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On edges and why they persist

In our investment practice we use a suite of strategies designed to produce outsized risk-adjusted returns, or better returns per unit of risk, relative to mainstream methods such as buying and holding a stock index and bond fund. Our methods leverage the well known anomaly of momentum on top of the inherent advantage of global diversification. Additionally, in my newsletter I show how the simplest valuation-based models can also consistently outperform buy-and-hold on a risk-adjusted basis, if not an absolute basis.

As a systematic investor, a common theme of thought and discussion centers around the concept of investment “edges.” An edge can be roughly defined as a statistical pattern that can be profitably exploited, after all costs are taken into account. A perfect blackjack card counter might find an edge of 1% or less, but with a rational betting system (raising when the odds are good, folding when not), a strong stomach, and a deep bankroll, this edge can be parlayed into winnings over scores of hands through many hours of play. Investment edges are much the same – they require solid statistical work, methodical application, and enough time to turn the law of large numbers in your favor. It’s no coincidence that one of the pioneers of systematic quantitative investing, Ed Thorp, first rose to fame for inventing card counting.

Markets aren’t purely random like a card game, but they are complex systems rife with chaos, and nearly as impossible to predict. Given our core beliefs about markets, how could we have the audacity to believe that we can earn outsized returns relative to more generally accepted investment methods? After all, advocates of indexing often say the same thing about the futility of prediction. Our models are realistic and robust, and the results of our testing are extremely strong on both an absolute and risk-adjusted basis, but we recognize that a passing view of our results can conjure feelings of disbelief.

These results are too good to be true. There is no way this is possible. This may have worked in the past, but markets are at least somewhat efficient, and these results cannot persist in the future.

Yet as you can see in the 36+ years of data in my newsletter, not to mention exhaustive academic papers and the track records of systematic investors, the value and momentum edges can bring home the bacon. Both kinds of systems deliver higher returns with less risk than buying and holding, whether applied to the Swedish stock market or oil futures. So why do so many investors and commentators fail to exploit them or even deny their existence?

As money managers and business owners, we have faced these feelings ourselves. The last thing we want to do is to pass up high-paying jobs with good career tracks, only to start an investment firm that fails to live up to its goals and flounders off into obscurity. In the form of personal investment in our systems and career investment by passing up other, more stable career opportunities, we have true skin in the game, not to mention the heavy responsibility of ensuring that our clients achieve their financial goals.

How is it that we have overcome these doubts? Why do we believe that we can substantially outperform far into the future? Why should our edges work? The answers to these questions are not simple, but they reveal much about how the investment industry fails its clients. We have dedicated our professional lives to this industry, and we have spent time working in hedge funds, investment research firms, financial product sales, and as individual traders. If our collective experience has taught us anything about markets it is this:

Financial markets are, without a doubt, extremely irrational and inefficient.

While markets are not predictable, the incentive structures upon which the financial services industry is built, and the human nature of those who act in this realm, create  edges that can be exploited by those willing to do the work and be different. These incentive structures are deep and persistent. Human nature, driven by evolution, does not change over short time frames. Our edges are not likely to be arbitraged away anytime soon.

The reasons are myriad, and a deserving of a full-length book, but we can enumerate some of the big ones here in passing:

1) Recency bias

Emotional memory is short. We focus on what has been working lately and extrapolate indefinitely. We worry about the last bad thing that has happened, not what else could go wrong. All strategies underperform at times, and recency bias makes us abandon our edges to chase what has been working lately.

2) Career risk

Noncorrelation with an index is a huge liability, as when an uncorrelated strategy lags an index, clients leave, and investment policy managers may call a portfolio manager to task. It’s far safer to be wrong with the crowd than eventually right on your own. Remember that all of this capital out there is not chasing returns. It’s chasing compensation, and compensation is first and foremost about retaining clients and your job.

3) Assets, not returns, drive compensation and status

Johnny Bigshot from Titanic Capital takes home the big bucks just for showing up. Why risk his career for eventual outperformance when Titanic Capital doesn’t even charge a performance fee?

Even big fund managers who have a mandate to exploit the value or momentum factor must hold many more positions than optimal, just so that all of that capital can be deployed. It’s well-known that returns go way up when a manager is allowed to hold concentrated positions, perhaps only 30 or fewer stocks out of the 3000 or so listed companies of any consequence. You can’t do that with Titanic’s momentum fund, because you would have to buy up all the daily volume (or the whole float!), thus moving the market and negating the edge. Remember that when Buffett and Munger were small, they took massively concentrated bets and fully exploited their value methodology, booking enormous returns. “Put all your eggs in one basket, and watch that basket!”

 

Don’t let narratives get in your way

The above are just a few of the cognitive biases and misplaced incentives that plague the majority and create opportunity for the few, but if we step back for a moment to the purely mathematical realm, none of this even matters. From that perspective, such explanations are mere narrative, and narrative has no place in quantitative investing. All that matters is statistical significance, and quants have that in spades. As an investor, you have to ask yourself if you base decisions on the evidence or on narratives. Market efficiency is just a narrative, and the more rational (read: coherent) a narrative the more followers it will draw and the harder it will be to ignore, even when roundly refuted by evidence. Refuting narratives with narratives is for IYIs. Practitioners only care about results.

 

In conclusion

Small firms and individuals have an enormous advantage in this game, as they can be different, and they can be nimble. A small investor who is as rational and systematic as a big fund has nothing holding him back. What are you waiting for?

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