正文
Prudent investing surely requires acknowledging the possibility of an extended bear market and constructing a portfolio that can grow, if necessary, no matter what. Bills accrue and liabilities grow regardless of what equity indices are doing unfortunately. But government bond yields are far below required actuarial targets. Worse is the dually damaging impact on portfolios of lower discount rates at the same time as the stock market falls apart.
Many investors cannot wait long enough for traditional bets to pay off and why should they when they can allocate to fund managers with the skill to generate reliable absolute returns from their edge? Investing and trading both have important roles to play in a portfolio but it is no place to gamble. The trades to make and the managers to pick are those with positive expectations and the odds in their favor.
Investing, Trading and Gambling
What is the difference between investing, trading and gambling? With the first two, it is the holding period; seconds to months is trading and years is investing. Investing and gambling are quite similar at first look; putting money at risk in the hope of making more money. Decision making under uncertainty. But most investors would balk at the idea of being called a gambler. Surely the difference is that investing is deploying capital when you DO have an edge while gambling is betting when you do NOT have an edge.
To make consistent absolute returns it is necessary either to have an advantage or identify someone else with one. An edge does not eliminate the possibility of small, manageable losses but it does mean persistent and predictable performance. By definition there is no edge in beta and it is not very reliable over most realistic time frames.
Asset classes cannot be looked at in isolation as they all have varying effects on each other. Commodities move stocks, currencies impact bonds and vice versa. Last year showed how long-biased credit strategies could hurt some of the more crowded market neutral equity strategies. Some central banks think raising interest rates will curb inflation and lowering interest rates will avoid recession. Maybe, but not necessarily anymore, as global capital flows and new, non-obvious relationships between assets and geographies may have changed the rules of the economic game. High risk free rates in Iceland or New Zealand or low rates in Japan or Taiwan haven\'t had quite the effect that theory anticipated. How things change; Western investors helped out Asian banks and now Asian investors are helping out Western banks.
Monitoring Non-Obvious Relationships Among Securities
The Department of Homeland Security, the CIA and many casinos are now using something called NORA or Non-Obvious Relationship Awareness in their surveillance work. Successful investing is very dependent on monitoring non-obvious relationships between securities. It was the key to doing well in 2007 and will be more so in 2008. This is where many err; looking at a single stock, pair of securities or one asset class when it is the ENTIRE interrelated puzzle that needs studying too. Sometimes a stock, bond, commodity, currency or any other specific asset goes up and other times it goes down. Predicting those moves is difficult but some can do it. Their changing relationships open up anomalies and inefficiencies that can be exploited.
Strategies make money out of asset classes. But in implementing the strategy, a fund must either have a wide protective moat of a talent-based barrier to entry or keep it secret. Many things in the public domain did NOT work last year but is that surprising? The Dogs of Dow, the January effect, the Magic formula of value investing were too well known to work anymore. Those arbs, among others, are gone. I hope for the sake of the long only crowd that the First 5 days in January effect is NOT predictive for 2008. However I would be pleasantly surprised if the Dow and Nikkei don\'t dip below 10,000 sometime this year. And if the two biggest economies have problems so will many others.
Short Sell the Rumor, Buy the Fact?
There are reasons to be bullish, of course, but there always are. The mythical private equity put and Greenspan put evaporated to be replaced by the Sovereign Wealth Fund put. Many economists are predicting a recession which, given their track record, means there is a chance there won\'t be one. Many US banks will report earnings this week and with new CEOs and new stock options, the temptation to write down doubtful CDOs, SIVs and loans to very conservative levels and adopt a kitchen sink approach to disclosing bad news must be high.
LAST quarter can be blamed on former management but not the NEXT quarter. Ben Bernanke promising substantial rate cuts was clearly preparing the market for bad news. Short sell the rumor, buy the fact?
You can dress the credit crisis up with the product jargon and exotica of Klio and Norma subprime CDOs, but basically it was poor quality financial engineering and fictitious capital rearing its monstrous Cetus-like impact. Incidentally one of the hedge funds that profited from the meltdown, Magnetar Capital, did not contribute to astronomical losses for the street; some bank structurers simply didn\'t know how to hedge credit tranches properly. Just like caveat emptor, caveat venditor or seller beware - if a sell-side firm can\'t manage the risk in a product, don\'t sell it to clients in the first place.
