Edges are Ephemeral

Wall Street Journal:

BOSTON— Jack Meyer trounced rivals when he ran Harvard University’s endowment in the 1990s. But as a hedge-fund manager, he is struggling.

His Convexity Capital Management LP has lost $1 billion of its clients’ money over the last few years as once reliable options trades backfired. Investors pulled more than $3.5 billion from the bond shop last year, its fifth down year in a row. The firm laid off a tenth of its staff in recent months.

This is one of the most frustrating aspects of the investment management business. Performance does not persist and strategies, upon becoming successful, can often start to fail once enough imitators show up or the market wizens up about someone keeping a big, giant edge to themselves. Almost no one has been able to keep their edge in this game over the years. It’s weird that investors expect this kind of persistence from hot managers when they have so many examples in the world outside of finance that demonstrate how unrealistic this sort of thing is.

Let’s just mention professional athletes, as an example. For obvious reasons, investing in Kobe or Jeter after 15 years of stellar performance wouldn’t make any sense to anyone. Why do we think a fund manager’s track record would be any more relevant?

The best managers have been the most adaptable. Warren Buffett went from owning passive stakes in high quality blue chip companies to acquiring them outright (see Burlington Northern Railroad). Then he moved on to becoming a private equity partner in the LBOs of others (see Heinz). Carl Icahn went from options market guru to activist hedge fund. But activism got crowded, so now he’s adapted. The new strategy appears to be making friends with the President of the United States and pushing for favorable regulatory changes to enhance the value of public companies he owns (see CVR Energy). Carl and Warren have been finding new edges and opportunities for decades and decades, but they are exceptional.

Not all investors have the capability of adapting their strategies. Most are more likely to stick to what they’re doing until it stops working, and then they keep going anyway. You can convince institutional investors that you’ve made money for that you’re only cyclically (temporarily) out of favor for a long time before they give up on you, especially if you’re a name brand.

Even if you do attempt to adapt, there’s no guarantee it will work. Lots of long-short hedge fund kings have been unable to generate the type of reliable alpha that has been legislated out of existence by the onset of Reg FD (Fair Disclosure). It just took a decade or so for this to become apparent. And in the meantime, their pivots into macro strategies have been mostly disastrous.

When you’re looking at the performance record of a firm like Renaissance Technologies, it’s tempting to believe that they’ve built an unstoppable alpha machine that could run itself, it’s so consistent. But this is hardly the case. Every day there are hundreds of PhDs and other assorted geniuses showing up to their cabin in the woods to keep coming up with new edges. Because the old ones eventually stop working. There are no alpha machines, there are only tools and systems that may allow them to find alpha somewhere new.

This is not the sort of enterprise in which thousands of professionals and organizations will thrive. There simply isn’t enough room. It’s a small, rarified world with enormous potential rewards being chased by millions. Maintaining an edge is unrealistic, but finding new edges on a regular basis may be even more unrealistic.

Former Harvard Money Whiz Jack Meyer Tries to Regain Midas Touch (Wall Street Journal)