature of abstractions is to require far more information — which usually means more time, too — to change their state. Think about when you’re explaining some complicated analogy to someone and they get confused (did you like my meta joke?). How much longer does it take you to get your conversation back on track? Think about the Keynsian Newspaper Beauty Contest. When you’re playing at the third or fourth level, how much more difficult is it to hold the pattern of what you’re evaluating in your mind, and how much more difficult is it to change that pattern to respond to new information once you’ve approximated it with some other thing, some heuristic or placeholder?

When an asset’s price, volatility behavior or direction is being driven by agreed-upon abstractions, so too is the required information to change its state far greater than usual. Missionaries explain away bad news, or create a new pro forma metric. Media members promote the new spin on the story. Supplicants call on confirmation bias to interpret it based on their existing thesis. And the contrarians who could move the price have all gone to the Hamptons for the decade. Notice how volatility spikes briefly and then disappears?

The question on whether to engage, or to try your luck with strategies that presume a strong, efficient link between economic facts and asset prices, is a question of timing. Unless your investment horizon — by which I mean the horizon over which your trade can go profoundly against you without your getting fired (if you’re a professional) or changing your mind (whether or not you’re a professional) — is more than 10 years, I simply don’t think you can have any confidence that your fundamental analysis has anything more than even odds. Sorry. And in case you were wondering, the answer is no. I don’t care who you are. You do not have a 10+ year horizon to survive being told by Mr. Market you were wrong without being fired or putting yourself under extreme pressure to change your mind.

Investing in a Time of Icarus

But we have already written about a lot of this. You know that Ben and I have said that many of these strategies just aren’t going to work the way that they used to, or when we’re looking for low-hanging fruit, that they haven’t worked the way that we all expected them to. You know that we think this is largely the result of markets and economies becoming utilities, Narrative replacing economic sensibility, and governments and oligarchs stepping into their own as missionaries for that utility and the Narratives that support it.

But what do we do? What do we do differently?

I’ve written about part of the answer fairly plainly in the Things that Matter and the Things that Don’t Matter series from 2017. There is a finite, definable list of investment principles which matter all the time, even in an Icarus Moment. Ben has written about the second element, which is to insulate.

For those who want to engage and continue the search for alpha, the answer depends.

First, it depends on the definition of alpha. When I say alpha, I mean any asset class-level decision that causes a portfolio to deviate from either the most diversified possible portfolio or a market cap-weighted portfolio of all global financial assets. I also mean any security-level decision that causes a portfolio to deviate from the broadest possible market-cap weighted benchmark for that asset class. It’s a simple definition that doesn’t get pedantic about whether a systematic active strategy is really a kind of “beta.” Sure it is. Or no, it’s not. It’s a stupid debate. I don’t care.

Second, it depends on the type of investment strategy you are using. It also depends on your methodology for implementing that strategy. Incorporating both of these requires some kind of framework to discuss.

Here’s what we’ll do: the dimensions I will use for the framework will be different from style boxes, and they’ll be different from categories used by many hedge fund index providers or asset allocators. I will define the categories instead by how I think they interact with an Icarus Moment, or a Three-Body Market — with a market in which asset price movements are heavily influenced by Narratives over an extended period of time.

The first dimension of those categories is what basis on which the strategy seeks to predict future asset prices (by which I include relative future asset prices). I roughly split strategy types into three categories: Economic Models, Behavioral Models and Idiosyncratic Models. Economic Models, in my definition, seek to predict future asset prices principally on the basis of actual and projected economic data about an economy, a financial market or an issuer, whether it’s a company or a government. Behavioral Models may incorporate some elements of Economic Models, but are principally driven by suppositions and beliefs about the behaviors of other market participants rather than the underlying companies. Idiosyncratic Models include various strategies which may even seek to exert direct influence on the future price of an asset.

For the second dimension of the framework, I think it is useful to separate investment strategies which are Systematic from those which are Discretionary. By Systematic Strategies, I refer to alpha-seeking strategies that reflect more-or-less static, if potentially emergent, beliefs about how prices are determined by certain characteristics or states, and whether those characteristics or states are directly related to economic data or more clearly influenced by observable investor behaviors.  The second category, Discretionary Strategies, refers to those in which there may be a process associated with similar beliefs, but in which the decision is made based on the judgment of a human portfolio manager. There are frequently observer effects in any investment strategy (i.e. where the act of observing something changes it), but particularly so in Narrative-driven markets. The systematic/discretionary dimension is important to understanding how this can manifest.

Those two dimensions give us six broad categories, which I have filled in with general descriptions of strategies that I think fall into each. There are things I haven’t captured here, but not many. Of active traditional and non-traditional investment strategies in public markets, I’m comfortable that this captures more than 80%. Close enough for government work.

Over the next few months, I will write a piece covering each of these six categories. My aim with this exercise is three-fold. For those who elect to both insulate and engage:

  • I want to tell you the strategies that I don’t think will work.
  • I want to tell allocators / asset owners how I think the evaluation of the strategies that may work should change.
  • I want to tell asset managers how I think they should consider adapting their strategies so that they still work in this environment.

If you think that I have bad news for the strategies on the left third of the table, thank you for paying attention. If you’re looking for a prize at the bottom, there is none.

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Year In Review

We’ve had a heckuva busy year at Epsilon Theory, so to ring out 2017 I thought it might be helpful to distribute a master list of our publications over the past 12 months. We’re long essay writers trying to make our way in a TLDR world, so even the most avid follower may well need a map!

It’s also a good opportunity to give thanks where thanks are due.

First, a heartfelt thank you to my partners at Salient for contributing a ton of resources to make Epsilon Theory happen, never once asking me to sell product, and allowing me the leeway to speak my mind with a strong voice that would make a less courageous firm blanch. Epsilon Theory isn’t charity, and it’s the smart move for a firm playing the long game, but no less rare for all that.

Second, an equally heartfelt thank you to the hundreds of thousands of readers who have contributed their most precious resource – their time and attention – to the Epsilon Theory effort. We live in a world that is simultaneously shattered and connected, where we are relentlessly encouraged to mistrust our fellow citizens IRL but to engage with complete strangers on social media. It’s an atomized and polarized existence, which works really well for the Nudging State and the Nudging Oligarchy, less well for everyone else. The lasting impact of Epsilon Theory won’t be in what we publish, but in how we’re able to bring together truth-seekers of all stripes and persuasions, because it’s your engagement with the ideas presented here that will change the world. I know that sounds corny, but it’s happening.

Now on to the 2017 publishing map.

Our big initiative for this year was to publish two coherent sets of long-form notes, one by yours truly and one by my partner Rusty Guinn.

