Socratic Solitaire: Russian Belligerence

One thing I like to do on this blog is engage in some “live” analytical exercises. So here is one in the vein of my reasoning from first principles post. I will play a round of Socratic Solitaire to examine Russia’s belligerence on the geopolitical stage. This is not a trivial exercise to me. I have real dollars on the line (see disclosure at bottom).

In general I think people do a poor job of analyzing geopolitical risk. There are many reasons for this. Availability bias is probably the most significant issue, especially in emerging markets. Also people do not put themselves in the shoes of the person on the other side of the table. Investment analysts especially tend to be quantitatively oriented people. They struggle to price the “squishy” stuff. So what I am really challenging myself to do here is think like Vladimir Putin.

What Motivates Me?

This is tough. But anyone who enters the political arena does it for some combination of the following three things:

  • Power
  • Money
  • To make the work a better place

Given Russia’s behavior on the geopolitical stage I would say we can safely rule out “making the world a better place.” That leaves me with money and power.

If I am Vladimir Putin, and I am motivated primarily by money, the smart thing for me to do is straightforward: play nice with the other Great Powers (US, China, EU) and simply focus my energy on looting the Russian economy. Without some overriding desire for political power, things like backing Bashar Al Assad and invading Crimea make no sense. They introduce catastrophic risks into the equation. Namely: a large scale military conflict I might lose.

Thus, on a weighted average basis I think it is safe to say that power is the most significant driver for my behavior. The relevant question from the perspective of an investor in Russian securities is: to what extent am I willing to put constraints on my drive for power?

Why Would I Constrain My Desire For Geopolitical Power?

All else equal I would simply work to swallow up the world. What would stop me?

As mentioned above, catastrophic downside risk might give me pause. That happens in a couple of different ways:

1) lose a war,

2) villagers with pitchforks revolt, and

3) a coup.

How Do I Protect Myself From Catastrophic Downside Risks?

In the short term, Risk #3 can be addressed in straightforward fashion with political repression and violence. Indeed, this appears to be the current game plan. The Financial Times recently published an interview with the Russian oligarch Vladimir Potanin. Potanin is notable for being one of the only old guard oligarchs who is still alive and wealthy.

“Why did we survive, [Mikhail] Fridman and myself? Maybe because we never tried to dictate to the government, to the Kremlin,” he says. He recalls a meeting where he and Fridman told Khodorkovsky, “Mikhail, the problem is you are trying to play political games. The perception is you are trying to buy power. It is unacceptable, not just for you but for all of us — we will all look dangerous.”

In Russia, it is perfectly okay to loot. It is not okay to play politics. A meta-reading of the interview suggests Potanin is addressing Putin and Russian state security directly. “I am not a threat,” he is saying. “I am not interested in political power. No need to bump me off or confiscate my wealth.”

Risk #2 is trickier to manage as it requires balancing economic and social considerations. The CIA World Factbook gives excellent high level macroeconomic data for Russia. We can slice and dice Russian GDP in several different ways but there are a couple of data points that stand out. Agriculture, energy and heavy industry play significant roles in the Russian economy. Russia also runs a trade surplus. Its top trade partners are China (22% of imports; 10% of exports); Germany (11% of imports; 7.8% of exports); and the United States (8% of imports). Heavy industry and energy are both intensely cyclical industries. The Russian economy is thus extremely sensitive to trends in global commodity prices, and subject to dramatic boom-bust cycles.

Unsurprisingly then, Vladimir Putin is acutely aware of “villagers with pitchforks risk.” In October 2017, The Financial Times reported on a 2009 incident where the Russian president publicly shamed oligarch Oleg Deripaska over unpaid workers:

In June 2009, in the depth of Russia’s previous sharp recession, Putin gave aluminium magnate Oleg Deripaska a public dressing-down after workers in the northern town of Pikalyovo, where his company is the main employer, took to the streets over production stoppages and unpaid wages.

“I must say that you’ve made thousands of residents of Pikalyovo hostages of your ambition, your unprofessionalism and maybe your greed,” the president told Deripaska in front of rolling cameras. As the tycoon hung his head, Putin asked why he had “neglected” his factory. Before the president had left town, Deripaska had ordered that all outstanding wages be paid.

“The effect of that show lingers until today,” says Zemlyansky. “After what happened in Pikalyovo, in all Deripaska towns, they keep on a certain number of employees even in companies that should be shut down, just because of the fear of Putin.”

And the Kremlin is keeping a close eye on things. The National Guard, the police force in charge of riot control, monitors social stability in some monotowns. The federal government has also set up a system to collect more comprehensive data on their social and economic state. The statistics are kept secret, making it impossible even for local governments to assess the situation properly.

