Investing Without People
Comment of the Day

June 20 2018

Commentary by Eoin Treacy

Investing Without People

Thanks to a subscriber for this memo from Howard Marks at Oaktree which may be of interest. Here is a section:

It seems obvious that s formula’s application and popularization eventually will bring an end to its effectiveness. Let’s say (in an incredibly simplified example) you study of the market show that a small-company stocks have beaten the market over a given period, so you overweight them.

Since “beating the market,” “out-appreciating” and “out-performing” often are just the flip of “becoming relatively expensive”, I doubt any group of stocks can outperform for long with becoming fully- or over-priced, and thus primed for underperformance.
And it seems equally clear that eventually others will detect the same “small-cap effect” and pile into it. In that case, small-cap investing will become widespread and – by definition – no longer a source of superiority.

To reiterate, George Soros’s Theory of Reflexivity says the behavior of market participants alters the market. Thus no formula will be a winner forever. For me, that means the achievement of superior returns through quantitative investing requires the ability to constantly and correctly update the formula. Since investing is dynamic, the rules relied on in quantitative investing have to be dynamic.  

According to Raj Mahajan of Goldman Sachs, my principal tutor on these matters. “The best models today will change exposures as the environment changes and as dynamics of the factors chance (e.g. as they become cheaper or more expensive). The rules have become increasingly complex, and they are able to “learn” (that is, they are “conditional” or “contextual”) in that they understand more of the environment.” Constant renewal – not “a formula along” – seems to be a minimum requirement for any quants’ long-term success.

Eoin Treacy's view

No trend persists indefinitely and nothing lasts forever. The more data points we have to support a trend the closer it is to being full valued. To my mind that has always been similar to Heisenberg’s Uncertainty Principle. Perhaps it is too simply described as the “more you know about the position of the particle the less you know about its trajectory and vice versa”.

When we look at trends they can persist in a consistent manner for a prolonged manner.  When that consistency eventually changes, either by an upward acceleration or by a marked loss of momentum, then we can conclude that the relationship between supply and demand that animated crowd’s activity has changes and therefore the response will be out of character with what our experience has been. That can either be a surprising advance with acceleration of an outsized decline which is much less welcome for man investors but equally surprising relative to the consistency of the trend.

A subscriber kindly forwarded this video of Richard Feynman’s lecture on probability and uncertainty and which may be of interest. 

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