by David Robertson, CFA
September 2017
Living in a knowledge economy it almost goes without saying that knowledge is important. In fact, Eric Beinhocker went a step further in his book, Origin of Wealth, when he concluded that knowledge is the genesis of wealth. More specifically, he explained that "Knowledge ... is information that is useful, that we can do something with, that is fit for some purpose." In many ways this is an uplifting message. By recognizing knowledge as a primary vehicle for human progress he also guides readers to a course of action that can improve almost any situation.
Of course this insight also applies to the world of investing and underlies much of what compels the best investors. Because securities prices tend to gravitate to the sum of discounted future cash flows, there are typically handsome rewards for those who can identify and act on instances of significant deviations from intrinsic value. Typically anyway. Over the last few years knowledge has lost much of its pre-eminence as a means by which to create wealth in the markets - and this has some very important implications for investors.
Historically, hedge funds have epitomized the application of knowledge for the purpose of creating wealth in the investment world. They tend to hire the smartest people and deploy the greatest resources in the endeavor of making tons of money. The industry is plastered with tales of their greatest trades and impressive track records.
Over the last few years something odd has happened with these funds, however: Many of them have been struggling. Of course hedge funds often take risky bets and it is not unusual for one to occasionally have a big bet go bad. What is unusual is that a large concentration of the best hedge fund managers have been suffering repeatedly and closing funds down and/or closing their shop down. There seems to be some information content in this pattern.
Going back a couple of years to 2015, for example, the Financial Times documented market turmoil [here] that caught several of the big hedge fund names. As the article reports, "Some of the worst hit were funds that specialised in stock picking," and noted that, "David Einhorn's $11bn Greenlight Capital lost 17% up to the end of September."
More recently John Burbank of Passport Capital shut down his long-short strategy [here] after a stretch of weak performance and some big redemptions. The story reports that the firm's flagship Passport Global fund also suffered major redemptions this year which substantially reduced the firm's assets under management.
Also of note is the case of Hugh Hendry and his Ecclectica funds. After suffering through a tough period after the financial crisis, [here] Hendry changed strategic course and seemed to be stabilizing performance. That all changed fairly quickly this summer, however, when a couple of consecutive months of negative returns were followed by significant redemptions and Hendry decided to close down shop altogether.
Mark Hart also made news this year with his Corriente Advisors [here]. Long a bear on the Chinese yuan, he “spent seven years and $240 million waiting on a crash in China’s currency." His rationale for such a big trade was solid: "Hart believes that the Chinese crawling devaluation is an error as it carries with it the latent threat of much more devaluation in the future, thus encouraging even more outflows, which in turn forces China to sell even more reserves, which destabilizes the economy even further, forcing even more devaluation and so on." Unfortunately for him and his investors, it just hasn't worked out that way. At least not yet.
While periods of poor performance are endemic to the business, the breadth of significant performance challenges among such high profile funds begs the question as to why it is happening now. One simple explanation is that the hedge fund business is a tough one. While managers have the potential to earn substantial fees, this must be done in the context of an environment that is intensely competitive and for which many clients are impatient. Not only must you be right about your trades, but you must be right within a short enough time horizon that your clients don't leave first.
That still doesn't answer why these performance travails among top managers have been more concentrated recently, however. Something else appears to be going on. One explanation is that the mechanism by which knowledge produces wealth in the capital markets is broken. In other words, it's not so much that these managers have been wrong as that the markets have failed to reflect information as accurately as they normally do. Unusually, mispricing in the markets has been both persistent and nearly systemic.
In an important sense, this is just another way of talking about valuation - which we and plenty of other commentators have been doing for some time now. One of the primary suspects in the case of persistent mispricing is the group of entities that are not sensitive to price (an issue we highlighted [here]). Whether this group has been comprised of central banks buying trillions of dollars worth of securities regardless of price or people buying passive funds with little regard for investment merits, this unbalanced demand for financial assets has changed the quality and quantity of information embedded in market prices.
As such, at least one of two things is likely to be true. One is that the phenomenon of widespread security mispricing is a temporary phenomenon and likely to revert. Insofar as this is the case, investors can expect the substantial disparities between intrinsic values and market prices to start dissipating. During this "normalization" process, it is likely that passive funds will persistently underperform and that some of the best active funds will post huge performance numbers.