Aside from economic policy measures, one highly effective way of managing “villagers with pitchfork risk” is through scapegoating. In fact, this tactic can be used to kill two birds with one stone. In China, for example, the Chinese premier (now dictator for life) has used an anti-corruption campaign as cover for greasing squeaky wheels. In the US, there is nothing Donald Trump loves more than making an individual or organization a scapegoat for some real or imagined threat.

The solution to Risk #1, meanwhile, is simple but not necessarily easy: do not lose a war with a Great Power.

If I Am Vladimir Putin, How Far Will I Push The Other Great Powers?

Answer: As far as they will let me.

There are military and economic dimensions to this and we could spend years gaming it all out. The bottom line is that the optimal strategy is a carefully choreographed dance, similar to the Cold War.

The underlying dynamics are similar to those of the Prisoner’s Dilemma in game theory. The Prisoner’s Dilemma, or, rather, the Iterated Prisoner’s Dilemma, is therefore an interesting model to consider. From Wikipedia:

Interest in the iterated prisoner’s dilemma (IPD) was kindled by Robert Axelrod in his book The Evolution of Cooperation (1984). In it he reports on a tournament he organized of the N step prisoner’s dilemma (with N fixed) in which participants have to choose their mutual strategy again and again, and have memory of their previous encounters. Axelrod invited academic colleagues all over the world to devise computer strategies to compete in an IPD tournament. The programs that were entered varied widely in algorithmic complexity, initial hostility, capacity for forgiveness, and so forth.

Axelrod discovered that when these encounters were repeated over a long period of time with many players, each with different strategies, greedy strategies tended to do very poorly in the long run while more altruistic strategies did better, as judged purely by self-interest. He used this to show a possible mechanism for the evolution of altruistic behaviour from mechanisms that are initially purely selfish, by natural selection.

The winning deterministic strategy was tit for tat, which Anatol Rapoport developed and entered into the tournament. It was the simplest of any program entered, containing only four lines of BASIC, and won the contest. The strategy is simply to cooperate on the first iteration of the game; after that, the player does what his or her opponent did on the previous move. Depending on the situation, a slightly better strategy can be “tit for tat with forgiveness”. When the opponent defects, on the next move, the player sometimes cooperates anyway, with a small probability (around 1–5%). This allows for occasional recovery from getting trapped in a cycle of defections. The exact probability depends on the line-up of opponents.

By analysing the top-scoring strategies, Axelrod stated several conditions necessary for a strategy to be successful.

Nice

The most important condition is that the strategy must be “nice”, that is, it will not defect before its opponent does (this is sometimes referred to as an “optimistic” algorithm). Almost all of the top-scoring strategies were nice; therefore, a purely selfish strategy will not “cheat” on its opponent, for purely self-interested reasons first.

Retaliating

However, Axelrod contended, the successful strategy must not be a blind optimist. It must sometimes retaliate. An example of a non-retaliating strategy is Always Cooperate. This is a very bad choice, as “nasty” strategies will ruthlessly exploit such players.

Forgiving

Successful strategies must also be forgiving. Though players will retaliate, they will once again fall back to cooperating if the opponent does not continue to defect. This stops long runs of revenge and counter-revenge, maximizing points.

Non-envious

The last quality is being non-envious, that is not striving to score more than the opponent.

If one views Russia’s behavior (or any belligerent nation state’s behavior) through this lens there are elements of the Iterated Prisoner’s Dilemma in play. In particular, some belligerence must be used as a deterrent. Likewise, some forgiveness and cooperation must be utilized to stop “long runs of revenge and counter-revenge” (read: World War III). In this context, seemingly “crazy” actions such as backing Bashar Al Assad are in fact totally rational.

Why Would I Start World War III?

As Charlie Munger says, “always invert.” So, let’s examine the issue of Russian belligerence through another angle. Why would I, as Vladimir Putin, intentionally ignite a global conflagration that could result in my total loss of power and personal demise?

  • I believe there is a high probability of winning
  • I am a pure ideologue / religious fanatic (not a rational actor)
  • Nothing left to lose

At this juncture none of these appear to dominate decision making on the Russian side. There is some level of ideology in play here in terms of a desire to ensure Russia remains a Great Power and a geopolitical player. However, it’s not the type of fanaticism that renders someone an irrational actor, such as Islamic Fundamentalism.

Key Learnings

Russian aggression is not irrational. There is a method to it. The method stems from the fact that Vladimir Putin is motivated to expand Russia’s power and influence (and by extension, his own power and influence). This requires a certain level of calculated belligerence so as not to be steamrolled by other Great Powers.

