The Relative Performance Game

I wrote in a previous post that much of what passes for “investing” is in fact just an exercise in “getting market exposure.” In writing that post, and in the course of many conversations, I have come to realize the investing public is generally ignorant of the game many asset managers are playing (not what they tell you they are doing but what is really going on under the hood). In this post, I want to elaborate on this.

Broadly speaking, there are two types of return objective for an investment portfolio:

Absolute return. For example: “I want to compound capital at a rate of 10% or greater, net of fees.”

Relative return. For example: “I want to outperform the S&P 500.” Or: “I want to outperform the S&P 500, with tracking error of 1-3%.”

We will look at each in turn.

 How Absolute Return Investors Play The Game

The true absolute return investor is concerned only with outperforming his established return hurdle. The return hurdle is his benchmark. When he underwrites an investment, he had better damn well be underwriting it for an IRR well in excess of  the hurdle rate (build in some margin of safety as some stuff will inevitably hit the fan). He will be conscious of sector exposures for risk management purposes but he is not checking himself against the sector weights of any particular index.

I emphasize “true absolute return investor” above because there are a lot of phonies out there. These people claim to be absolute return investors but still market their products funds to relative return oriented investors.

Guess what? The Golden Rule applies. If your investor base is relative return oriented, your fund will be relative return oriented. I don’t care what it says in your investor presentation.

How Relative Return Investors Play The Game

The relative return investor is concerned with outperforming a benchmark such as the S&P 500. Usually managers who cater to relative return investors also have to contend with being benchmarked against a peer group of their competitors. These evaluation criteria have a significant impact on how they play the game.

Say Amazon is 2.50% of the S&P 500 trading on 100x forward earnings and you’re running a long only (no shorting) fund benchmarked to the S&P 500. If you don’t like the stock because of the valuation, you can choose not to own it or you can choose to underweight it versus the benchmark (maybe you make it 2% of your portfolio).

In practice you will almost certainly own the stock. You may underweight it but you will own it at a not-insignificant weight and here’s why: it is a popular momentum stock that is going to drive a not-insignificant portion of the benchmark return in the near term. Many of your competitors will either overweight it (if they are reckless aggressive) or own it near the benchmark weight. Most of them will own it at or very near benchmark weight for the same reasons as you.

Sure, if you don’t own the stock and it sells off you may look like a hero. But if it rips upward you will look like a fool. And the last thing you want to be is the idiot PM defending himself to a bunch of retail channel financial advisors who “knew” Amazon was a winner all along.

The safe way to express your view is to own Amazon a little below the benchmark weight. You will do incrementally better if the name crashes and incrementally worse if the name rips upward but the effects will not be catastrophic. When you are ranked against peers you will be less likely to fall into the dreaded third or (god forbid) fourth quartile of performance.

This is the relative performance game.

Note that the underlying merits of the stock as a business or a long-term investment get little attention. The relative performance game is about maximizing incremental return per unit of career risk (“career risk” meaning “the magnitude of relative underperformance a client will tolerate before shitcanning you”).

If you are thinking, “gee, this is kind of a prisoner’s dilemma scenario” I couldn’t agree more. In the relative performance world, you are playing a game that is rigged against you. You are handcuffed to a benchmark that has no transaction costs or management expenses. And clients expect consistent outperformance. Good luck with that.

I am absolutely not arguing that anyone who manages a strategy geared to relative return investors is a charlatan. In fact I use these types of strategies to get broad market exposure in my own portfolio.

I do, however, argue that the appropriate expectation for such strategies is broad market returns +/-, that the +/- is likely to be statistically indistinguishable from random noise over the long run*, and that this has a lot to do with the popularity of market cap weighted index funds.

 

Corollary: Don’t Be An Idiot

If you are one of those high net worth individuals who likes to run “horse races” between investment managers based on their absolute performance, the corollary to this is that you are an idiot.

The guys at Ritholtz Wealth Management (see my Recommended Reading page) have written and spoken extensively about the problems with such an incentive system. It is nonetheless worth re-hashing the idiocy inherent in such a system to close out this discussion. It will further illustrate how economic incentives impact portfolio construction.

If you say to three guys, “I will give each of you 33% of my net worth and whoever has the best performance one year from now gets all the money to manage,” you will end up with a big winner, a big loser and one middle of the road performer. You will choose the the big winner who will go on to be a loser in a year or two. Except the losses will be extra painful because now he is managing all your money.

Here’s why. You have created an incentive system that encourages the prospective managers to bet as aggressively as possible. This is exacerbated by the fact that your selection process is biased toward aggressive managers to begin with. No self-respecting fiduciary would waste his time with you. People like you make for terrible clients and anyway a self-respecting fiduciary’s portfolio is not likely to win your ill-conceived contest. Your prospect pool will self-select for gamblers and charlatans.

In Closing

Incentive systems matter. Knowing what game you are playing matters. There is a name for people who play games without really understanding the nature of the games.

They’re called suckers.

 

*Yes, I know it is trivial to cherry pick someone ex post who has generated statistically significant levels of alpha. I can point to plenty of examples of this myself. Whether it is possible to do this reliably ex ante is what I care about and I have yet to see evidence such a thing is possible. Also defining an appropriate threshold for “statistical significance” is a dicey proposition at best. If you feel differently, please email me as I would love to compare notes.