My series of essays is called Notes From the Field. As many long-time readers know, I’m originally from Alabama but now live out in the wilds of Fairfield County, Connecticut, on a “farm” of 44 acres. I put that word in quotations because although we have horses and sheep and goats and chickens and bees, my grandfather – who owned a pre-electrification, pre-refrigeration, pre-pasteurization dairy farm in the 1930s – would surely enjoy a good belly laugh at my calling this a farm. Still, I’ve learned a few things over the years from the farm and its animals, and they’ve helped me to become a better investor.

  1. Notes From the Field: The eponymous note has two essays: “Fingernail Clean”, introducing the concept of the Industrially Necessary Egg – something we take for granted as proper and “natural” when it’s anything but, and “Structure is a Cruel Master”, introducing the genius of both humans and bees – our ability to build complex societies with simple algorithms.
  2. The Goldfinch in Winter: What can a bird teach us about value investing? To everything there is a season.
  3. Horsepower: The horse and horse collar revolutionized European agriculture in the 10th and 11th centuries, a revolution that lives on in words like “horsepower” and changed the course of human civilization. Today we are struggling with a productivity devolution, not revolution, and there is nothing more important for our investments and our politics and our future than understanding its causes and remedies.
  4. The Arborist: We are overrun with Oriental Bittersweet, privet, and kudzu — or as I like to call them, monetary policy, the regulatory state, and fiat news — invasive species that crowd out the small-l liberal virtues of free markets and free elections. What to do about it? Well, that’s citizenship, and I’ve got some ideas.
  5. Always Go To the Funeral: Going to the funeral is part of the personal obligation that we have to others, obligation that doesn’t fit neatly or at all into our bizarro world of crystalized self-interest, where scale and mass distribution are ends in themselves, where the supercilious State knows what’s best for you and your family, where communication policy and fiat news shout down authenticity, where rapacious, know-nothing narcissism is celebrated as leadership even as civility, expertise, and service are mocked as cuckery. Going to the funeral is at the heart of playing the meta-game – the game behind the game – of social systems like markets and elections, and it’s something we all need to understand so that we’re not played for fools.
  6. Sheep Logic: We think we are wolves, living by the logic of the pack. In truth we are sheep, living by the logic of the flock. In both markets and politics, our human intelligences are being trained to be sheep intelligences. Why? Because that’s how you transform capital markets into a political utility, which is just about the greatest gift status quo political institutions can imagine.
  7. Clever Hans: You don’t break a wild horse by crushing its spirit. You nudge it into willingly surrendering its autonomy. Because once you’re trained to welcome the saddle, you’re going to take the bit. We are Clever Hans, dutifully hanging on every word or signal from the Nudging Fed and the Nudging Street as we stomp out our investment behavior.
  8. Pecking Order: The pecking order is a social system designed to preserve economic inequality: inequality of food for chickens, inequality of wealth for humans. We are trained and told by Team Elite that the pecking order is not a real and brutal thing in the human species, but this is a lie. It is an intentional lie, formed by two powerful Narratives: trickle-down monetary policy and massive consumer debt financing.

The Three-Body Problem: What if I told you that the dominant strategies for human investing are, without exception, algorithms and derivatives? I don’t mean computer-driven investing, I mean good old-fashioned human investing … stock-picking and the like. And what if I told you that these algorithms and derivatives might all be broken today?

Rusty’s series of essays, Things that Matter (and Things that Don’t), connects to mine with his just published The Three-Body Portfolio. It’s a wonderful piece on its own (I can’t believe I didn’t think of the Soylent Green reference – Epsilon is people!) and is a great segue to his 2017 serial opus. In chronological order:

  1. With A Man Must Have a Code, Rusty begins the conversation about why we think that all investors ought to have a consistent way of approaching their major investment decisions.
  2. In I am Spartacus, Rusty writes that the passive-active debate doesn’t matter, and that the premise itself is fraudulent.
  3. In What a Good-Looking Question, Rusty writes that trying to pick stocks doesn’t matter, and is largely a waste of time for the majority of investors.
  4. In Break the Wheel, Rusty argues that fund picking doesn’t matter either, and he takes on the cyclical, mean-reverting patterns by which we evaluate fund managers.
  5. In And they Did Live by Watchfires, Rusty highlights how whatever skill we think we have in timing and trading (which is probably none) doesn’t matter anyway.
  6. In Chili P is My Signature, Rusty writes that the typical half-hearted tilts, even to legitimate factors like value and momentum, don’t matter either.
  7. In Whom Fortune Favors (Part 2 here), Rusty writes that quantity of risk matters more than anything else (and that most investors probably aren’t taking enough).
  8. In You Still Have Made a Choice, Rusty writes that maximizing the benefits of diversification matters more than the vast majority of views we may have on one market over another.
  9. In The Myth of Market In-Itself (Part 2 here), Rusty writes that investor behavior matters, and he spends a lot of electrons on the idea that returns are always a reflection of human behavior and emotion.
  10. In Wall Street’s Merry Pranks, Rusty acknowledges that costs matter, but he emphasizes that trading costs, taxes and indirect costs from bad buy/sell behaviors nearly always matter more than the far more frequently maligned advisory and fund management expenses.

But wait, there’s more!

You’ve got two more essays from Rusty:

  1. Before and After the Storm
  2. Gandalf, GZA and Granovetter

You’ve got 10 more essays from me:

  1. Harvey Weinstein and the Common Knowledge Game
  2. Mailbag! Fall 2017 Edition
  3. Mailbag! Midsummer 2017 Edition
  4. Gradually and Then Suddenly
  5. Tell My Horse
  6. Westworld
  7. The Horse in Motion
  8. Mailbag! Life in Trumpland
  9. The Evolution of Competition
  10. Fiat Money, Fiat News

Oh yeah, and you’ve got eleven 2017 podcasts here.

So there’s your 2017 Epsilon Theory map. 2018 will be even better.

And They Did Live by Watchfires: Things that Don’t Matter #4

Oliver Bird

There are two kinds of stories we tell our children. The first kind: once upon a time, there was a fuzzy little rabbit named Frizzy-Top who went on a quantum, fun adventure only to face a big setback, which he overcame through perseverance and by being adorable. This kind of story teaches empathy. Put yourself in Frizzy-Top’s shoes, in other words.

The other kind: Oliver Anthony Bird, if you get too close to that ocean, you’ll be sucked into the sea and drowned! This kind of story teaches them fear. And for the rest of their lives, these two stories compete: empathy and fear.

Oliver Bird, Legion, Chapter 4 (2017)

Skinner: What are you doing in here?
Linguini: I’m just familiarizing myself with, you know, the vegetables and such.
Skinner: Get out. One can get too familiar with vegetables, you know!
— Ratatouille (2007)

It’s four in the morning, and he finds himself drawn to a hotel and casino that has been out of style for thirty years, still running until tomorrow or six months from now when they’ll implode it and knock it down and build a pleasure palace where it was, and forget it forever. Nobody knows him, nobody remembers him, but the lobby bar is tacky and quiet, and the air is blue with old cigarette smoke and someone’s about to drop several million dollars on a poker game in a private room upstairs. The man in the charcoal suit settles himself in the bar several floors below the game, and is ignored by a waitress. A Muzak version of “Why Can’t He Be You” is playing, almost subliminally. Five Elvis Presley impersonators, each man wearing a different colored jumpsuit, watch a late-night rerun of a football game on the bar TV.