Domestically, the #1 rule for business leaders is to keep out of politics. The #2 rule is to allow the state some latitude for looting. Most investors look at #2 and say “forget it, I am  out” (availability bias). I look at SBRCY on forward PE of 5.67 with a 20% ROE, having just announced a doubling of its dividend, and say, “gee, maybe the looting is more than priced into the stock.”

The most controversial asset expropriation in the history of modern Russia is Yukos, which was owned largely by the oligarch Mikhail Khodorkovsky. Russia did not expropriate Yukos for arbitrary reasons. Khodorkovsky had political ambitions. Worse yet (from the Russian government’s point of view), his vision for Russia ran counter to that of Vladimir Putin. Therefore, if you are invested in Russia, an easy qualitative screen to run is whether company management and ownership is aligned with the Putin regime. This is a critical to assessing expropriation risk and ensuring you are taking calculated risks versus stupid risks.

Full Disclosure: Long OGZPY, SBRCY and RSXJ. Short RSX (as a partial hedge)

Mental Model: Time Dilation

Time dilation is a consequence of relativity in physics. Put simply: individuals moving at different speeds perceive time differently. The most extreme example of this would be someone moving at the speed of light versus a stationary observer. For the person traveling at the speed of light, time measured from the point of view of the stationary observer would appear to have stopped.

Crazy, right?

Take a moment and allow that to sink in. It is pretty wild to think about. It took me two passes through A Brief History of Time before I felt like I had a decent handle on the concept.

Below is a fun animation to help illustrate.

Nonsymmetric_velocity_time_dilation
Time dilation illustrated. The motion inside each “clock” represents the perceived passage of time from the blue clock’s perspective. Source: Wikipedia

In financial markets, we experience our own form of time dilation. A high frequency trader experiences time differently than Warren Buffett. Here the relative velocity we are concerned with isn’t physical motion, but rather the velocity of activity in a portfolio of financial assets. The more you trade, the slower time moves for you.

Below are two charts for AAPL, one for the last trading day and one for a trailing 1-year period. All the price action depicted in the first chart is imperceptible on the second.

AAPL_1_Day
Source: Google
AAPL_1_Year
Source: Google

This idea of time dilation presents significant challenges for investment organizations.

The first challenge is the friction it creates between stated investment horizons and performance measurement. It is tough to manage money to a three or five-year horizon if your investors are measuring performance monthly. With that kind of mismatch, stuff that wouldn’t seem significant over three or five years starts to look significant (in a way, it is). And so you are tempted to “do stuff” to keep your investors happy.

While you should be focused on the “signal” from annual reports, you get bogged down in the “noise” of quarterly fluctuations in earnings. Or, god forbid, daily and weekly newsflow. Unless you are a proper trader, nothing good ever comes of focusing attention on daily and weekly newsflow.

Also, since people pay money for investment management, it is easy for them to mistake large volumes of activity for productive activity. Yet, just because you “do a lot of stuff” doesn’t mean your results will be any better. In fact, plenty of empirical evidence argues the opposite. The more “stuff” you do, the worse your results will be.

Here is an example of market time dilation from Professor Sanjay Bakshi. Years ago he executed a “very cool” arbitrage trade involving Bosch stock for a triple digit IRR. That’s an objectively fantastic result. And yet, Prof Bakshi readily admits to missing the forest for the trees. Why? He was operating on a different time horizon.

bakshi_bosch
Source: Professor Sanjay Bakshi

You can judge whether someone truly has a long term mindset based on how he feels about being “taken out” of a stock in a merger or buyout. Long-term thinkers don’t like to be taken out of their positions! They would rather compound capital at 20% annually for 30 years than have a 100% return in a single year.

They all explain this the same way: there aren’t that many businesses capable of compounding value at 20% annually for 30 years. When you find one you should own it in size. Selling it should be physically painful. Only phony long term thinkers are happy about getting taken out of good businesses.

Now, that’s certainly not the only way to make money in the markets. The trick isn’t so much finding “the best way” to make money as it is genuinely aligning your process with your time horizon. This is not a trivial thing. Particularly if you manage other people’s money.

Clear Thinking: Why Many Great Investors Are Also Great Writers

Morgan Housel observes:

Communicating and allocating capital are miles apart. Completely different topics. But look around, and the two are constantly paired.

Warren Buffett is a great writer. Paul Graham is a great writer. John Bogle is a great writer. Howard Marks is a great writer. Josh Brown is a great writer. Brent Beshore, Seth Klarman, Joel Greenblat, Ben Graham – the list goes on.