High Performing Non Hedge Fund - Nevada Slots Opportunities Fund
Around New Year I spent a few days in that bastion of statistical arbitrage, Las Vegas, the only city in the world named after a volatility metric. I am always long vega and long Vegas. The usual opinion on casinos is you can\'t beat the house just like conventional wisdom in finance is that you can\'t beat the market. In general that is indeed true. The sweat equity, concentration and aptitude required to perform such a difficult task on a consistent basis is rare. Difficult yes, impossible no. Like others I\'ve taken the time to try to find an edge in picking fund managers and picking securities. And a few people have an edge in Vegas.
As in financial markets, there are slight advantages that can be developed in a few casino games to change the negative expectation of gambling to the positive expectation of investing. But it requires dedication, insight and proprietary research. Many people are aware blackjack can be beaten but disclosure of the techniques and changes in the rules have reduced that edge. The first time I visited Vegas I had mastered basic strategy and the probabilities almost as well as Ed Thorp and could memorize cards almost as well as Dustin Hoffman and I did reasonably well; nowadays I am content to break even. But others have higher skill and can do better than that.
Despite the increased sophistication and monitoring at casinos, there are still professional blackjack players making good money from innovating their strategy and developing their talent,just like a hedge fund keeps refining and adapting its edges and finding new ones. Even roulette and dice games can be beaten if beaten means having a small probabilistic bias that reduces the house\'s advantage; it just takes very high skill AND years of practice to do it.
Skeptics can read the book Eudaemonic Pie or dice control for some basic tips though what works NOW is not going to be written about or easy to implement for obvious reasons. Poker is a game of luck over one deal but skill over many deals. When I look up at the sports book, I see potential mispricings and arbitrages on the board just like on a futures floor or page of stock price quotes; but it does take hard work, an informational advantage and domain knowledge of the teams, players and horses to identify them. But there are larger edges available in financial markets than in casinos.
Slot machines are interesting too. The house has the edge but that does NOT mean they should ALWAYS be avoided. The POSSIBILITY of enormous payouts for a very low capital outlay provides a different value proposition. Experts say that the odds of winning big are so remote (1 in 100 million or so) as to make them a loser\'s game. But as with a lottery, the probability that the jackpot will be won is 1, i.e. a certainty. Someone WILL win it. If you don\'t play you have ZERO chance of winning. If you DO play you have an unlikely but NON-ZERO chance. Since any number divided by zero is infinity, that means the simple act of risking a few bucks increases the chance of winning by an infinite multiple! The optimal trading algorithm on a lottery or a Megabucks slot machine IS to play but only with small cash. Similar to buying far out of money options; even if most expire worthless, you only need a single high pay out.
By complete fluke, I happened to put $20 into a machine one evening and won $1,000. Deducting management fees of 5% and 50% that is a return of 2,400%. So now you know what the highest performing non hedge fund was last year - the Nevada Slots Opportunities Fund. A stupid claim of course but sadly such unrepeatable luck has been used to market many a fund. Naturally that return was pure alpha as I needed the skill to pick the right machine in the right casino at the right time. Not. But I have seen even sillier contentions in powerpoint presentations and at capital-raising investment conferences.
Strategies vs. Asset Classes
Suppose I lent the $1,000 to someone who promised to pay back $2,000 if they won speculating on real estate. What if I assigned an overly optimistic default probability to this trade and launched the Enhanced Nevada Credit Fund on the back of this amazing mark-to-model yield? Sounds sillier still but that is what Merrill Lynch (MER), Citigroup (C), Bear Stearns (BSC), Northern Rock (NHRKF.PK), Sowood and Dillon Read among several others were effectively doing in their credit trading last year.
High yield only makes sense if it is higher than the risk. High volatility and extended drawdowns don\'t always compensate with returns either. Whenever I hear the arguments for long term passive investing, I wonder what temporal era is meant - geological or cosmological time. Over periods of relevance to living humans, I\'d rather invest in alpha than gamble on beta. Suppose in 2020 or 2030 major equity indices are LOWER than today? Lost year, lost decade?