The other possibility is that, we are now in a period of semi-permanent market inefficiency in which market prices remain detached from underlying values for a substantial but indeterminate period of time. Under this hypothesis, markets are no longer clearinghouses of supply and demand for securities that reveal useful information, but rather instruments of (often capricious) public policy and expressions of mindless attachment to stocks and bonds. In this scenario, market prices contain very little information and therefore provide little basis upon which to efficiently allocate capital throughout the economy.
This is a critically important point for investors. Information greases the wheels of capitalistic, free market economies and keeps them moving efficiently. Less information means less efficient capital allocation - means less economic growth - means less wealth creation. In other words, wealth is not signaled by securities prices per se, but rather by the information imbued in those prices. If those prices don't contain useful information, then they are just arbitrary numbers
If this seems a bit unnerving, it should be. Anyone who is saving for retirement (or a similar long term goal) and is trying to maximize their chance of succeeding should be alarmed by any element of arbitrariness in the process. Yet this is exactly what happens with most investment plans because most plans focus almost exclusively on financial assets. Such an emphasis creates a discernible risk that the reported totals in these plans overstate the real wealth that has been accumulated. In other words, many investors probably don't have as much saved up as they think they do.
Although this presents a challenge for investors, fortunately there are things that can be done. An example from the technology world points the way and not surprisingly, it involves knowledge! More specifically, as Tristan Harris describes [here], it essentially involves inoculating oneself against the imposition of false choices. Harris knows a lot about the subject; he spent three years at Google as a Design Ethicist "caring about how to design things in a way that defends a billion people’s minds from getting hijacked."
In his hijack prevention effort, Harris discloses something of a taxonomy of ways to fool people. The number one spot on that list is to "control the menu," or, as he puts it, "If you control the menu, you control the choices."
As he describes, "Western Culture is built around ideals of individual choice and freedom. Millions of us fiercely defend our right to make 'free' choices, while we ignore how those choices are manipulated upstream by menus we didn’t choose in the first place." He provides an illustrative example: "This is exactly what magicians do. They give people the illusion of free choice while architecting the menu so that they win, no matter what you choose." He concludes with the message, "I can’t emphasize enough how deep this insight is."
While Harris' intent is to prevent people from being sucked into a limited menu of apps on their smart phone and foregoing a world of other, often more fruitful activities, the lesson is just as apt for investors. It is much harder to make good decisions when you don’t consider the alternatives. As it stands, the vast majority of advisers, for a variety of reasons, focus almost exclusively on financial assets when creating investment plans. But that focus creates a false choice. Worse, when financial assets are overvalued, not only are they a false choice, but a bad choice. Paraphrasing Harris, no matter what you choose, you lose.
The best way to avoid being fooled by false choices (such as picking one fund over another) then, is to always consider the broader realm of possibilities. As Harris notes, the types of potentially revealing, but rarely asked questions include things like: "What’s not on the menu?" "Why am I being given these options and not others?" "Do I know the menu provider’s goals?" "Is this menu empowering for my original need, or are the choices actually a distraction?"
And there's the catch that seriously challenges the assumptions of most investment plans. Does this menu empower your original need? Do financial assets completely fulfill your needs for retirement? Or do they introduce undue risk and uncertainty?
No doubt, financial assets are great when they are working. You put away some money and it just keeps growing. You get a benefit with no extra work. But when they don't work, and by definition there are no guarantees, they can fall in value at really inopportune times. And if they are overpriced to begin with, declines can be permanent. The nightmare scenario is when this happens at a time when you are too old to recoup losses, but young enough to have to endure the consequences for a long time.
Fortunately, it is not difficult to expand the realm of investment possibilities to non financial assets. In fact many thoughtful investors may already be doing this on some level anyway - with or without help from their advisers.
One key non financial asset for consideration is cash. Not only does cash serve as a relatively secure store of value, but it also provides an option to buy other assets more cheaply in the future. In addition, real assets like rental properties can produce their own cash flows regardless of prices for the asset. Precious metals don't produce cash flows, but can help preserve wealth against the threat of inflation. Finally, intellectual capital in the form of new skills that can be remunerated also constitutes a potential avenue for investment.
In many respects then, knowledge is more than just a virtue that can improve people's lives. It is also a means by which to create, and to some degree, measure wealth. This ends up being a useful concept at times when market prices lose their information content and drift from intrinsic values. While many people enjoy watching prices go up, the reality is that this phenomenon only makes the job of accumulating wealth that much harder. At worst, it sets investors up for a nasty surprise at a time when it is too late to do much about it.
