The Ghosts of Commentary Future

“Are these the shadows of the things that Will be, or are they shadows of things that May be, only?”

A Christmas Carol, by Charles Dickens (1843)

With Thanksgiving in the books, we are approaching a special time of year. No, not Christmas. Not Hanukkah. Not even the season when some dumpster fire of a team from the NFC East manages to limp into the playoffs with a 5-11 record.

It’s outlook season.

Now, we are critical of financial market commentary most of the time, for the rather uncontroversial reason that it is nearly always composed of an equal blend of five loathsome traits: backward-looking, narrative-conforming, book-talking, non-actionable and (most damning of all) boring. But in outlook season, financial news outlets, financial social media, and both buy-side and sell-side institutions take each of those traits and dial them up to an eleven. And it’s always for the same three types of pieces.

Like I said, boring.

These are The Ghosts of Commentary Future, if you will. And if their chains are not already clanking around in your inbox, they will be very, very soon.

You will first be visited by the Ghost of a Good Environment For Active Management. Actually, I feel rather confident this specter is among those that has already darkened your doorstep. This is the obligatory end-of-year piece in which the fund manager, financial media outlet or bank offers you all sorts of reasons why you should believe in (read: why you should pay for) stock-picking over the coming months.

These pieces are very painful to read. And because small cap and volatile stocks have outperformed recently (and because those are, by a hilarious margin, the largest drivers of relative performance for the bulk of AUM invested in 100% net exposure active portfolios), these pieces in 2020 will be especially painful. If you’re an FA or institutional allocator that uses third-party managers, starting December 1st you will start to receive a stream of, “Well, we told you that this [unprecedented volatility / unprecedented stimulus / unprecedented pandemic] would create volatility and clear winners. After outperforming the S&P 500 by [X%] in November, we’re happy to say we were winners. We think this target-rich environment for active management is here to stay.” letters.

Gird yourself.

From Basically A Snake Don’t Have Parts (2018):

[C]onsider that any reason given in defense of the vaunted better environment for active management will inevitably take the form of one of these three ideas: (1) There will be more volatility in markets and dispersion among stocks, (2) forces causing markets to rise and fall in unison (e.g. central banks) will relax or (3) information disperses more slowly in this market, creating inefficiencies to exploit…

Fortunately, all this nonsense is easy pickins’ for the critic, who observes dryly that even if these above three states were to exist, alpha would remain a zero sum game, and that increased dispersion would simply cause the transmission mechanism between active share and active risk to rise. In other words, none of this changes whether active management will work better or worse on average, it just widens the gap between the winners and losers.

That’s obvious enough, I think? Except this idea, too, is right in all the ways that don’t matter and wrong in all the ways that do.  

Yes, yes, the market is zero sum and all that. But after she interviews a hundred fund managers, and only finds one or two that are actually overweight Apple or Microsoft, any realistic assessor of a public markets asset class will quickly come to the conclusion that the universes of active managers we most often refer to are not a reflection of the market capitalization weighted definition of that asset class. If you added up every position held by every US Large Cap mutual fund and separately managed account in the world, the portfolio you ended up with would look very different from the S&P 500.

Why? Because there are huge pools of unbenchmarked assets which would be included in a formal or academic definition of “active management”, but which exist outside of any practical definition of the universes that any asset allocator would encounter, like the actual funds, commingled funds, SMA pools and hedge funds that they can actually invest in.

These other pools are snake-and-a-squirrel portfolios, and they exist everywhere. These are not people or institutions sitting around matching what they own with a “US Mid Cap Growth” mandate. They are the holdings of wealthy individuals and restricted stock-compensated executives. They are the custom unbenchmarked (or poorly benchmarked) multi-asset income portfolios built by consultants and FAs. They are the one-off holdings of corporations, partnerships, banks and other institutions. They are the holdings of foreign investors who want to hold US stocks, but for whom that means buying the well-known megacap multinationals. And no matter how much we want Kathy Bates to tell us a comfortable story about how they’d fit into our style boxes and asset classes, they won’t. That’s why alpha is absolutely a zero-sum game in academic space, but is absolutely not a zero-sum game in any practical definition of our industry-related constructs of investable asset classes and products. What we invest in isn’t a set of strategies choosing to underweight or overweight the stocks in the S&P 500, but a set of strategies that invest in what’s left over after mama has served up a few hundred billion dollars worth of snake and a squirrel. 

The reality, then, is that there absolutely are good and bad environments for outperformance of the average fund in different asset classes, but they have nothing to do with pedantic zero-sum game arguments OR security-level dispersion. If you want heuristics for what an “active management environment” looks like, it’s this.

Your actively managed portfolio will usually be underweight the defining traits of the index you have selected. It will be less fully invested (i.e. it will hold more cash). It will usually hold less of the market cap range in question (i.e. large cap will underweight large cap, small cap will underweight small cap). It will usually hold less of the largest country weight. It will usually hold less of the largest sector weight. It will usually have a less pronounced bet on any factor (e.g. value) used to define your index.

Your actively managed portfolio will usually be overweight volatility – not in the “long vol” sense we use to talk about benefiting from market volatility, but in the sense that your portfolios will tend to own more volatile stocks than your index. This is usually because most stock-pickers seek out stocks with more idiosyncratic risk, which (surprise) happens to be positively correlated with outright stock price volatility.

Basically a Snake Don’t Have Parts (Epsilon Theory, December 2018)

The second visit will be from the Ghost of Annual Predictions That Nobody Uses and Everybody Demands. This is mostly a sell-side thing, sometimes a buy-side thing, and filler content for traditional financial media when they don’t have a CEO booked to pump up the stock price before a scheduled sale event.