That long term asset called Gold may be above $900 today but remains far below its inflation-adjusted high set nearly 600 years ago. Gold traders and gold miner shovel makers - yes, long only gold - no. I\'ll take different strategies applied to assets rather than asset classes themselves every time. It just snowed in Baghdad; unlikely events can and do happen.
Many investors cannot wait long enough for traditional bets to pay off and why should they when they can allocate to fund managers with the skill to generate reliable absolute returns from their edge? Investing and trading both have important roles to play in a portfolio but it is no place to gamble. The trades to make and the managers to pick are those with positive expectations and the odds in their favor.
Investing, Trading and Gambling
What is the difference between investing, trading and gambling? With the first two, it is the holding period; seconds to months is trading and years is investing. Investing and gambling are quite similar at first look; putting money at risk in the hope of making more money. Decision making under uncertainty. But most investors would balk at the idea of being called a gambler. Surely the difference is that investing is deploying capital when you DO have an edge while gambling is betting when you do NOT have an edge.
To make consistent absolute returns it is necessary either to have an advantage or identify someone else with one. An edge does not eliminate the possibility of small, manageable losses but it does mean persistent and predictable performance. By definition there is no edge in beta and it is not very reliable over most realistic time frames.
Asset classes cannot be looked at in isolation as they all have varying effects on each other. Commodities move stocks, currencies impact bonds and vice versa. Last year showed how long-biased credit strategies could hurt some of the more crowded market neutral equity strategies. Some central banks think raising interest rates will curb inflation and lowering interest rates will avoid recession. Maybe, but not necessarily anymore, as global capital flows and new, non-obvious relationships between assets and geographies may have changed the rules of the economic game. High risk free rates in Iceland or New Zealand or low rates in Japan or Taiwan haven\'t had quite the effect that theory anticipated. How things change; Western investors helped out Asian banks and now Asian investors are helping out Western banks.
Monitoring Non-Obvious Relationships Among Securities
The Department of Homeland Security, the CIA and many casinos are now using something called NORA or Non-Obvious Relationship Awareness in their surveillance work. Successful investing is very dependent on monitoring non-obvious relationships between securities. It was the key to doing well in 2007 and will be more so in 2008. This is where many err; looking at a single stock, pair of securities or one asset class when it is the ENTIRE interrelated puzzle that needs studying too. Sometimes a stock, bond, commodity, currency or any other specific asset goes up and other times it goes down. Predicting those moves is difficult but some can do it. Their changing relationships open up anomalies and inefficiencies that can be exploited.
Strategies make money out of asset classes. But in implementing the strategy, a fund must either have a wide protective moat of a talent-based barrier to entry or keep it secret. Many things in the public domain did NOT work last year but is that surprising? The Dogs of Dow, the January effect, the Magic formula of value investing were too well known to work anymore. Those arbs, among others, are gone. I hope for the sake of the long only crowd that the First 5 days in January effect is NOT predictive for 2008. However I would be pleasantly surprised if the Dow and Nikkei don\'t dip below 10,000 sometime this year. And if the two biggest economies have problems so will many others.
Short Sell the Rumor, Buy the Fact?
There are reasons to be bullish, of course, but there always are. The mythical private equity put and Greenspan put evaporated to be replaced by the Sovereign Wealth Fund put. Many economists are predicting a recession which, given their track record, means there is a chance there won\'t be one. Many US banks will report earnings this week and with new CEOs and new stock options, the temptation to write down doubtful CDOs, SIVs and loans to very conservative levels and adopt a kitchen sink approach to disclosing bad news must be high.
LAST quarter can be blamed on former management but not the NEXT quarter. Ben Bernanke promising substantial rate cuts was clearly preparing the market for bad news. Short sell the rumor, buy the fact?
You can dress the credit crisis up with the product jargon and exotica of Klio and Norma subprime CDOs, but basically it was poor quality financial engineering and fictitious capital rearing its monstrous Cetus-like impact. Incidentally one of the hedge funds that profited from the meltdown, Magnetar Capital, did not contribute to astronomical losses for the street; some bank structurers simply didn\'t know how to hedge credit tranches properly. Just like caveat emptor, caveat venditor or seller beware - if a sell-side firm can\'t manage the risk in a product, don\'t sell it to clients in the first place.