A big man in a light gray suit sits at the man in the charcoal suit’s table, and, noticing him even if she does not notice the man in the charcoal suit, the waitress, who is too thin to be pretty, too obviously anorectic to work Luxor or the Tropicana, and who is counting the minutes until she gets off work, comes straight over and smiles. He grins widely at her, “You’re looking a treat tonight, m’dear, a fine sight for these poor old eyes,” he says, and, scenting a large tip, she smiles broadly at him. The man in the light gray suit orders a Jack Daniel’s for himself and a Laphroaig and water for the man in the charcoal suit sitting beside him.

“You know,” says, the man in the light gray suit, when his drink arrives, “the finest line of poetry ever uttered in the history of this whole damn country was said by Canada Bill Jones in 1853, in Baton Rouge, while he was being robbed blind in a crooked game of faro. George Devol, who was, like Canada Bill, not a man who was averse to fleecing the odd sucker, drew Bill aside and asked him if he couldn’t see that the game was crooked. And Canada Bill sighed, and shrugged his shoulders, and said. “I know. But it’s the only game in town.” And he went back to the game.

— Neil Gaiman, American Gods (2001)

I had a dream, which was not all a dream.
The bright sun was extinguish’d, and the stars
Did wander darkling in the eternal space,
Rayless, and pathless, and the icy earth
Swung blind and blackening in the moonless air;
Morn came and went—and came, and brought no day,
And men forgot their passions in the dread
Of this their desolation; and all hearts
Were chill’d into a selfish prayer for light:
And they did live by watchfires…
— George Gordon, Lord Byron, Darkness (1816)

A Year Without Summer

In 1816 — 200 years ago — much of the world was experiencing a “Year without Summer.” We now know this was a result of the 1815 eruption of Mount Tambora, a volcano on the sparsely populated Indonesian island of Sumbawa, an eruption which sent some 38 cubic miles of rock, ash, dust and other ejecta into the atmosphere. For reference, that’s roughly 200 times the volume of material ejected in the eruption of Mount St. Helens, but only a tenth or so the size of the Lake Toba explosion off Sumatra that some researchers believe caused one of the most perilous bottlenecks in human genetic history.

At the time in 1816, the world didn’t know the cause. Well, except for maybe the people living on Sumbawa. The effects, on the other hand, couldn’t be missed.

In New England, the clouds of ash that blocked the sun led to remarkable drops and extraordinary variations in temperature and precipitation. In the Berkshires, there was a deep freeze in May. It snowed in Boston as late as June 7. Cornfields in New Hampshire were ruined by frost on August 14. The Dartmouth College campus was blanketed by snow as late (early?) as September. It caused as near a true famine as the U.S. has ever experienced. Hardy crops — some strains of wheat, potatoes and the like — got most of the nation through the year, as did a culling of wild game that likely came as a bit of an unpleasant surprise to the squirrels, hogs and possums that were usually spared a place on the American table.

The situation was not much better in Western Europe, where average temperatures fell as much as 3-4°C. On the British Isles, failed wheat and potato crops meant famine for much of Ireland, Wales and Scotland. Germany had food riots. And in Switzerland, where Lord Byron was in residence with Shelley, the constant rain and cold led each to create a great deal of poetry, which, depending on your opinion of early romanticism, was either more or less catastrophic than the torrential rains that accompanied it. Under the circumstances, it is not surprising that Byron was inspired to write about the heat death of the universe some 35 years before Lord Kelvin proposed it rather more formally (and perhaps less melodramatically).

Byron’s poem, Darkness, envisions a world in which the sun has been extinguished, in which morning never comes. In this time of desperation, the world is literally tearing itself apart. Palaces are ripped to pieces for firewood, forests are set alight and people gather “round their blazing homes” just so they can see their own hands, and the faces of their family and friends. Everything the world has built is pulled apart piece by piece in search of a solution to the problem of darkness.

The stories we tell about such times of desperation tend to fall into the two archetypes Jemaine Clement’s character describes in Legion: stories of fear and stories of empathy. Byron gave us a story of fear. Empathy stories, on the other hand, follow the usual trope of necessity as the mother of invention. But even this is often just a fear story with a different outcome, not uncommonly summoning a sort of deus ex machina. Luke listening to Obi Wan’s disembodied voice instead of the computer as he aims his last shot at the Death Star. Gollum showing up to bite off Frodo’s ring finger and take a dive into Mt. Doom, saving the hobbit from the now too-strong temptation to wear the ring and return it to Sauron. And maybe there’s a story where Byron’s humanity finds a real solution to the coming darkness instead of tearing their homes and businesses apart looking for something else to burn.

The investment environment we face is not so dire as all this, but it does feel a bit grim, doesn’t it? Market returns have continued to defy the odds, but the data, our consultants, our advisors, our home offices and our instincts are telling us that the combination of demographic slowing, stagnant productivity, limited debt capacity, low rates and high valuations isn’t going to end well. Or at a minimum, we remain optimistic but confused. I’m sure we’ve all asked or heard clients and constituents asking us, “What the hell do we invest in when everything is expensive and nothing is growing?” In this call to action, are we successfully turning this into an empathy story? Or are we just ripping apart our homes for tinder so that it looks like we are doing something?

When it’s hard to see what’s two feet ahead of our own noses, when the game feels rigged, sometimes it feels like we have no choice but to stay at the table and play. After all, it’s the only game in town. And so instead of walking away and taking what the market gives us, we tweak, we tilt, we “take chips off the table,” we “go all in” and we hack, hack, hack at the beams and joists of our own homes for the great bonfire.

This bias to action is a road to ruin. That’s why the endless tweaking, trading and rebalancing of our portfolios takes spot #4 on our list of Things that Don’t Matter.

Of Priuses and Passive Investors

In 2011 a group of researchers at Berkeley examined an age-old question: are rich people driving expensive cars the asshats we all think they are? The findings? Yes, indeed they are! The study found that drivers of expensive cars were three times more likely than drivers of inexpensive cars to fail to yield to pedestrians at crosswalks requiring it, and four times more likely to go out of turn at a stop sign. The team performed similar tests in other non-traffic areas (e.g., cheating at games of chance, etc.) that arrived at the same conclusion, and furthermore identified that simply making people believe that they were part of the 2% Club made them behave more rudely.

