First Mover Alpha

Ed Thorp is arguably the best investor who never gets mentioned on the lists of history’s best investors.

The investment strategies he developed at Princeton Newport are widely copied today but were new and innovative at the time. A researcher at his firm stumbled across the idea for statistical arbitrage in 1979, a strategy employed by the majority of quantitative hedge funds around the world today.

He came up with an options pricing strategy called delta hedging that was light years beyond anything traders were using at the time. Fischer Black and Myron Scoles would eventually use Thorp’s work to develop their own options pricing formula. The Black-Scholes equation went on to win a Nobel Prize.

In 1990, Thorp was the first limited partner in Ken Griffin’s Citadel Investment Group, which has produced one of the most successful hedge fund track records in the business.

But maybe the most interesting of Thorp’s activities came in the casinos, where he was a pioneer at putting probabilities in his favor to win money.

Thorp literally wrote the book — Beat the Dealer — on how to win at blackjack in the 1960s. He became so good at counting cards1 that all of the casinos in Las Vegas got together and literally changes the rules of blackjack to take away his edge.

Thorp wrote in his biography:

From a mathematical idea in my head, I forged a system for beating the game. Then I was ridiculed by the casino beast, which said that it sent cabs for fools like me. Thinking they played fair and that I was taking my secret weapon, a brain, to a sporting event, I found myself barred, cheated, betrayed by a representative of the gaming control board, and generally persona non grata at the tables. I felt satisfaction and vindication when the great beast panicked. It felt good to know that, just by sitting in a room and using pure math, I could change the world around me. Rather than quit the field, I launched an army with Beat the Dealer. Thus continued the great blackjack war between the casinos and the players that still rages, more than fifty years after the invention of card counting.

Following the release of his book, card counters morphed from individuals to teams to entrepreneurs who used professionally funded organizations of people to systematically beat the casinos (check out the Ben Mezrich book Bringing Down the House for more on this).

He even developed a wearable computer that could predict the roulette wheel by measuring the time it would take for the ball to make it around the wheel once and using that data to calculate where it would land. The fact that he did this in the 1960s may be the most impressive aspect of this story.

An overarching theme runs through each of Thorp’s money endeavors — he was there first.

Figuring these things out before anyone else gave Thorp first mover alpha. Those who entered immediately after him had a window but those windows tend to close fairly quickly when that information gets to the masses.

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At last week’s annual meeting for the Daily Journal, Charlie Munger held court, making comments and answering questions on the investment landscape in his typical straightforward fashion.

To excel when investing Munger recommended, “The whole trick is to have a few times where you know something is better. Invest only where you have that extra knowledge.”

There are a number of reasons having “that extra knowledge” is becoming harder to come by in the markets.

Warren Buffett opened up his first investment partnership in 1956. Trading volume in that time has increased from a few million shares a day to well over 5 billion.

In the 1950s, retail investors controlled 95% of all trades. Today 95% of trades are executed by professional investors.

In the first year of the rigorous 3-year Chartered Financial Analyst exam (a test which was started by Benjamin Graham) in 1963, there were 284 people who took the test. Last year there were more than 256,000 CFA candidates. And according to the Wall Street Journal, 30% of those sitting for the exam were from mainland China. Investing has truly become a global sport.

In 2000, the SEC rolled out Regulation FD (fair disclosure) which required any significant information from corporations to be made available to all investors simultaneously. Proprietary information was once an edge for investors. Hedge fund returns since Reg FD went into place have been noticeably pedestrian overall.

There are well over 300,000 Bloomberg Terminals worldwide, giving professional investors more data every single minute of the day than most will need in their lifetime.

Thorp himself decided to close down his statistical arbitrage fund in 2002 following a few years of respectable, yet lower returns than he was used to. He claimed growth in hedge fund assets and competition in the space had driven away most of the profit opportunities.

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You cannot discount the historical track records of legendary investors. They took advantage of the hands they were dealt. At any time in history, there has been a level playing field at that time.

But it’s not a level playing field now when you’re trying to compete with history’s greatest investment track records.

I have worshipped at the altar of Buffett and Munger ever since I started in this industry. I still believe there is an immense amount we can learn from the giants of the investment world. I just think it’s a mistake to try to emulate their success in the exact same way.

When he was asked is if it’s still possible to employ his blackjack card counting techniques today, Thorp responded, “Today the best players still thrive, but opportunities are increasingly limited and newcomers find success much more difficult.”

This is a good way to think about the investment landscape as well.

To learn more about Thorp check out his excellent biography:
A Man for All Markets

Further Reading:
Ed Thorp’s Advice on How to Live a Good Life

1The basic idea was to bet big when the odds were high of more face cards remaining in the deck and small when the odds were low for more face cards.

 
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