A False Sense of Security

Over an 18 year period Bernie Madoff claimed to offer his investors annual returns of nearly 11%, not too far from the average long-term gains in the stock market. The crazy thing about Madoff’s Ponzi Scheme was not that he was offering outrageously high (fake) returns to his unwitting investors. It’s that he was offering very good returns at extremely low levels of volatility, estimated to be close to 2.5%.

To put that into perspective, the historical volatility on the stock market is close to 20%. On bonds it’s closer to 8%. Even on cash (t-bills), the volatility of returns has been just over 3% for the past 90 years or so. This means Madoff was offering stock-like returns with cash-like volatility. As investors are always on the lookout for the Holy Grail of investing that will maximize gain and minimize pain, it’s no wonder that so many people were duped by this scheme. They wanted to believe it was possible that the performance could be so smooth and predictable.

I was reminded of the false sense of security that low volatility can provide after reading a great piece by investor and hedge fund manager Dominique Dassault at Global Slant. Dassault discusses the algorithms created by himself in the past and many of the largest hedge funds in the world that seek to exploit market anomalies through their quantitative trading strategies. These funds seek to produce high risk-adjusted returns, and many of them do, but there’s a catch (there’s always a catch):

A very good model would generate a net 5-7%…but 3.5-5% was acceptable too. So how then could anybody make any real money especially after considering the labor costs to construct/manage/monitor these models…which…BTW…was substantial?

Of course there was only one real way…although it would incrementally cut into performance even more, in the near term, but ultimately pay off if the “live” model performed as tested. The answer = LEVERAGE…and I mean a lot of it…as long as the volatility was low enough.

The most well-known example of the problems this can cause was Long-Term Capital Management, the fund from the 1990s run by a group of Nobel Prize winners that focused on exploiting minor relative value price differentials and applying huge amounts of leverage to boost total returns. For a while they were able to produce extraordinary results, including the risk-adjusted returns so many in the industry are aiming for. As most people know by now, they eventually blew-up from the excessive leverage applied and had to be bailed out by the Federal Reserve when Russia defaulted on its debt. The models created by some of the brightest minds on the planet still ranks as one of the biggest fund failures ever.

Dassault shared some wisdom from another portfolio manager who told him the following about why these types of funds eventually blow-up:

“Because despite what we all want to believe about our own intellectual unique-ness, at its core, we are all doing the same thing. And when that occurs a lot of trades get too crowded…and when we all want to liquidate [these similar trades] at the same time…that’s when it gets very ugly.”

I’m not suggesting quant hedge funds will meet this same fate as LTCM, nor am I saying they are frauds like Madoff. Those are the extreme examples. These trades wouldn’t become overcrowded if they didn’t work. The risk increases because of the fact that everyone piles into the same areas of the markets.

It just goes to show you that consistent or seemingly easy returns can lull investors into a false sense of security. It blinds them to the other risks they are accepting for the comfort of lower volatility from month to month. It becomes much easier for investors to lose focus on the other risks they create when trying to control for a single variable such as volatility. They get fooled by fancy formulas and risk models.

Risk is like a chameleon that changes depending on the environment. There’s never going to be an easy way to completely rid your portfolio of risk. It simply morphs into other forms. Everything in the markets require some sort of trade-off. If you don’t understand or allow for the unintended consequences there could be huge surprises when things don’t go as planned.

It will be interesting to see if the black box quant funds have learned their lesson from their last big blow-up at the onset of the financial crisis.

Source:
Black Box Trading: Why They All Blog-Up (Global Slant)

Further Reading:
Doubling Down on Risk

Here’s the stuff I’ve been reading lately:

• Charley Ellis on why investment management is like the pre-1950s medical profession (Evidence-Based Investor)
• Why jargon feeds on lazy minds (Scott Berkun)
• What exactly constitutes good advice? (Think Advisor)
• Why millions of Americans should hope for a market crash (Asset Builder)
• Why momentum is so widely misunderstood (Irrelevant Investor)
• Staying in your job even after you reach financial independence (Finance Buff)
• The positive feedback lop is broken (Reformed Broker)
• Creating and following a real financial plan with Carl Richards (AAII)
• The lessons from this long bull market (Morningstar)
• Why investing is so hard (ETF Reference) and why all strategies are easier said than done (Abnormal Returns)

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My new book, A Wealth of Common Sense: Why Simplicity Trumps Complexity in Any Investment Plan, is out now.