High Performing Non Hedge Fund - Nevada Slots Opportunities Fund
Around New Year I spent a few days in that bastion of statistical arbitrage, Las Vegas, the only city in the world named after a volatility metric. I am always long vega and long Vegas. The usual opinion on casinos is you can\'t beat the house just like conventional wisdom in finance is that you can\'t beat the market. In general that is indeed true. The sweat equity, concentration and aptitude required to perform such a difficult task on a consistent basis is rare. Difficult yes, impossible no. Like others I\'ve taken the time to try to find an edge in picking fund managers and picking securities. And a few people have an edge in Vegas.
As in financial markets, there are slight advantages that can be developed in a few casino games to change the negative expectation of gambling to the positive expectation of investing. But it requires dedication, insight and proprietary research. Many people are aware blackjack can be beaten but disclosure of the techniques and changes in the rules have reduced that edge. The first time I visited Vegas I had mastered basic strategy and the probabilities almost as well as Ed Thorp and could memorize cards almost as well as Dustin Hoffman and I did reasonably well; nowadays I am content to break even. But others have higher skill and can do better than that.
Despite the increased sophistication and monitoring at casinos, there are still professional blackjack players making good money from innovating their strategy and developing their talent,just like a hedge fund keeps refining and adapting its edges and finding new ones. Even roulette and dice games can be beaten if beaten means having a small probabilistic bias that reduces the house\'s advantage; it just takes very high skill AND years of practice to do it.
Skeptics can read the book Eudaemonic Pie or dice control for some basic tips though what works NOW is not going to be written about or easy to implement for obvious reasons. Poker is a game of luck over one deal but skill over many deals. When I look up at the sports book, I see potential mispricings and arbitrages on the board just like on a futures floor or page of stock price quotes; but it does take hard work, an informational advantage and domain knowledge of the teams, players and horses to identify them. But there are larger edges available in financial markets than in casinos.
Slot machines are interesting too. The house has the edge but that does NOT mean they should ALWAYS be avoided. The POSSIBILITY of enormous payouts for a very low capital outlay provides a different value proposition. Experts say that the odds of winning big are so remote (1 in 100 million or so) as to make them a loser\'s game. But as with a lottery, the probability that the jackpot will be won is 1, i.e. a certainty. Someone WILL win it. If you don\'t play you have ZERO chance of winning. If you DO play you have an unlikely but NON-ZERO chance. Since any number divided by zero is infinity, that means the simple act of risking a few bucks increases the chance of winning by an infinite multiple! The optimal trading algorithm on a lottery or a Megabucks slot machine IS to play but only with small cash. Similar to buying far out of money options; even if most expire worthless, you only need a single high pay out.
By complete fluke, I happened to put $20 into a machine one evening and won $1,000. Deducting management fees of 5% and 50% that is a return of 2,400%. So now you know what the highest performing non hedge fund was last year - the Nevada Slots Opportunities Fund. A stupid claim of course but sadly such unrepeatable luck has been used to market many a fund. Naturally that return was pure alpha as I needed the skill to pick the right machine in the right casino at the right time. Not. But I have seen even sillier contentions in powerpoint presentations and at capital-raising investment conferences.
Strategies vs. Asset Classes
Suppose I lent the $1,000 to someone who promised to pay back $2,000 if they won speculating on real estate. What if I assigned an overly optimistic default probability to this trade and launched the Enhanced Nevada Credit Fund on the back of this amazing mark-to-model yield? Sounds sillier still but that is what Merrill Lynch (MER), Citigroup (C), Bear Stearns (BSC), Northern Rock (NHRKF.PK), Sowood and Dillon Read among several others were effectively doing in their credit trading last year.
High yield only makes sense if it is higher than the risk. High volatility and extended drawdowns don\'t always compensate with returns either. Whenever I hear the arguments for long term passive investing, I wonder what temporal era is meant - geological or cosmological time. Over periods of relevance to living humans, I\'d rather invest in alpha than gamble on beta. Suppose in 2020 or 2030 major equity indices are LOWER than today? Lost year, lost decade?
That long term asset called Gold may be above $900 today but remains far below its inflation-adjusted high set nearly 600 years ago. Gold traders and gold miner shovel makers - yes, long only gold - no. I\'ll take different strategies applied to assets rather than asset classes themselves every time. It just snowed in Baghdad; unlikely events can and do happen.
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