My favorite discovery from the research was the odd outlier they discovered: the moderately priced Toyota Prius. Fully one third of Prius drivers blew by intrepid Berkeley grad students (taking a night off from throwing trash cans through the windows of some poor Wells Fargo branch, perhaps) who stepped into a busy crosswalk for science. This put it very near the top of the tables for rudeness. Most of you will recognize this as our old friend moral licensing: the subconscious tendency to feel empowered/entitled to do something bad, immoral or indulgent after having done something to elevate our estimation of our own value. The Prius owner has earned the right to drive like a jerk, since he’s saving the world by driving a hybrid car, after all. Alberto Villar of Amerindo Investment Advisors, who was the largest opera donor since Marie Antoinette, could easily justify stealing his clients’ money to make good on charitable pledges. Of course I can eat that Big Mac and large fries when I sneak over to the McDonald’s across the street from our San Francisco office — I ordered a Diet Coke, after all.

And so on behalf of insufferable hipsters, fraudulent philanthropists and Big Mac dieters everywhere, I would like to extend a gracious invitation to our club: ETF investors who pride themselves on being passive investors while they tactically trade in and out of positions over the course of the year.

Now there’s a lot of old research protesting too much that “ETFs don’t promote excessive trading!” A cursory review of news media and finance journals will uncover a lot of literature arguing exactly that, although the richest studies are several years old now. You’ll even find some informing you that leveraged ETFs aren’t being abused any more. Those of you who are closest to clients, are you buying what the missionaries are selling on this one?

I hope not.

Even when some of the original studies were published (most of which said that mutual funds were held around three years on average, while ETFs were held about two-and-a-half years), it was plainly evident to anyone who works with consumers of ETFs that basing claims on the “average” holding behavior was a poor representation of how these instruments were being held and traded. The people with skin in the game who weren’t selling ETFs were aware that holders fell by and large into three camps:

  1. The long-term holders seeking out market exposure,
  2. The speculators trading in and out of ETFs to generate additional returns, and
  3. The increasingly sad and depressing long/short guys shorting SPY to hedge their longs, telling the young whippersnappers stories from a decade ago about “alpha shorts” before yelling for them to get off their lawn.

Source: Morningstar. For illustrative purposes only.

The mean holding period in the old research was still pretty long because Group 1 was a big group. I think that it was also because a lot of the ETF exposure that Group 2 was swinging around was in smaller, niche funds or leveraged ETFs. Both of these things are still true. They’re also becoming less true. A few weeks ago, Ben Johnson from Morningstar published this chart of the ten largest ETFs and their average holding period. There’s all sorts of caveats to showing a chart like this — some of the causes of ETF trading aren’t concerning — but if SPY turning over every two weeks doesn’t get your antennae twitching, I’m not sure what to tell you.

There are a lot of reasons to believe that we are lighting our houses on fire with the almost comically active use of “passive” instruments, and trading costs are one of them. Jason Zweig wrote an excellent piece recently highlighting research from Antti Petajisto on this topic. Petajisto’s work in the FAJ estimates that “investors” may be paying as much as $18 billion a year to trade ETFs. Zweig, perhaps feeling rather charitable, concedes that as a percentage of overall trading volume, this number isn’t really all that high. And he’s technically correct.

But who cares about trading volume, at least for this discussion, which isn’t really about the liquidity of the market? If — as so many investors and asset managers are fond of saying — the ETF revolution is but a trapping of the broader active vs. passive debate (insert audible yawn), we should really be thinking of this in terms of the asset size of the space. And in context of the $3 trillion, give or take, that is invested in ETFs, $18 billion is a LOT. It’s 60bp, which would be a lot even if it weren’t impacting investors who often make a fuss over whether they’re paying 15bp or 8bp in operating expenses.

And then there’s taxes. Now, actively managed strategies, especially those implemented through mutual funds, have plenty of tax issues and peculiarities of their own. But the short-term gains taxable investors are forcing themselves into by timing and day-trading ETFs are potentially huge.  If we assume, say, a 6% average annual portfolio return, the investor who shifts 100% of his return from long-term gains into short-term gains is costing himself 60-120bp per year before we consider any time value or compounding effects of deferring tax liabilities. Given that the largest ten ETFs all have average holding periods of less than a year, this doesn’t seem to be all that inappropriate an assumption.

The growing Group 2 above, our day traders — oops, I mean, our “passive ETF investors” — may be giving away as much as 1.2%-1.8% in incremental return. Those fee savings sure didn’t go very far, and the direct costs of all this tinkering may not even be the biggest effect!

Every piece of data on this topic tells the same story: when we try to time our cash positions to have “ammo to take advantage of opportunities,” when we decide a market is overbought, when we rotate to this sector because of this “environment” that is about to kick off, when we move out of markets that “look like they’ve gotten riskier,” when we get back in because there’s “support” at a price, we are burning down our houses to live by watchfires.

There are two ways in which we as investors do this, one familiar and one less so.

Of Clients and Crooked Card Games

First, the familiar. We stay in the crooked game because it’s what’s expected of us. It’s tempting to think of the desire, this inclination toward constant “tactical” trading as an internal impulse. A response to boredom or, perhaps, an addiction to certain of the chemical responses associated with winning, with risking capital, even with losing. I think that’s probably true for some investors. I know that when I sat in an allocator’s seat, when I heard a portfolio manager tell me he had “fallen in love with the market” when he was six years old and started trading options with his dad when he was 10, I didn’t see that as a particularly good thing. One can get too familiar with vegetables, you know.

But just as often, the impulse to stay in the game is external, and that pressure usually comes from the client. I’m empathetic to it, and it’s not unique to our industry.

Have you ever sent a document to a lawyer and gotten no comments back? Have you ever visited a doctor and gotten a 100% clean bill of health with no recommendations? Have you ever taken your car to a mechanic and had them tell you about just the thing you brought it in for? Have you ever consulted with a therapist or psychiatrist who didn’t find something wrong with you, even if they had the bedside manner to avoid using those exact words? It isn’t just that those folks are being paid for the additional services they’re proposing. There is a natural feeling among professional providers of advice that they must justify their cost to their clients even if the best possible advice is to do nothing.

The result is that the crooked card game usually takes three different forms, which, in addition to all the fees and tax impact discussed above, may add risk and harm returns for portfolios in other ways as well:

  • The Cash Game: When investors feel concerned about the timing of their entry into markets, the direction of markets, upcoming events, or some other factor and temporarily sell investments and go to cash, they’re playing the Cash Game. I recently had a meeting with an intermediary who had recently launched a system to integrate all client holdings (including accounts held away). Their initial run identified average aggregate cash positions of more than 15%!
  • The PerformanceChasing Game: I’ve talked about this ad nauseam in prior notes. We investors find all sorts of vaguely dishonest ways to pretend that we aren’t just performance-chasing. It doesn’t work, and a goodly portion of the damage done by tinkering and “tactical” moves is just performance-chasing in guise, even if we are high-minded enough to pretend that we’re making the decision because “the fund manager changed his process” or euphemistically inclined enough to say the investment “just wasn’t working,” whatever that means.
  • The In-Over-Our-Heads Game: Still other games are essentially designed to “fleece the odd sucker,” causing investors to seek out hedges and interesting trades to take advantage of events and “low cost” insurance for portfolios. As a case study, please take a gander at the size and volume of instruments and funds tracking the VIX. Please look at the return experience of holders of those various instruments. It’s not the vehicles themselves that are flawed, but the way in which these markets prey on misplaced expectations of investors that they know when insurance is cheap or expensive. As a quick test: if you can’t define gamma without looking it up on Investopedia, you probably shouldn’t own any of these instruments, much less be flopping in and out of them. This concept is broadly transferable to a variety of things investors do to “hedge” — buying S&P puts, buying short ETFs, etc.

