Liquidity, Noise, and Signal

One of our favorite authors, Nassim Taleb, has a new book coming out, and we were glad to see an excerpt available online. We were especially interested in the following passage on data frequency and getting too much “noise” (useless information) mixed in with the “signal” (useful information):

The more frequently you look at data, the more noise you are disproportionally likely to get (rather than the valuable part called the signal); hence the higher the noise to signal ratio. And there is a confusion, that is not psychological at all, but inherent in the data itself. Say you look at information on a yearly basis, for stock prices or the fertilizer sales of your father-in-law’s factory, or inflation numbers in Vladivostock. Assume further that for what you are observing, at the yearly frequency the ratio of signal to noise is about one to one (say half noise, half signal) —it means that about half of changes are real improvements or degradations, the other half comes from randomness. This ratio is what you get from yearly observations. But if you look at the very same data on a daily basis, the composition would change to 95% noise, 5% signal. And if you observe data on an hourly basis, as people immersed in the news and markets price variations do, the split becomes 99.5% noise to .5% signal. That is two hundred times more noise than signal —which is why anyone who listens to news (except when very, very significant events take place) is one step below sucker.

We couldn’t agree more with this assessment, and it definitely holds true for managed futures investments. A long volatility investment like managed futures is, by design, going to take small but more frequent losing trades in exchange for larger, but less frequent winning trades. An investor who looks at their statements every day is not just getting useless information, but is probably actively harming their ability to evaluate the investment. You’d see the 95% noise (frequent trading losses), and only 5% signal (the outlier gains on winning trades) – and potentially make poorer investment decisions as a result.

So how does this fit in with the often-touted daily liquidity of managed accounts? Isn’t the push for daily reporting just producing more noise, too? Liquidity in a portfolio is extremely important to getting through day-to-day cash flow management. However, when investing in an asset class with the objective of achieving close to zero correlation to traditional asset classes (which is typically achieved by holding it over a 3-5 year period), daily liquidity may cause problems.

No one sets out with the intention to buy high and sell low, but that’s often exactly what happens when investors are glued to their monitor, watching every tick up or down in their account. When it comes to equity mutual funds, net inflows tend to rise with stock prices, and fall as stock prices fall.  In managed futures, where performance is not dependent on how many people are buying or selling into the asset class – returns are independent of the flows into/out of the asset class – a weird thing happened during 2008. Managed futures actually saw an outflow of $14.2 billion in October of 2008 as investors used their best performing investment like a piggy bank to cover cash flow needs elsewhere, despite the fact that managed futures was the best-performing asset class that year, with managed futures indices showing an average 8.9% return between the months of October and December of 2008 (Average of Dow Jones Credit Suisse Managed Futures Index, Newedge CTA Index, and BarclayHedge CTA Index. Disclaimer: past performance is not necessarily indicative of future results).

So while it is admittedly nice to have an investment that can be used as such a piggy bank – it is also a double edged sword. Liquidity is a loaded gun of sorts – good to have, but very dangerous to use. Liquidity enables people to make rash investment decisions which may not be in the best long-term interest of their portfolio. Liquidity enables people to react to the noise at the expense of the signal (in Taleb-speak).

So, if you are buying managed futures for their crisis period performance, low correlation to other asset classes, exposure to commodity price movements (in either direction), and their daily liquidity – don’t forget that liquidity is just one of the reasons you liked the investment. It is also the one most likely to cause you to prematurely exit the investment, allowing investors to act on a mood swing or panic due to something you heard on the news.  With twenty times more noise than signal, according to Taleb, you should be very careful utilizing that liquidity – as you may just be reacting to the noise.