Tuesday, March 3, 2009

I didn't make these rules!

I would like to thank everyone who gave me the feedback on my post In defense of the mutual fund manager, both online and by email.

What’s handcuffing the fund manager?
Pity the poor fund manager. Not only can he not even beat plain vanilla index funds, now a study shows that fund managers are bad market timers. What is handcuffing the fund manager?

The problems that the fund manager faces can be separated into the four categories:

  • Alpha generation is hard
  • Turning good investment ideas into investment performance is hard
  • The System really doesn’t like people who think “outside the box”
  • Mis-aligned incentives

Alpha generation is hard: A case of low signal-to-noise ratio

Henry Kaufman, in the Wall Street Journal, recently wrote that:

Why do our computers work so well -- except when we use them to manage derivatives and hedge funds? The answer lies in methodology. In science and technology, we rely on the scientific method: experimental design with dependent and independent variables and with reproducible results.

Economists and financial experts like to fancy themselves as exact scientists as well. Back in the 1960s, when we landed on the moon, economists emulated the terminology of Space Age navigation. They spoke of "midcourse corrections" and of bringing in the economy for a "soft landing." Since then, quantification and modeling have only grown thicker in the economics profession, where econometricians and other "quants" employ complicated analytical techniques and mathematical formulas.
Investing isn’t engineering. Good investment professionals and quants understand that we work in a business that has a low signal-to-noise ratio. It isn’t physics. You can’t repeat experiments. Investment returns depend on human behavior, which is fickle and depend on people’s hopes and fears.

As an illustration of how difficult investing is, a study shows that the Sharpe ratio of legendary investors like Buffett, Robertson and Soros don’t significantly top 1.1. Who of us, as mere mortals, can hope to top those kinds of results?

Turning good investment ideas into investment results is hard!
Even if you a good investment idea, putting it together into a portfolio, or what quants call the task of alpha transference, is not easy. Peter Schiff had the right grand idea, but his implementation was lacking. He was not alone as many others were in the same boat.

How sure are you of your idea? How much do you want to bet on it? How do you manage risk (your client’s risk, your business risk and your career risk)?

When do you trade? How do you time your trade? If you are a large fund, how do you move in and out of a position without leaving footprints in the market?

If things didn’t work out, what happened? Did your selection techniques fail? Did your risk control fail? Did all parts of your investment process work together or were they fighting each other?

These are all issues that a fund managers need to address and face.

Do we really want people who think “outside the box”?
We all like to see innovative thinkers. We laud people who think “outside the box”. The reality is that society and organizations really don’t want people to think too far outside the box.

Frankly, people who do that are mavericks. It’s hard to manage mavericks. They tell their superiors to FOAD (the last two stand for “And Die”). A frequent theme seen in Hollywood movies is the rebel who defies the system and win. How many rebels have you actually seen in real life do that?

One example of a maverick who won was Colonel John Boyd. He spearheaded the design of important U.S. fighter planes and had a strong influence in U.S. military thinking over the years. However, the system doesn’t like rebels. My question is: "If he was so great, why did he retire in 1975 a colonel? Why didn’t he have some stars on his shoulders?" (Imagine someone with the stature of a Myron Scholes retiring after a long career at an investment bank with the rank of a junior director and you get the idea.)

The System is not built to accommodate rebels. It certainly does not reward them.

Here in Vancouver, there has been a long-standing tradition among the engineering students at the local university to engage in creative hijinks and pranks. Years ago, they stole the Speaker’s Chair from the provincial parliament. I recall one instance when a number of student engineers managed to steal the emergency lights from a police car. At one level, these are creative activities that should be encouraged. At another level, they are anti-social and disruptive and people who engage in such destructive behavior should be punished. Recently, a story emerged that some engineering students got caught trying to suspend a car from a bridge. Some of them may get charged. Criminal records may be involved and possibly future careers may be destroyed.

In defense of the System, we can’t let every rebel and maverick run wild. Should mavericks like the Unabomber be made a hero? What about the perpetrators of the Oklahoma City bombings? What about the member of the Red Brigade? Baader-Meinhof gang? Weatherman underground?

A case of mis-aligned incentives
Tom Brakke, who writes the blog Research Puzzle, correctly pointed out that fund managers at actively unconnected to investors. In other words, there is a severe case of mis-aligned incentives.

The current paradigm is: asset allocation accounts for most of an investor’s risk and return, followed (in equity-land) by country allocation, sector allocation, along with style (value/growth), sector and market cap. As a result, we allocate by these style boxes: international, emerging markets, domestic equities, large/small cap, value/growth, etc. Fund managers are expected to stay within their mandate and remain fully invested. Their job is to beat their style benchmark (e.g. large cap growth).

There are funds that are permitted to be opportunistic and rotate between asset classes but those funds are relatively rare (e.g. Hussman Funds). While every few years or so, there have been calls to reform the fund management industry, I don’t see any looming competitive threats that will compelling a drastic re-thinking of this investment paradigm. A few years ago, hedge funds might have posed a serious threat had they been able to generate pure alpha, but it turns out that what hedge funds mostly deliver are different forms of beta, which in aggregate are not worthy of their 2 and 20 fee structures.

I didn’t make these rules. Until something radical happens to challenge the business model of fund management, we are stuck with the current paradigm.

Addendum: Barry Ritholz at Big Picture has an interesting post about conflicts of interest and mis-aligned interest at the asset allocation level for individual investors.


keithpiccirillo said...

I have a question that has been tugging at me for some time.
CGMFX has many options in the prospectus to short and do other things but he has "followed the crowd" lately, with no shorting activity in the last quarterly.
Is the reason because a fund's position can get trapped and "shot against" by hedge funds and market maker's and effectively destroyed? Would not options soften the blow? Is it part trepidation and or fear of more redemptions for the fund manager which then causes loss of flexibility?
It seems the stocks sold short and etf inverses have been winning for too long a stretch here, and the behemoths have failed to push back.
I realize there are also long/short funds that try to remain market neutral also.

Otto Rock said...

Another good thinkpiece. TY Cam.

You wrote: "...Until something radical happens to challenge the business model of fund management, we are stuck with the current paradigm...."

Seems that this is happening right now. Clients are voting with their feet, are they not?

It's times like these that the system reels in a few of the not-too-radical mavericks (not the Unabombers) and says "hey, what was that bright idea you had a couple of years back again?".

Mike C said...

In defense of the System, we can’t let every rebel and maverick run wild. Should mavericks like the Unabomber be made a hero? What about the perpetrators of the Oklahoma City bombings? What about the member of the Red Brigade? Baader-Meinhof gang? Weatherman underground?

Whoaaa....you've kinda gone off the deep end with this analogy here.

I think you've got a great blog here and are part of my must read list so I am not a hater....

but I fail to see how the Unabomber and terrorists have anything to do with people who want to maybe shake up the mutual fund world a bit. The comparison is frankly ludicrous.

I own 2 and only 2 equity mutual funds. Hussman and Fairholme. I want rebels and unconventional fund managers with a go anywhere mandate. If I need/want "pure" exposure to an asset class, there are plenty of low cost ETFs for that. I don't need to pay 1.5% expense ratio to a guy to get a million dollar salary to replicate his asset class index with a few irrelevant tweaks here and there.