Stop confusing clever with lucky

I get very annoyed when I see idiotic journalism, such as this article (admittedly Business Insider does not exactly maintain high standards of journalism, but in this case they just copied CNBC). To recap: one 22-year old kid put all his savings into Tesla shares (and later options on Tesla shares) and today has made quite a hefty profit. But when his friends told him he was crazy, they were right.

It is stupid to present this kid’s outstanding luck as success. He was not successful – he was blindly, stupidly, and ignorantly lucky. There was absolutely no way of knowing that Tesla would outshine all the other technology companies. There must be thousands of investors who have similarly bet heavily in some particular stock and found themselves losing everything. I am, of course, not saying anything new here. Taleb argued just these lines in his book Fooled by Randomness, which everyone should read.
But we don’t hear about the investors who lose everything. We only hear about the ones who strike it lucky. Because we think they are special, that they had some special foresight. Mostly they were just lucky.

I admit that markets are not efficient. Some people may have the ability, through research, to increase their chances of doing well. Most active managers think they have this ability (and all of them claim to have it). But only the stupid ones would invest most of their capital in one stock. There is too much room for error.

Warren Buffett is often cited as an example of an investor that managed to beat the market with his foresight, and this may be true (considering his long track record). But he was also very lucky. When he was just starting he invested 75% of his worth in one stock, GEICO, which paid off handsomely. This was after just one conversation with an executive there (one who became CEO shortly afterward). Buffett was extremely lucky. If that single investment had not paid off (and how do you really know it will pay off after speaking to one person, who can’t control the direction of the entire company?) we would never have heard the name Buffett.

Taking stupid risks is fine if you have a safety net (for instance rich parents), because then you’re not really putting all your eggs in one basket. For the rest of us: ignore the media when it tells you people who risked everything were smart. They were lucky.

References

• Buffett, W. (2010). Letter to the shareholders of Berkshire Hathaway Inc. October. Retrieved from http://www.berkshirehathaway.com/letters/2010ltr.pdf
• Lebeau, P. (2013). College Student Put His Life Savings Into Tesla, Made A Killing. Business Insider. Retrieved August 28, 2013, from http://www.businessinsider.com/college-student-put-his-life-savings-into-tesla-made-a-killing-2013-8
• Taleb, N. N. (2007). Fooled by Randomness (2nd ed.). Penguin.

Imaginary Alpha

Alpha is what hedge funds sell. It is the skill of the investment manager(s), allowing them to earn a higher return than justified merely by the amount of risk they take. In practice this means earning more than a simple index fund. For this excess return, hedge funds charge higher fees. Presumably this is justified. In an efficient market alpha would be zero – there would be no way to earn (on average) higher returns than the market as a whole. No one (except economists and some MBA students) believes markets are efficient anymore. However, since 1998, hedge fund clients (in the US) have earned on average only half the rate of return on treasuries.

Self-selection bias

Indices of hedge fund performance suffer from a crucial flaw which make them (in my opinion) all but useless. Reporting to the indices is voluntary. And as such only hedge funds that perform well will start to report. Those that perform badly will stop reporting. The indices thus overstate hedge fund returns.

It has been argued that this may well be offset by the fact that the top-performing hedge funds may also choose not to report. They may do so because they have already raised enough capital or because they no longer need the exposure.

It would, however, appear that the latter effect is far smaller than the former, making any studies based on this data (which is most studies up to this point) suspect.

Damnation

A recent study by Aiken, Clifford and Ellis indicates that hedge fund alpha may well be much lower than previously thought. They find that, in fact, most of the alpha of hedge funds is explained by their decision to report (or not) in the commercial indices. In order to get past the self—selection problem they use the figures of funds of funds registered with the Securities and Exchange Commission. These funds invest in other hedge funds, whose returns can thus be scrutinised.

Funds that stop reporting afterward have dramatically lower returns than those that continue. The delisted funds continue to operate for some time and contribute zero alpha. This would still mean a positive alpha for hedge funds overall, but smaller than given by only examining the reporting funds.

Why not invest only in funds that do report returns? The hedge fund sector is illiquid – it takes time to get your money out. There is also a lag in the reporting of returns. An investor cannot be sure that a hedge will report its most recent returns.

Another problem (not tackled by the paper) is that some funds may perform well when they are small, which allows them to attract more money. This performance may or may not be simply due to luck. However, when (not if) the fund performs badly, its cash losses may well exceed all previous gains, simply because it now has more money. Investors, on average, lose out.

The above can be applied to the industry as a whole. When it was small, it was making high returns, and attracted capital from various sources. However, the losses in 2008, may have wiped out all cumulative gains in the industry going back ten years.

Caveats

The Aiken, Clifford and Ellis paper does suffer from flaws and these should be considered when evaluating the results. For instance, the period studied is from 2004 to 2009. It may be that a longer time period (or a future time period) gives different results. There is at least one study that finds no evidence of a selection bias due to the fact that funds that perform well may choose to stop reporting after having raised sufficient capital. The Aiken, Clifford and Ellis study itself has a selection bias, in that it only examines hedge funds that are invested in by funds of funds reporting to the SEC. The authors do, however, perform various tests which suggest that this results in no systematic errors. The statistical methods used are based on normal theory and as returns patently do not follow normal distributions, results should be treated with some scepticism. However, this latter point applies to most financial papers.

The dilemma

Hedge fund managers earn very large fees. They have done so, despite that their clients have walked away with meagre returns. This raises the question of whether the alpha displayed by some managers is anything more than mere luck. People have trouble believing in luck. They attribute high returns to skill. This is good for hedge fund managers, but it may be very bad for investors.

Some references

• Aiken, A. L., Clifford, C. P., & Ellis, J. (2010). Out of the dark: Hedge fund reporting biases and commercial databases. Finance.
• The Economist. (2012a). Hedge fund returns: More damning data. The Economist. Retrieved January 21, 2012, from http://www.economist.com/blogs/buttonwood/2012/01/hedge-fund-returns?fsrc=scn/fb/wl/bl/moredamningdata
• The Economist. (2012b). Rich managers, poor clients. The Economist. Retrieved January 21, 2012, from http://www.economist.com/node/21542452
• Wikipedia. (2012). Alpha (investment). Wikipedia. Retrieved January 21, 2012, from http://en.wikipedia.org/wiki/Alpha_(investment)