None of this is a coincidence. These aren’t just great investors who happen to be good communicators; their ability to communicate well helped make them great investors.

The post focuses on the importance of clear and effective client communication. However, I would argue that great investors often make for great writers because great investing and great writing both require clarity of thought. Parsimony is a beautiful thing.

In writing, the ultimate example of this is Hemingway’s “six word novel.” Here it is in its entirety:

For sale: baby shoes, never worn

Those six words evoke an entire lifetime of experiences and emotions. You could write a thousand page novel about the death of a child and you would struggle to make the impact of the six word Hemingway story. Why? The six word story contains only the most important parts. Your thousand page novel is going to contain all kinds of extraneous crap. And that extraneous crap dilutes the emotional impact of the most important parts.

Likewise in investing, you need clarity of thought to identify the key drivers of a situation. Most great investments hinge on two or three key drivers. Everything else is noise. You get lost in the noise at your peril. In Margin of Safety, Seth Klarman tells the story of an analyst who (badly) missed the forest for the trees on Clorox:

David Dreman recounts, “the story of an analyst so knowledgeable about Clorox that ‘he could recite bleach shares by brand in every small town in the Southwest and tell you the production levels of Clorox’s line number 2, plant number 3.’ But somehow, when the company began to develop massive problems, he missed the signs… .” The stock fell from a high of 53 to 11.

The analyst knew a lot of crap about Clorox. But he wasn’t thinking clearly. All that extraneous crap he knew about Clorox blinded him to what really mattered. So knowing all that crap about Clorox was irrelevant to the outcome.

Elsewhere, Charlie Munger has commented on how important clarity of thought is at Berkshire Hathaway:

Our ideas are so simple. People keep asking us for mysteries, but all we have are the most elementary ideas.

I have this pet theory that you should be able to go through a portfolio and summarize every single investment thesis (as a falsifiable statement, of course!) in just a couple of lines. If there are things you can’t do that for, you probably shouldn’t own them.

Futures Did Not Crash The Bitcoin Price

Longtime readers know I am largely a crypto skeptic. Specifically I am one of those annoying the-principles-underlying-crypto-are-undeniably-transformational-but-I-am-skeptical-of-the-investability-today people. However, there is one crypto myth I cannot really abide and that is the myth that the start of futures trading is responsible for the crypto drawdown that started in January 2018.

I first wrote about this issue of Bitcoin futures here.

But this isn’t that complicated. The reality is that BTC futures volumes are low. Like really low in comparison to volumes for BTC overall. Below is the data for BTC:

BTC_Trading_Volume
Source: data.bitcoinity.org

And here is the data from CME Group for its contract (note: multiply by 5 because each CME contract is for 5 BTC):

CME_BTC_Futures_Volume
Source: CME Grou

Let’s double that to account for the fact that CBOE offers its own Bitcoin futures. Even then you are talking about maybe 30,000 BTC worth of total volume. I struggle to believe these meager volumes are pushing the market around.

More importantly, just because I sell a BTC futures contract does not mean the spot price of BTC automatically drops.

Someone has got to push the sell button in the spot market for that to happen. My selling of BTC futures does not in and of itself compel anyone to sell spot BTC. It may encourage someone to to come in and take a position based on how my order impacts the term structure of BTC futures in relation to the spot price. But that is a very different proposition from “I am short Bitcoin futures so now the spot market is falling.”

Now maybe there is data out there beyond someone lining up dates that shows a clear causal relationship between the BTC selloff and the start of futures trading, but I have yet to see it (if you have such data please get in touch).

Otherwise, repeat after me: correlation is not causation.

Deworsification [WONKISH]

If you are not interested in the mathematics of portfolio construction you can safely skip this post. This is a (relatively) plain language summary of a research paper published in The Financial Analysts Journal. It is not investment advice and should not be used as the basis for any investment decision.

One of the issues that I have been interested in for a long time is the issue of overdiversification in investment portfolios. We are conditioned by portfolio theory to accept diversification as a universal good. However, depending on the investor’s objectives diversification can be counterproductive–particular when higher cost investment strategies are involved. This post examines the research paper, “What Free Lunch? The Costs of Over Diversification” by Shawn McKay, Robert Shapiro and Ric Thomas, which offers a rigorous treatment of the issue.

Summary

The authors use empirical and simulated data to develop a framework for assessing the optimal number of active managers in an investment allocation. They find that as one adds managers to an investment allocation, the active risk (a.k.a “tracking error”) decreases while investment management expenses remain constant or even increase. This leads to the problem of “overdiversification” or, more colloquially, “deworsification.”