I know I’m not treading new ground here. Borrowing from the work done in a thorough survey on the literature that itself concludes a 1.0% impact from the ways in which investors trade in and out of funds, the figures are pretty consistent. The folks over at Dalbar concluded in 2016 that investors in equity mutual funds underperformed equity indices by 3.5% over the last 20 years, 1.5% of which they attribute to “panic selling, exuberant buying and attempts at market timing.” Frazzini and Lamont previously estimated 0.85%. In 2007, Friesen and Sapp said 1.56%. We’ve got something for hedge fund investors, too.

You’ve heard this story before. So why am I telling you this?

Because when I meet or speak with investors, I often worry that when they think about dominant narratives and observations about human behaviors, they are focused on identifying tradable trends and signals. In rare cases, that is a worthwhile endeavor. And we’ve made no secret that we’re spending a lot of time thinking about the Narrative Machine — after all, if we believe that investors systematically make mistakes that cost them returns and money, it should be possible to identify ways to capitalize on the actions taken by others.

But far more often, the message from the analysis of prevailing narratives is to back away from the table. Investors I’ve spoken to in the past few years have heard a voice of caution against rotating away chunks of portfolios that by all rights ought to be invested in bonds based on flimsy rationale like, “rates couldn’t possibly get lower!” I’ve likewise cautioned against haphazardly fleeing equity markets into cash on the basis of historically high valuations, perceived political turmoil and the like. There will come times where it may be right to make strong positive observations on opportunities for tactical allocations, but as in all decisions we make when investing, it is imperative that we be aware that the hurdle for staying at the table to play the only game in town is very high. Our skepticism about opportunities to play it should be extreme.

Of Bambi and Battle Tanks

Since I’m advising you to be skeptical, I’ll forgo the apocryphal (it’s real to me, dammit!) story I was going to tell at this point in my little piece. I was going to tell you a story my brother told me once about a high school classmate, an M1A1 Abrams tank and a whitetail deer. It is apparently not normal in polite company to discuss the disintegration of adorable animals, and so I won’t unless you buy me a drink (Lagavulin and water, please). What I will do is highlight that the often-overlooked pitfall of the tinkering mentality is the tendency to use very big tools to accomplish very small things, for which the intended aim is almost always overwhelmed by the unintended consequence. Pointing a 120mm smoothbore cannon at a tiny animal isn’t going to shrink the explosion it causes. Likewise, pointing a major change in risk posture or asset allocation at an event we’re a bit nervous about isn’t going to change the fact that we’ve made a change to some very fundamental characteristics of the portfolio.

This happens all the time.

In the last year, I’ve met with advisors, allocators and investors convinced of the inexorable, unstoppable, indomitable rise of interest rates who exited their government and investment-grade bond portfolios — in many cases, the only remnant of their portfolio standing against them and a downturn in risk assets — in favor of higher yielding equity portfolios that wouldn’t be as exposed to the environment they expect. I’ve seen investors leaving passive equity allocations in favor of concentrated private deals because they are concerned about the broader economy’s impact on stocks. I’ve seen investors switch asset classes because they didn’t like the manager they were invested with.

There may be reasons for some of those views, and in some cases even for acting on them. But I am always concerned when I see changes like that unaccompanied by consideration of the magnitude of the unintended consequences: are we still taking the right amount of risk? Are we achieving adequate diversification? As we close out the list of Things that Don’t Matter, I look forward to publishing our list of things that actually DO, because these questions play prominently. There is hope. There are things we can do, and most of them will run contrary to our instincts to take rapid, “nimble” action in our portolios.

Within that thread of hope, a plea first to readers who prefer poetry: that we feel disillusioned or confused about the outcomes for markets does not mean we ought to be more active, more nimble in modifying our asset allocation, however good and wise those things sound when we say them to ourselves and our clients. All the data tell us that we are likely to find ourselves warming our hands at a watchfire before long. To those who prefer poker: you don’t have to play the game. It is OK to step away from the table, walk back to the elevator bank and call it a night, to take what the market gives us.

Make no mistake: the alternative is worse. It’s an expensive alternative. It’s often a risk-additive alternative. It’s a tax-producing alternative. It’s an alternative that frankly most of us just aren’t in a position to successfully execute. There is a reason that most global macro and GTAA hedge funds hire traders who have success in individual markets, even individual types of trading strategies within individual markets. It’s because being able to effectively determine when to switch among managers, among asset classes and among drivers of risk and return is very, very hard. The data bear this out, and no matter how hard we feel like we have to do something, it won’t change the fact that lighting our house on fire isn’t going to make the sun come back.

Understanding the dominant impact of narratives in markets today doesn’t mean abandoning our well-designed processes and our work determining asset allocation, risk targets and portfolio construction in favor of a haphazard chasing of the narrative-driven theme for the day. It means that human behavior and unstructured forms of information should — must — increasingly play a role in the structure of each of those processes in the first place.

After all, all investing is behavioral investing. Anyone who tells you different is either incompetent, selling something or both. One of the most pointless such behaviors — our unquenchable desire to act — nearly completes our list of the Things that Don’t Matter.

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What a Good-Looking Question: Things that Don’t Matter #2

Peter Griffin buys a tank.

Peter Griffin: What can you tell me about this one?

Car Salesman: Oh, that’s just an old tank I use for those commercials where I declare war on high prices. Now about that sedan…

Peter Griffin: Hang on there, slick. Now I see your game. We come in here wanting a practical car, but then you dangle this tank in front of me and expect me to walk away. Now, I may be an idiot, but there is one thing I am not, sir, and that, sir, is an idiot. Now, I demand you tell me more about this tank!

Car Salesman: Well, if you’re looking for quality, then look no further.

Peter: That’s more like it! Tell me, what are the tank’s safety features?

Car Salesman: What a good-looking question. Three inches of reinforced steel protects your daughter from short-range missile attacks.

Peter: I see. And does the sedan protect against missiles?

Car Salesman: It does not.

