There’s been plenty of press around Nassim Taleb’s new short paper arguing that those who are doing well in the investment business are just benefitting from luck (or more technically – spurious returns), plus the compounding effect of “winners win.” That latter part is the idea that success begets more success (in terms of raising assets), via the advantage of a larger pool of money in terms of being able to hire top talent, get beneficial terms (see Buffet’s 10% paying preferred shares in Goldman), and so on – making it that much more difficult for smaller managers to compete.
Business Insider has already summarized the main points pretty well, and the Wall St. Journal has even gone so far as to link it to Bill Gross’ recent comments about the death of the cult of equities. The line that’s getting the most reaction is the one Taleb ends with:
To conclude, if you are starting a career, move away from investment management and performance related lotteries as you will be competing with a swelling future spurious tail.
In English – the lucky few have amassed huge asset bases, which will make it that much harder to knock them from their perch, and that much harder for the small guy to make a dent. That’s quite a claim – stay away from investment management entirely? You know we’re big Taleb fans, and there’s certainly something to be said for his argument, but we’re not so sure Taleb’s argument applies to managed futures.
You see, we’ve pointed out a few times that the really big CTAs tend to have lower volatilities, and lower average rates of returns than managers with smaller AUM. In our experience, as managers get bigger, their returns tend to turn over and flatten out. Case in point – the following graphic.
Whether this is intentional or a result of their being unable to access markets like the recently rallied grain markets is up for debate. But there is no doubting the statistics above showing the reduction of returns on both the up side and down side (they likely sell the fact that they are reducing the downside…but it’s hard to do one without the other).
So, while we agree with Taleb that a hedge fund manager may get more ‘lucky’ the bigger he gets and continue to see outsized returns, the argument for the same happening in the futures space may not match up, with limited ability to add ever increasing positions in exchange traded futures markets (see Bacon’s recent return of investor money). In fact, there is likely some upper bound for hedge fund managers as well – when their size stops begetting more size and starts to become an impediment (see the London Whale).
As for spurious returns in managed futures… We ran Taleb’s simple luck experiment on the BarclayHedge managed futures database. He posits that by simple luck, half of all managers can make money in a year, and the year after that half of those winners again winning, and so on until after 10 years you can end up with someone who has never had a losing year just because of dumb luck. Well, with 326 managers in the BarclayHedge database in 2002 – the number of managers currently who should have had no losing years over the past 10 should be 326/2=163/2=81/2=40/2=20/2=10/2=5/2=2/2=1/2 = 0.5/2 = 0. Given only 300 managers, only a fraction should be at perfect track records after 10 years – and that is exactly where we are, with no managers we know of having that perfect track record.
All in all, we love seeing Taleb approach such topics, and only wish he maintained a blog or newsletter where we would get such insight on a more regular basis.