Source: McKay, et al.

The authors propose two measures to analyze the impact of overdiversification:

Fees For Active Risk (FAR) = Fees / Active Risk

Fees For Active Share (FAS) = Fees / Active Share

All else equal, one would like the FAR and FAS ratios to be as low as possible.

Source: McKay, et al.

However, perhaps the most important conclusion the authors reach is that as active risk decreases, the security selection skill needed to deliver outperformance versus a benchmark rises exponentially:

Holding breadth [portfolio size] constant allows us to develop a framework that illustrates the trade-offs between active risk and the information coefficient for various levels of expected return. Each line in Figure 5 is an isometric line, highlighting various combinations that give a fixed level of expected return. The curve at the bottom shows all combinations of active risk and the information coefficient in which the excess return equals 1% when holding breadth constant at 100. The two other lines show the same trade-offs for breadth levels of 60 and 20, respectively.

As expected, the required information coefficient increases as tracking error declines, but it rises exponentially as we approach lower levels of active risk. Allowing for greater breadth shifts the line downward, beneficially, but in all cases, there is a similar convex relationship.

Active_Risk_vs_Skill
Source: McKay, et al.

Practical Implications

  • The more diversified your allocation, the more difficult the relative performance game gets due to increasing fee drag on decreasing levels of active risk.
  • Investors who are aiming for significant outperformance via active management should concentrate capital with a small number of managers.
  • Investors who desire highly diversified portfolios are thus better off allocating to a passive, factor and enhanced-index funds than dozens of highly active equity managers.
  • Capacity and fiduciary constraints make it extra challenging for capacity constrained investors such as large pension funds to generate substantial alpha at the portfolio level, as it is imprudent for them to run highly concentrated portfolios. For these investors in particular, a core-satellite approach likely makes sense.

Different Priorities, Different Portfolios

So I pushed out my big behavioral finance/investing values post last week only to discover today that Morgan Housel is riffing on the same themes. He writes:

[W]e rarely recognize that most investment debates – debates that literally make markets – are just a reflection of people making different decisions not because they disagree with each other, but because they view investing with a different set of priorities.

If you’re trying to maximize risk-adjusted returns you have no idea why someone would buy a 10-year Treasury bond with a 2% interest rate. But the investment probably makes perfect sense to Daniel Kahneman. Paying off your mortgage with a 3% tax-deductible interest rate is probably crazy on a spreadsheet but might be the right move if it helps you sleep at night. Trading 3X leveraged inverse ETFs is financial suicide for some and a cool game for others. Long-term investors who criticize day traders bet on football games because it’s fun. People who scream at you for over-allocating into REITS buy six-bathroom homes for their four-person family. The flip side of Daniel Kahneman is the billionaire who risks his valuable reputation to gain money he doesn’t need. Have you been on Twitter? People see the world differently.

Two rational people the same age with the same finances may come to totally different conclusions about what’s right for them, just as two people with the same cancer can pick radically different treatments. And just as medical textbooks can’t summarize those decisions, finance textbooks can’t either.

This isn’t just about differences in risk tolerance.

People who work in finance underestimate that watching markets go up and down isn’t intellectually stimulating for most regular people. It’s a burden. And even if they can technically stomach investment risk, the added complexity robs bandwidth from other stuff they’d rather be doing. The opposite is true. Claiming your investment product is entertaining is usually the refuge of those who can’t point to performance. But it’s crazy to assume that many people don’t find investing incredibly entertaining – so much so that they rationally do nutty stuff regardless of what it does to their returns.

Everyone giving investing advice – or even just sharing investing opinions – should keep top of mind how emotional money is and how different people are. If the appropriate path of cancer treatments isn’t universal, man, don’t pretend like your bond strategy is appropriate for everyone, even when it aligns with their time horizon and net worth.

Here are some areas where I think personal values and priorities will play a significant role in your view of optimal portfolio construction:

Definition of risk. Do you define risk as volatility (“prices going up and down a lot”), or as permanent impairment of capital (“realizing losses in real dollar terms”)?

Definition of performance. Are you focused on absolute performance (“I want to compound my capital at 10% annually”) or performance relative to a benchmark index (“I want to outperform the S&P 500”)?

Tax sensitivity. Are you someone who will spend $1.05 to save $1.00 in taxes based on “the principle of the thing?” Or are taxes just something you have to deal with if you want to make money?

People who use volatility as their risk measure, focus on relative performance and are extremely tax sensitive tend to gravitate toward passive investing strategies. Those who define risk as permanent impairment of capital, focus on absolute performance and are less tax sensitive might favor a more active approach.

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.