Family Guy, Season 5, Episode 3, “Hell Comes to Quahog”

There was an unclouded fountain, with silver-bright water, which neither shepherds nor goats grazing the hills, nor other flocks, touched, that no animal or bird disturbed not even a branch falling from a tree. Grass was around it, fed by the moisture nearby, and a grove of trees that prevented the sun from warming the place. Here, the boy, tired by the heat and his enthusiasm for the chase, lies down, drawn to it by its look and by the fountain. While he desires to quench his thirst, a different thirst is created. While he drinks he is seized by the vision of his reflected form. He loves a bodiless dream. He thinks that a body, that is only a shadow. He is astonished by himself, and hangs there motionless, with a fixed expression, like a statue carved from Parian marble.

Flat on the ground, he contemplates two stars, his eyes, and his hair, fit for Bacchus, fit for Apollo, his youthful cheeks and ivory neck, the beauty of his face, the rose-flush mingled in the whiteness of snow, admiring everything for which he is himself admired. Unknowingly he desires himself, and the one who praises is himself praised, and, while he courts, is courted, so that, equally, he inflames and burns. How often he gave his lips in vain to the deceptive pool, how often, trying to embrace the neck he could see, he plunged his arms into the water, but could not catch himself within them! What he has seen he does not understand, but what he sees he is on fire for, and the same error both seduces and deceives his eyes.
― Ovid, Metamorphoses, Book III

Brian: Look, you’ve got it all wrong! You don’t need to follow me. You’ve got to think for yourselves! You’re all individuals!

Crowd: Yes! We’re all individuals!

Brian: You’re all different!

Crowd: Yes! We’re all different!

Man: I’m not.

Crowd: Shhh!

Life of Brian (1979)

There may be members of the committee who might fail to distinguish between asbestos and galvanized iron, but every man there knows about coffee — what it is, how it should be made, where it should be bought — and whether indeed it should be bought at all. This item on the agenda will occupy the members for an hour and a quarter, and they will end by asking the Secretary to procure further information, leaving the matter to be decided at the next meeting.

― C. Northcote Parkinson, Parkinson’s Law: Or the Pursuit of Progress

One of our portfolio managers at Salient started his career working the desk at a retail branch of a large financial services firm in Braintree, Massachusetts. He likes to tell the story of “Danny from Quincy” (pronounced Qwin’-zee). Danny is a rabid Boston sports fan who frequently called in to a local sports talk radio show. Your mind may have already conjured an image of our protagonist, but for the uninitiated, American sports talk radio is community theatre at its most bizarre (and entertaining), its callers a parade of exaggerated regional accents shouting really awful things at no one in particular. Local sports talk radio is even more of an oddity, since on the clear fundamental question, that is, which team everyone supports, practically all parties involved agree.

Lest Bostonians feel singled out, this phenomenon is infinitely transferable. In Buffalo, Pittsburgh, Chicago, Kansas City and Oakland, it is much the same. In each, the listener can expect the same level of anger, whether it is shouting about things everyone listening agrees on, like the ‘fact’ that the NFL has always preferred Peyton Manning to Tom Brady and that Deflategate just boiled down to jealousy, or relatively petty items of disagreement, like the ‘fact’ that Belichick reached on a player in the draft who would have been available in the 4th or 5th rounds when what they really needed was help at defensive back.

When Danny from Quincy wandered into our colleague’s Braintree branch, Danny’s voice was distinctive enough that he was immediately recognized. From their conversation, it was clear that this happened to Danny all the time. Here was a local celebrity minted by nothing other than the fact that he could shout agreed-upon concepts at the loudest possible volume and with proper non-rhotic diction.

It is hardly a novel observation that disputes among those who agree on the most critical questions and disagree on details are often among the most violent. After all, more died in the disputes between French Catholics and Huguenots alone than in all three of the Crusades. And it took twice as long for John Lennon and Paul McCartney to get in a recording studio together after the Yoko Ono Experience than it took for King George III to receive John Adams as ambassador after the Treaty of Paris. As investors, however, we have turned this seemingly normal human behavior into an art form.

There are all sorts of social and psychological reasons why we so enjoy wallowing in issues of lesser import with those with whom we otherwise largely agree. One of the main reasons is that big, important issues — the ones that divide us into broad groups — tend to be either issues outside of our control, or complex and more difficult to understand. By contrast, the smaller, less important issues are more likely to be understood by a wider range of people. Or at least they are more familiar.

In 1957, C. Northcote Parkinson’s eponymously titled book Parkinson’s Law: Or the Pursuit of Progress dubbed this phenomenon the Law of Triviality. In referencing the work of a finance committee, it concluded that “…the time spent on any item of the agenda will be in inverse proportion to the sum involved.” In other words, the more trivial something is, the more time we are likely to spend discussing it.

In his book, Parkinson dramatically reenacts the three agenda items before a finance committee: a $10 million nuclear reactor, a $2,350 bicycle shed and a $57 annual committee meeting refreshment budget. As you might expect, the details of a plan to build a nuclear reactor would fall well outside the abilities of even sophisticated committees, and even for those members with some sophistication, the task of bringing legitimate concerns or questions before an otherwise unknowledgeable group is daunting. In Parkinson’s example, the knowledgeable Mr. Brickworth considers commenting on the item but “…does not know where to begin. The other members could not read the blueprint if he referred to it. He would have to begin by explaining what a reactor is and no one there would admit that he did not already know.” He concludes that it is “better to say nothing.”

The item passes after two and a half minutes of discussion.

The next item before the committee is the discussion of a committee to build a bicycle shed for clerical staff. The discussion includes a range of topics, from cost to necessity to the choice of construction materials. As Parkinson puts it, “A sum of $2,350 is well within everybody’s comprehension. Everyone can visualize a bicycle shed. Discussion goes on, therefore, for 45 minutes, with the possible result of saving some $300. Members at length sit back with a feeling of achievement.” It is not difficult to guess where the meeting goes from there. It becomes a multi-hour marathon discussion of the $57 coffee budget, which leads to a demand for additional research and a subsequent meeting.

This dynamic should be familiar to almost anyone in the investment industry. Whether you are a financial advisor, institutional allocator, professional investor or just an individual trying to navigate the waters of an industry seemingly designed with the purpose of confusing investors, you’re at risk of more than a few Bike Shed discussions.

The code-driven investor doesn’t waste his time on the Things that Don’t Matter.

The Biggest Bike Shed of them All

Problematically, the biggest, most egregious Bike Shed probably dominates more discussions between asset owners (individuals, institutional investors) and asset managers than anything else: talking stocks.

Stop for a moment and take an inventory. If you’re an individual investor, think about your last meeting with your financial advisor. Financial advisors, pension fund execs, endowment managers, think about your last meeting with your fund managers. How much of the meeting did you spend talking about or listening to them talk about stocks and companies? A third of the meeting? Half? More? Maybe you were well-behaved and focused on things that matter, but let’s be honest with each other. We all talk about stocks way too much and we know it.