September 2017
Living in a knowledge economy it almost goes without saying that knowledge is important. In fact, Eric Beinhocker went a step further in his book, Origin of Wealth, when he concluded that knowledge is the genesis of wealth. More specifically, he explained that "Knowledge ... is information that is useful, that we can do something with, that is fit for some purpose." In many ways this is an uplifting message. By recognizing knowledge as a primary vehicle for human progress he also guides readers to a course of action that can improve almost any situation.
Of course this insight also applies to the world of investing and underlies much of what compels the best investors. Because securities prices tend to gravitate to the sum of discounted future cash flows, there are typically handsome rewards for those who can identify and act on instances of significant deviations from intrinsic value. Typically anyway. Over the last few years knowledge has lost much of its pre-eminence as a means by which to create wealth in the markets - and this has some very important implications for investors.
Historically, hedge funds have epitomized the application of knowledge for the purpose of creating wealth in the investment world. They tend to hire the smartest people and deploy the greatest resources in the endeavor of making tons of money. The industry is plastered with tales of their greatest trades and impressive track records.
Over the last few years something odd has happened with these funds, however: Many of them have been struggling. Of course hedge funds often take risky bets and it is not unusual for one to occasionally have a big bet go bad. What is unusual is that a large concentration of the best hedge fund managers have been suffering repeatedly and closing funds down and/or closing their shop down. There seems to be some information content in this pattern.
Going back a couple of years to 2015, for example, the Financial Times documented market turmoil [here] that caught several of the big hedge fund names. As the article reports, "Some of the worst hit were funds that specialised in stock picking," and noted that, "David Einhorn's $11bn Greenlight Capital lost 17% up to the end of September."
More recently John Burbank of Passport Capital shut down his long-short strategy [here] after a stretch of weak performance and some big redemptions. The story reports that the firm's flagship Passport Global fund also suffered major redemptions this year which substantially reduced the firm's assets under management.
Also of note is the case of Hugh Hendry and his Ecclectica funds. After suffering through a tough period after the financial crisis, [here] Hendry changed strategic course and seemed to be stabilizing performance. That all changed fairly quickly this summer, however, when a couple of consecutive months of negative returns were followed by significant redemptions and Hendry decided to close down shop altogether.
Mark Hart also made news this year with his Corriente Advisors [here]. Long a bear on the Chinese yuan, he “spent seven years and $240 million waiting on a crash in China’s currency." His rationale for such a big trade was solid: "Hart believes that the Chinese crawling devaluation is an error as it carries with it the latent threat of much more devaluation in the future, thus encouraging even more outflows, which in turn forces China to sell even more reserves, which destabilizes the economy even further, forcing even more devaluation and so on." Unfortunately for him and his investors, it just hasn't worked out that way. At least not yet.
While periods of poor performance are endemic to the business, the breadth of significant performance challenges among such high profile funds begs the question as to why it is happening now. One simple explanation is that the hedge fund business is a tough one. While managers have the potential to earn substantial fees, this must be done in the context of an environment that is intensely competitive and for which many clients are impatient. Not only must you be right about your trades, but you must be right within a short enough time horizon that your clients don't leave first.
That still doesn't answer why these performance travails among top managers have been more concentrated recently, however. Something else appears to be going on. One explanation is that the mechanism by which knowledge produces wealth in the capital markets is broken. In other words, it's not so much that these managers have been wrong as that the markets have failed to reflect information as accurately as they normally do. Unusually, mispricing in the markets has been both persistent and nearly systemic.
In an important sense, this is just another way of talking about valuation - which we and plenty of other commentators have been doing for some time now. One of the primary suspects in the case of persistent mispricing is the group of entities that are not sensitive to price (an issue we highlighted [here]). Whether this group has been comprised of central banks buying trillions of dollars worth of securities regardless of price or people buying passive funds with little regard for investment merits, this unbalanced demand for financial assets has changed the quality and quantity of information embedded in market prices.
As such, at least one of two things is likely to be true. One is that the phenomenon of widespread security mispricing is a temporary phenomenon and likely to revert. Insofar as this is the case, investors can expect the substantial disparities between intrinsic values and market prices to start dissipating. During this "normalization" process, it is likely that passive funds will persistently underperform and that some of the best active funds will post huge performance numbers.