From The Prediction Polka (2018):

As you start to read these pieces, however, I want you to bear something in mind: nobody uses them.


Those recession probabilities from an economist at a sell-side shop or standalone research house – something one of Ben’s and my new favorite bloggers brought up today – is anyone dropping those assumptions into asset allocation models? The predictions on year-end S&P 500 and 10-year levels? Odds on this outcome or that from the China trade war negotiations? Who is making adjustments to model portfolios or strategic asset allocation plans for new clients going into 2019 based on all these brilliant research pieces?

OK, sure, maybe there is a financial adviser or two out there who really is adjusting his positions because this research house or that thinks that this is where levels are going to be at year end. But that’s not what these are for. That’s not what these are really about. At every level, the Prediction Polka is a sales tool and nothing else.

The best way to understand this very odd thing that we do is (as so many things are) through the immortal genius of Trey Parker and Matt Stone. In an episode called Cash for Gold, the South Park boys walk viewers through a fanciful version of the low-end gold jewelry purchase-gift-and-exchange-for-cash cycle. It is a process, much like the market prediction racket, in which no one actually wants the product, but in which everyone needs to sell the product. The video, which is obviously offensive in three or four different ways – it’s South Park, y’all – is must watch, even if it does require you to install Flash like some kind of 20th Century barbarian.

The Prediction Polka (Epsilon Theory, December 2018)

The third visit will come from the Ghost of Alignment. Its visit is occasioned by the necessity of end-of-year reviews between financial advisers and their clients, and the inevitable frustration felt by advisers after being asked, “What do I pay for you to do” and grousing about the nature of fees. It manifests in all sorts of ways, not least in one adviser or other thinking they’ve found the silver bullet which shall forever fix “alignment” in our industry. Alas, it is not to be. This ghost is usually experienced somewhere on the spectrum between “company blog over the Christmas break” and “guest submission to a trade publication,” so it is somewhat easier to avoid.

From By Our Own Petard:

The inevitable final form of the professional allocator or adviser is not so much the nihilist as the practitioner of serendipity. They recognize that randomness reigns and control what they can control. In a perfect world, they control what they can control by leaning on lasting, demonstrable, biologically determined human behavioral traits to try to guide someone they think is talented and process-oriented to results that will benefit both principal and agent alike. It is a stoic, right-sounding, eminently reasonable, perfectly justifiable framework. There’s just one problem. A tiny, insignificant problem that I almost hesitate to mention:

We will never – can never – be aligned with our agents.

As citizens, shareholders and investors, we worry with good reason that the agents working on our behalf – our political representatives, corporate management teams and the investment consultants, advisers and managers we rely on, respectively – actually will work on our behalf. Preferably for a reason that goes somewhat beyond ‘not going to jail’ or ‘because they seem like someone you could have a beer with.’ We want them to feel like they have skin in the game. Like we both win if either of us wins.

When we, as a principal, select an agent, we have every reason to shout “Yay, alignment!” from the rafters.

And because we have every reason to shout “Yay, alignment!”, our agents have every reason to sell us compensation structures which permit them to extract undeserved economic rents by demonstrating the superficial trappings of alignment. This job is made a hell of a lot easier by the fact that we investment professionals – nominally principals in the relationship – are often ourselves agents of some other party. We are using delegated authority to act on behalf of a client, a family, an institution, a board. People to whom we need to demonstrate alignment.

Necessity being the mother of invention and all, our need for a story that will make us or our own charges shout “Yay, alignment!” makes us vulnerable to structures and features from our agents which don’t deliver anything of the sort – but seem to.

Hoisted by our own petard, as it were.

By Our Own Petard (Epsilon Theory, November 2019)

The observation that the information swirling about us isn’t necessarily connected to antiquated notions like “facts” or “reality” is typically one we’d call irrelevant. If it affects the marginal mover in a market, it matters, even if we think it shouldn’t. That’s the power of narrative.

That said, if there is something to be thankful for this season, it is that these ghosts are a rare exception to that rule. By and large, there is no relevant narrative in any of these because there is no informational content in them. They are not designed to change anyone’s mind about anything, and everybody knows that they are not designed to change anyone’s mind about anything. These are the end-of-year rites, Forms Which Must Be Observed.

So if your predisposition is to roll over, go back to sleep and ignore them all, consider this our permission to go right ahead.

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  1. Avatar for Zenzei Zenzei says:

    Hey Rusty…I’ve been looking forward to Epsilon Theory’s top ten predictions for 2021. when do y’all think you will have that ready?

  2. Avatar for rguinn rguinn says:

    It’s going to be a great year for Top Ten predictions!

  3. Fun story that I hope you’ll enjoy.

    My firm has an internal SMA, access to about a million external ones, and one that’s kind of a weird hybrid. They aren’t a wholly owned subsidiary, but 95% of their AUM comes from our firm and they don’t accept any outside money. They run the shop as they please–and they’re pretty good as far as that goes–and they are quite accessible to us lowly FAs. They have a fund that is based entirely on our company’s research. If we don’t cover it then it’s not in the fund. The MD told us at a meeting that not one single dollar from anyone within his group of employees or PMs is in said fund. He was explicitly telling us to not buy this dog for our clients. See, he answers to all the FAs, and when we have a client get burned by a bad fund we pull everything and go elsewhere. All his other funds perform well, or at least they don’t embarrass him. But this one fund, the research fund, is an embarrassment. Our company puts out research that very few read, even fewer take seriously, and that is utterly ignored–accept for a contractual obligation–by PMs. That should tell you all you need to know about this particular corner of the financial services world.

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