It makes me think a bit about doctors in the post-WebMD era. Once upon a time, an experienced and well-trained physician could practice medicine with deference — almost a sort of detached awe — from the patient. That is, until the internet convinced every one of us who ran in sheer terror from the syllabus for organic chemistry that we have every bit as much skill as a doctor in diagnosing ourselves with every kind of malady. For the professional investor — especially the professional investor in common stocks — this has been the case for centuries. There is no profession for which the lay person considers himself so prepared to succeed as in the management of stock portfolios.

Lest you feel any empathy for the professional in this case, our layperson isn’t entirely wrong. Not because he has some latent talent but because the average stock portfolio manager probably doesn’t. This shouldn’t be provocative. It also isn’t an opinion, as Nobel Prize winner Eugene Fama famously said, and as I rather less famously agreed in I Am Spartacus. It’s math. To pick winners and losers in the stock market is a zero-sum game, which means that for every winner who is overweight a good stock, there is a loser who is underweight. And both of them are paying fees.

As I wrote previously, it is true that this notion is driven by a narrow capitalization-weighted view of the world. It also doesn’t take into account that investors with different utility functions may differ in what they consider a win. Yet the point remains: so long as math is still a thing, on average, active managers won’t outperform because they can’t. This is a big reason why over long periods only 3% of mutual fund managers demonstrate the skill to do so after fees (Fama & French, 2010).

But the question of whether we ought to hire active stock managers isn’t even the Bike Shed discussion — after all, the phony active vs. passive debate took the top spot on this ignominious list. Instead, the mistake is the obscene amount of time we as investors spend thinking about, discussing and debating our views on individual stocks.

So why do we spend so much time doing this?

Well, for one, it’s a hell of a lot of fun. Whether we are investors on our own behalf or professionals in the industry, dealing with financial lives and investments can be drudgery. As individuals, it’s taxes and household budgets and 401(k) deferral percentages and paying people fees. As professionals, it’s due diligence and sales meetings and prospectuses and post-Christmas-party trips to HR training. Daydreaming about a stock where you really feel like you have a unique view that you haven’t heard from someone else is a blast by comparison.

Fun aside, familiarity plays an even more significant role. Each investor encounters companies with public stocks as a consumer and citizen on a daily basis. We are familiar with Apple because we buy their phones and tablet devices. We know Exxon because we have a friend or family member who works there. We work at another pharmaceuticals company and we think that gives us an edge in understanding Merck.

It is so important to recognize that these things give you an edge in talking about a stock, but absolutely zero advantage in investing in one. Lest we think that something is better than nothing, in this case, that is decidedly not so. When we know nothing, and know that we know nothing (h/t Socrates) about a company that will matter to its stock, we are far more likely to make sensible decisions concerning it, which typically means making no decision at all. When we know nothing and think we know something valuable, we are more likely to take actions for which we have no realistic expectation of a positive payoff. But it’s worse than taking a random uncompensated risk, because this kind of false-knowledge-driven investing also engenders all sorts of emotional and behavioral biases. These biases will drive you to hold positions longer than you should, ignore negative information and all other sorts of things that emotionally compromised humans do.

We also spend time doing this because talking about companies and stocks gives us a sort of feeling of parity that we usually don’t feel when we’re talking to our fund managers and financial advisors. These guys are often some of the smartest people we get to talk to. It can be intimidating. We look for any common ground we can find. We love being told we asked a very good or smart question. Strangely, my questions were much smarter when I worked at a $120 billion fund than since that time. I must have gotten stupider.

In case this is hitting a bit too close to home, let me assure you that you are not alone.

Before I was an asset manager — when I represented an asset owner — I was occasionally invited to speak at conferences. One such conference was in Monaco. Now, our fund had an investment with a hedge fund based there and given the travel expenses associated with conducting diligence meetings in Europe, combining the two made good fiscal sense. It also meant that our usual practice of conducting diligence in pairs wasn’t really feasible. So, I was running solo.

On Tuesday, I attended the conference, giving speeches to other asset owners about what effective diversification in a hedge fund portfolio looks like, and then speaking later on a panel to an audience of hedge funds on how to present effectively to pension fund prospects. I could barely leave the room without a mob of people looking for a minute of my time or a business card, and friends, I’m not a particularly interesting public speaker. I felt like a big shot.

On Wednesday, I met our fund manager for lunch. I don’t remember the name of the venue, but it was attached to some Belle Époque hotel with a patio overlooking the Mediterranean. From the front of the hotel, we were ushered through a sort of secret passageway by a tuxedoed man who, when we arrived at the patio, was joined by three similarly attired partners who proceeded to lift and move a 400-some-odd-pound concrete planter that isolated the table we would be sitting at from the rest of the patrons. When we had passed by and sat down — not without a Monsieur-so-and-so greeting and obsequious bow of the head to my host — they then lifted and returned the planter to its place and disappeared.

The gentleman welcomed me to his city graciously in Oxbridge English, but I knew from my notes that he spoke Italian, German and French as a native as well. I think he was conversant in Dutch and several other languages besides. He was an activist investor, and had such a penetrating understanding of the companies in which he invested (usually no more than 5 or 6 at any time) that I could tell immediately I was several leagues out of my depth. He was so intimately familiar with the tax loss carryforward implications of eight potential cross-border merger partners for a portfolio financial services holding that I deemed it impossible he didn’t sport an eidetic memory.

By the time I had finished a cup of bisque and he had finished (food untouched) passionately discussing solutions to flawed regulator-driven capital adequacy measures, I was so thoroughly terrified of this brilliant and just disgustingly knowledgeable man that I couldn’t help but grasp at the thing I knew I could hang with him on. I wasn’t going to be the sucker at this table!

“So, what about your position in this British consumer electronics retailer?”

And down we go into the rabbit hole, Alice. Ugh.

Look, we’ve all been there. Or maybe it’s just me and none of you have ever felt intimidated and stupid and reached out for something, anything. Either way, it’s so critical that you know that your fund manager, even your financial advisor, loves it when you want to talk stocks. Loves. It. He loves it because he knows his client will have some knowledge of them, which gives him a chance to establish common ground and develop rapport with you. It keeps the meeting going without forcing him to talk about the things he doesn’t want to talk about, namely his performance, his fees and how he actually makes money for his clients.

It’s a great use of time for him — he’s selling! — and an absolutely terrible use of time and attention for you, the investor. If they drive the conversation in that direction, stop them. If you commit an unforced error and try to get them to sell you the tank instead of the sedan, stop yourself.

Why It Doesn’t Matter

But is thinking about your individual stock investments and those made on your behalf really always such a terrible use of time? Even though I asked the question I just answered in a rhetorical way that might have indicated I was going to change my mind and go a different direction here, yeah, no, seriously, it’s a ridiculously bad use of time. Let me be specific:

If you are spending more than a miniscule fraction of your day (say, 5% of whatever time you spend working on or talking to people about investments) trying to pick or talk about individual stocks, and you are not (1) an equity portfolio manager or (2) managing a portfolio with multiple individual stock positions that are more than 5% of total capital each, this is absolutely one of the Five Things that Don’t Matter.

