Last week I went to a talk by David Harding of Winton Capital Management. He is an impressive speaker, as someone who is the “H” in AHL, a $16bn hedge fund. Even more impressively, he sold AHL in the 1990s, and started a new fund Winton managing $2m in 1997, growing to over $30bn today. He even funded a centre for “risk literacy”, which Gerd Gigerenzer heads. Given all this, I thought it was worth going all the way to Canary Wharf for.
David Harding wanted to talk about Efficient Markets Theory, the idea that it is impossible to consistently beat markets, and that anyone who does outperform is merely lucky, not skilful. Obviously as a hedge fund manager in charge of $30bn, with a track record built up over 30 years, he really doesn’t like the implications that he is merely “lucky”, not “clever and skilful”. In the 1980s, there could have been many other similarly bright physics graduates who tried to start quantitative hedge funds, but we don’t hear about them, because they were “unlucky”.
This is an argument that has been rumbling on for years. With economists failing to acknowledge that there are plenty of very rich people who have done well, in contradiction to the way economists think the world should work. Economists think these outperformers are merely gamblers who make money on a winning streak that will come to an end.
David Harding perhaps should have mentioned Bertrand Russell, a clearer thinker than many economists. Russell defined the problem as
“The mere fact that something has happened a certain number of times causes animals and men to expect that it will happen again. Thus our instincts certainly cause us to believe the sun will rise to-morrow, but we may be in no better a position than the chicken which unexpectedly has its neck wrung.” – The Problems of Philosophy
The instinct that the sun will rise tomorrow is plausible, and supported by a lot evidence. We can probably rely on that instinct, even if it is not “true”. But relying on instincts can get us into trouble sometimes, like the chicken. How do we know when to distrust both our instincts and the observable evidence?
Russell lived to be 98 years old despite being a pipe smoker. He delighted in this sort of paradox. He was well aware of all the evidence that smoking was harmful, and yet was rationally able to explain how smoking had increased his life span. He enjoyed telling the story about a flight to Oslo in 1948, when asked if he would like to sit in the smoking or non-smoking section of the plane. He replied that he would surely die if he couldn’t smoke. Later, the plane ditched in the Oslo fjord, and only those at the back of the plane in the smoking section managed to get out alive. The non-smokers drowned. Russell himself in his late 70’s at the time had to swim in the Oslo fjord for 10 minutes before he was rescued.
But the presentation was interesting for other reasons.
Rather than just the hedge fund managers and their clients who believe they can beat the odds, David observed that many people had made vast sums of money assuming that Efficient Markets Theory was actually true. That is, they had grown wealthy assuming they couldn’t beat the market. Using options pricing formulas, derivative pricing, and complicated models they assume that markets behave in predictably random ways, which allow them to leverage and take advantage of the randomness in mathematically elegant and financially rewarding ways. Long Term Capital Management, which blew up around the time David Harding was starting his second hedge fund would be an example of this. But also David Viniar, the Chief Financial Officer of Goldman Sachs who claimed in August 2007 that
“We were seeing things that were 25-standard deviation moves, several days in a row.”
The probability of a single 25 sigma event is like winning the UK national lottery (1 in 14 million) 20 weeks in a row. And Goldman’s didn’t experience one of these events, the bank won the lottery 20 times, then won the lottery 20 times again and again.
That is Efficient Market Theory assumes that some things are so unlikely, that it is possible to create leverage and borrow large sums because sophisticated mathematical models suggest some events are so unlikely they can be discounted. So even though they assumed the EMT was true, those clever people at LTCM and Goldman Sachs found ways to make money, and (this is important) pass on the risks to others. Instead, in the talk he suggested that the idea that volatility was predictable and that volatility was the same as the risk of loss, was a malevolent idea. The irony is that:
Far more systemic risk was created by, and far higher rewards for failure have been received by people who adhered to the Efficient Market Theory than risk takers who believed the theory was flawed.
David talked about “harking” a phrase I had not heard of before. It means an explanation in retrospect, why something works with the benefit of hindsight. He suggested it was like “Just So Stories” – how the leopard got its spots. Instead, he believes much of his Intellectual Property, is in testing his models, seeing what works, and really trying to disprove things (he used the word “falsify”, in reference to the philosopher Karl Popper) that seem superficially true. Most results are inconclusive, results of significance are enormously valuable, and, he said, “We haven’t had many.”
A startling admission for a man that has founded two successful hedge funds. But that while the first hedge fund he started AHL has floundered under a different management, his second hedge fund has repeated his early success, seemed to me good evidence that he is not merely lucky.
Indeed, I wondered if a simple heuristic “the Lindy effect” might be a useful way of thinking about “black box” quantitative hedge fund managers. NN Taleb mentions in Antifragile, Richard Gott made a list of Broadway shows in 1993, and predicted that the longest running ones would last longest, and vice versa. He was proven right with 95% accuracy. He had got this idea from visiting the Great Pyramid (fifty seven hundred years old), and the Berlin Wall (twelve years old) and correctly guessed that the Pyramid would outlast the Berlin Wall. This contradicts our instincts about life expectancy. And of course all those disclaimers that financial regulators write about “past performance being no guide to the future.” But, a credible rule of thumb might be: the longer a hedge fund manager has credible track record for, the more likely he is to annoy economists and stay a persistently lucky chicken. Probalistically.