The other possibility is that, we are now in a period of semi-permanent market inefficiency in which market prices remain detached from underlying values for a substantial but indeterminate period of time. Under this hypothesis, markets are no longer clearinghouses of supply and demand for securities that reveal useful information, but rather instruments of (often capricious) public policy and expressions of mindless attachment to stocks and bonds. In this scenario, market prices contain very little information and therefore provide little basis upon which to efficiently allocate capital throughout the economy.
This is a critically important point for investors. Information greases the wheels of capitalistic, free market economies and keeps them moving efficiently. Less information means less efficient capital allocation - means less economic growth - means less wealth creation. In other words, wealth is not signaled by securities prices per se, but rather by the information imbued in those prices. If those prices don't contain useful information, then they are just arbitrary numbers
If this seems a bit unnerving, it should be. Anyone who is saving for retirement (or a similar long term goal) and is trying to maximize their chance of succeeding should be alarmed by any element of arbitrariness in the process. Yet this is exactly what happens with most investment plans because most plans focus almost exclusively on financial assets. Such an emphasis creates a discernible risk that the reported totals in these plans overstate the real wealth that has been accumulated. In other words, many investors probably don't have as much saved up as they think they do.
Although this presents a challenge for investors, fortunately there are things that can be done. An example from the technology world points the way and not surprisingly, it involves knowledge! More specifically, as Tristan Harris describes [here], it essentially involves inoculating oneself against the imposition of false choices. Harris knows a lot about the subject; he spent three years at Google as a Design Ethicist "caring about how to design things in a way that defends a billion people’s minds from getting hijacked."
In his hijack prevention effort, Harris discloses something of a taxonomy of ways to fool people. The number one spot on that list is to "control the menu," or, as he puts it, "If you control the menu, you control the choices."
As he describes, "Western Culture is built around ideals of individual choice and freedom. Millions of us fiercely defend our right to make 'free' choices, while we ignore how those choices are manipulated upstream by menus we didn’t choose in the first place." He provides an illustrative example: "This is exactly what magicians do. They give people the illusion of free choice while architecting the menu so that they win, no matter what you choose." He concludes with the message, "I can’t emphasize enough how deep this insight is."
While Harris' intent is to prevent people from being sucked into a limited menu of apps on their smart phone and foregoing a world of other, often more fruitful activities, the lesson is just as apt for investors. It is much harder to make good decisions when you don’t consider the alternatives. As it stands, the vast majority of advisers, for a variety of reasons, focus almost exclusively on financial assets when creating investment plans. But that focus creates a false choice. Worse, when financial assets are overvalued, not only are they a false choice, but a bad choice. Paraphrasing Harris, no matter what you choose, you lose.
The best way to avoid being fooled by false choices (such as picking one fund over another) then, is to always consider the broader realm of possibilities. As Harris notes, the types of potentially revealing, but rarely asked questions include things like: "What’s not on the menu?" "Why am I being given these options and not others?" "Do I know the menu provider’s goals?" "Is this menu empowering for my original need, or are the choices actually a distraction?"
And there's the catch that seriously challenges the assumptions of most investment plans. Does this menu empower your original need? Do financial assets completely fulfill your needs for retirement? Or do they introduce undue risk and uncertainty?
No doubt, financial assets are great when they are working. You put away some money and it just keeps growing. You get a benefit with no extra work. But when they don't work, and by definition there are no guarantees, they can fall in value at really inopportune times. And if they are overpriced to begin with, declines can be permanent. The nightmare scenario is when this happens at a time when you are too old to recoup losses, but young enough to have to endure the consequences for a long time.
Fortunately, it is not difficult to expand the realm of investment possibilities to non financial assets. In fact many thoughtful investors may already be doing this on some level anyway - with or without help from their advisers.
One key non financial asset for consideration is cash. Not only does cash serve as a relatively secure store of value, but it also provides an option to buy other assets more cheaply in the future. In addition, real assets like rental properties can produce their own cash flows regardless of prices for the asset. Precious metals don't produce cash flows, but can help preserve wealth against the threat of inflation. Finally, intellectual capital in the form of new skills that can be remunerated also constitutes a potential avenue for investment.
In many respects then, knowledge is more than just a virtue that can improve people's lives. It is also a means by which to create, and to some degree, measure wealth. This ends up being a useful concept at times when market prices lose their information content and drift from intrinsic values. While many people enjoy watching prices go up, the reality is that this phenomenon only makes the job of accumulating wealth that much harder. At worst, it sets investors up for a nasty surprise at a time when it is too late to do much about it.
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