Why? The answer has more to do with the nature of stock picking than anything else, but in short:

  1. You probably don’t have an edge.
  2. Even if you do, being right about it won’t necessarily make the stock go up.
  3. And even if it sometimes did, it wouldn’t matter to your portfolio.

There are empirical ways to tell you how hard it is to have an edge. Academics and asset managers alike have published innumerable studies highlighting the poor performance of active equity managers against broad benchmarks and pointing out the statistical inevitability of outliers like Buffett or Miller. But you’ve probably already read those, and if you’re like me you want to know why. So here’s why it’s so damned hard.

There are only two possible ways to outperform as a stock-picker:

Method 1: Having a different view about a company’s fundamental characteristics than the market expects, being right, and the market recognizing that you are right.

Method 2: Having a view that market perception about a company will change or is changing, estimating how that will impact buying and selling behaviors, and being right.

That’s it. Any investment strategy that works must by definition do one of these things, whether consciously or subconsciously. Deep value investors, quality investors, Holt and CFROI and CROCE aficionados, DDM wonks, intrinsic value guys, “intuitive” guys, day traders, the San Diego Momentum Mafia, quants — whatever. It’s all packaging for different ways of systematically or intuitively cracking one of these two components in a repeatable way.

The problem for almost all of us — individuals, FAs, fund managers, asset owners — is that we want to think that doing truly excellent fundamental analysis guided by a rigorous process and well-constructed models is enough. Friends, this is the fundamental message of Epsilon Theory, so I hope this doesn’t offend, but fundamental analysis alone is never enough to generate alpha.

This is what leads us to focus our efforts vainly on trying to find the most blindingly intelligent people we can find to build the best models and find that one-off balance sheet detail in the 10-K notes that no one else has found. We’re then disappointed after three straight years of underperformance, and then we fire them and hire the next rising star. It is what leads us to spending time researching companies ourselves, evaluating their new products, comparing their profitability ratios to those of other companies, and the like.

This isn’t to say that fundamental analysis doesn’t have value to a valid equity investment strategy. It certainly can and may, but as a necessary but insufficient component of Method 1 described above. The missing and absolutely indispensable piece is an accurate picture of what the market actually knows and is expecting for the stock, and how participants will react to your fundamental thesis being correct.

This is where (probably) you, I and the overwhelming majority of fund managers and financial professionals sit. We may have the capacity to understand what makes a company tick, how it works. We may even be able to identify the key variables that will determine its success. But when it comes to really assessing what the next $500 million of marginal buyers and sellers — you know, the people who determine what the price of the thing actually is — really think about this stock and how they would respond to our thesis being right, I believe we are typically lost. We’ve built a Ferrari with no tires to grip the road. A beautiful, perfectly engineered, useless masterpiece of an engine.

This is one of the reasons I think that platforms that canvass the views of the people that mostly closely influence the decision-making framework of buy-side investors (i.e., sell-side research) are one of the rare forms of true and defensible edge in our industry. It’s also why I think highly of quantitative investors who systematically exploit behavioral biases that continuously creep into both Methods above over time. It’s why statistical arbitrage and high-speed trading methods work by focusing on nothing other than how the marginal buyer or seller will implement a change in their views. It’s why I think you can make an argument for activist investing on the basis that it takes direct control of both a key fundamental factor and how it is being messaged to market participants. It’s also why we’re so excited about the Narrative Machine.

But it’s also why — despite my biases toward all things technological — I also retain respect for the rare instances of accumulated knowledge and intuition about the drivers of investor behavior. I can add no thoughts or added value concerning the most recent allegations against him, but Lee Cooperman is the best case study I can think of for an investor who gets Method 1. This is a man who defines old school in terms of fundamental analysis. He sits at a marble desk, shelves behind him bedecked with binders of his team’s research and Value Line books flanking a recording studio-style window looking out on his trading floor. His process leverages a large team of hungry young analysts in a classic you-propose-I-dispose model. So yes, the fundamental analysis is the centerpiece. But in my opinion what set him and his returns apart was his ability from 50 years in this city, training or working with half of his competitors, to understand how his peers — the marginal buyer and seller — would be thinking about and would respond to what he discovered in his team’s fundamental analysis.

Ladies and gents, if you think the savvy kid from the Bronx who gets people in an intuitive sense doesn’t occupy a prominent seat at this table, you simply don’t know what you’re talking about.

But even so, let’s daydream. Let’s imagine that you are, in fact, Leon-effing-Cooperman in the flesh, with all his skills and experience. But instead of holding his relatively concentrated book, you’re holding what you and I probably own or advise for our clients or constituents (or at least should): some form of a balanced and diversified portfolio. Even if you knew that you were good at this one part of the game, would it even matter?

Sadly, not really.

You see, in a typical diversified investor’s portfolio, the idiosyncratic characteristics of individual securities — the ones driven by the factors truly unique to that company — are unlikely to represent even a fraction of a fraction of the risk an investor takes.

Consider for example a generalized case where an investor built a portfolio from an index portfolio — say US stocks — and a separate “tracking error” portfolio. This is kind of what we’re doing when we select an active manager. Even with relatively robust expectations for tracking error and the unrealistic assumption that all of the tracking error came from idiosyncratic (those unique to that security) sources with no correlation to our equity portfolio, the bets made on individual stocks account for less than 10% of total risk.

Percent of Portfolio Risk from Active Risk

Source: Salient Partners, L.P., as of 03/31/2017

Now think about this in context of our larger portfolio! In practice, most stock discussions take place in context of multi-manager structures or portfolios, in which case the number of stocks will rise and the level of tracking error will fall even further than the above. To take that even further, the majority of the sources of that tracking error will often not be related so much to the individual securities selected by the underlying managers, but a small number of systematic factors that end up looking like equity risk, namely (1) a bias to small cap stocks and (2) a bias toward or away from market volatility.

In the context of any adequately diversified portfolio, stock picks are a Bike Shed. If it is your job in the context of a very large organization to evaluate the impact of active management, you may bristle a bit at this. I remember how I justified it to myself by saying, “Well, I’m only talking about stocks this much because I want to get a picture of how she thinks about investing, and what her process is.” That’s all well and good, if true. Even so, consider whether the discussion is really allowing you to fully determine whether the advisor or fund manager has an edge under the Methods described above.

For the rest of us, spending time thinking about, discussing and debating your stock picks or those of your advisors is almost certainly a bad use of time, no matter how enjoyable. That’s why it sits at #2 on our Code’s list of Things that Don’t Matter. And if you still think we’ve given fund managers too much of a pass here, you’ll find more to like at #3.

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