Blood In The Water

I was reading a cryptocurrency report from Goldman Sachs this morning and stumbled upon the following chart:

ICO_vs_Venture_Capital_GS
Source: Goldman Sachs

Now, put those dates in the context of the Bitcoin price action (which I think is a fair approximation of investor appetite for cryptos more generally):

ICO_vs_Venture_BTC_Price_Chart
Source: Bloomberg / coindesk

This speaks to a corollary of The Golden Rule:* The market supplieth what investors doth demand. If people are willing to throw billions of dollars at crypto lottery tickets, you can bet they will find an ample supply of coins and tokens to invest in.

Another, perhaps more intuitive way of thinking about this is that “easy” money attracts “investors” like blood attracts sharks. The sharks come swimming, and if there is enough blood in the water a feeding frenzy will ensue.

This description from Wikipedia is rather evocative:

In ecology, a feeding frenzy occurs when predators are overwhelmed by the amount of prey available. For example, a large school of fish can cause nearby sharks, such as the lemon shark, to enter into a feeding frenzy. This can cause the sharks to go wild, biting anything that moves, including each other or anything else within biting range. Another functional explanation for feeding frenzy is competition amongst predators.

In boring old non-tokenized finance, this dynamic drives the credit cycle. Suppliers of capital get good deals when capital is scarce. They get crap deals when capital is plentiful. When capital is plentiful, and investors are overly trusting, capital ends up in the hands of miscreants and value destroyers (though admittedly, many value destroyers are well-intentioned). In fact, driven wild by greed and vying for deal flow, investors compete aggressively to offer capital on favorable terms to miscreants and value destroyers.

What kind of deal do you suppose you are getting when you exchange cold hard cash for a token with no protective covenants, that gives you no claim on equity or future cash flows, and which may not even exist yet?

1024px-White_shark_(Carcharodon_carcharias)_scavenging_on_whale_carcass_-_journal.pone.0060797.g004-A
Source: Wikipedia

* The Golden Rule: He who hath the gold, maketh the rules.

#ContrarianProblems

I am generally a contrarian by nature.

To illustrate:

  • I am skeptical of home ownership as wealth creating endeavor.
  • I do not like reading “popular” books or seeing “popular” movies for the sake of being able to have conversations about them.
  • In my view at least 50% of the episodes of Game of Thrones are time-wasting filler.
  • I am generally not that into big events that draw crowds (sports victory parades, Coachella, Burning Man or Fyre Festival–but there are exceptions).

Perhaps unsurprisingly this permeates my investment philosophy. Things I like right now include a Russian natural gas company, a Brazilian aerospace company and sub-Saharan African bank holding company (I have a North African/Middle Eastern bank on my watch list, too, if the valuation ever comes down to earth). This is not a recipe for outperformance. It is not investment advice. It is just who I am as an investor.

Being a contrarian investor is great. You have good company in people like Seth Klarman and Howard Marks. On the other hand, being a contrarian in the investment business is not nearly so pleasant.

Contrarian ideas are often hard to sell and investment committees are engineered to arrive at consensus decisions. Consensus decisions are generally good for business. Consensus decisions will not deliver top quartile performance but they will not deliver bottom quartile performance, either. You can have a very nice business and never deliver top quartile performance. But woe betide you if you end up in the bottom quartile. It may well be the end of your business.

I sometimes hear about firms that designate “devil’s advocates” on committees. The devil’s advocate’s job is to argue against every single investment thesis. She is not allowed to argue in favor, or to moderate her argument. She is a dedicated short and everyone knows it in advance. This is a neat solution to the problem of encouraging a contrarian viewpoint in a high pressure group setting (contrarians can often grate on their fellow committee members). But does it make any difference?

What percent of ideas get blown up because of the devil’s advocate? Or is the whole thing just an exercise in box-checking dreamed up to please consultants? I suspect in most cases it’s the latter.

Edward Hess summarizes the issue quite nicely in an article titled “Why Is Innovation So Hard?”:

Most organizational environments won’t help us overcome our fear of failure and build our innovative thinking skills. That’s because most organizations exist to produce predictable, reliable, standardized results. In those environments, mistakes and failures are bad. That is a problem. To innovate, you must simultaneously tolerate mistakes and insist on operational excellence. Many businesses struggle with implementing that dual mentality.

Here we can learn from exemplar companies like IDEO, Pixar, Intuit INTU -1.84%, W.L. Gore & Associates, and Bridgewater Associates. In those organizations, mistakes and failures are redefined as “learning opportunities.” IDEO takes it even further, characterizing failure as good because it helps people develop the humility that is necessary for empathy—a critical skill in user-centric innovation.

But in many workplaces, people do not “feel safe enough to dare.” They don’t necessarily feel that they can speak with candor up and down the organization. Can you tell your boss the truth?  Innovation occurs best in an “idea meritocracy,” a culture where the best evidence-based ideas win. There can’t be two sets of rules—everyone’s ideas must be subject to the same rigorous scrutiny. As Ray Dalio, the founder of Bridgewater Associates, one of the largest hedge funds in the world, so bluntly said, “We all are dumb shits.” That’s why everyone at his company is engaged in a radically transparent “search for truth,” which involves candid feedback and a deliberate effort to “get above yourself,” to get past the emotional defenses that inhibit our thinking.

In other words, organizational incentives are skewed toward rewarding preservation of the status quo. If The Golden Rule is “He who hath the gold, maketh the rules,” surely immediate the corollary is “He who f***eth with The Golden Goose shall meet with a pointy reckoning.”

#ContrarianProblems.