Investors Don’t Really Want Absolute Returns
Random thought for today for other strategy developers …
Investors believe that they’re in a perpetual search for returns that are uncorrelated to the market…or absolute rather than relative returns.
The Holy Grail is, of course, to add enough of these non-correlated ingredients to the portfolio stew that we’re left with smooth Madoff’esque returns.
To that (as it applies to most investors) I call bulls**t.
Consider two hypothetical scenarios…
- An absolute return strategy gains 1% for the month, the market gains 10%
- The same strategy loses 1% for the month, while the market falls a gut-wrenching 10%
In which month did the strategy perform best? Worst?
Regardless of how a rational investor might answer seeing those two scenarios juxtaposed, in the real world, the overwhelming majority would feel much happier in scenario 2.
Scenario 2 lost money, but in investor parlance it “protected capital”. Scenario 1 made money, but “left gains on the table”. Outperforming the market daily, monthly, yearly, etc. (regardless of terminal wealth) has intrinsic value.
Back in the rational world we know that if this is really an absolute return strategy with no correlation to the market, what the market did is meaningless. Scenario 1 is an infinitely better outcome because the investor made money…period.
But alas, investors are, and always will be, irrational.
None of this is new. The point of this random thought is to say that as a strategy developer I’ve begun to change my thinking vis-à-vis how I should be building our strategies.
I realized that the reason the original MarketSci strategies were so successful way back when is that we inadvertently provided an excellent relative-return program. The strategy crushed the 2006-07 bull and went flat through the 2008-09 bear.
I saw that as a failure in an otherwise outstanding track record. Investors made clear with their wallets that they saw it as a success.
Our top program today, YK Strategy, was designed to be very much uncorrelated with the broader market. That’s been a boon when we outperformed in bearish or neutral months, but a problem when we turned in so-so performances in bullish months.
So beginning with the new PWB (Pairs-Trading) Strategy (launched Jul/Aug 2010) I’ve begun intentionally adding a pinch of consistent positive beta (market exposure).
Not a lot mind you, not every day, and not blindly, but enough that the strategy will gravitate towards positive correlation with the broader market, and tend to perform better/worse in bullish/bearish markets.
That’s clearly not the best solution in a rational world, but belief in a rational world is in and of itself irrational. Whether they realize it or not, investors value consistent OUTperformance and come hell or high water, that’s what they’re going to get.
Happy Trading,
ms
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Filed under: Random Stuff | 20 Comments
One man’s opinion: I am interested in UNcorrelated strategies. However, as always, I thoroughly enjoy you exploration.
RE to docdan: you sir might be one of the handful of rational men left =)
Hello Michael,
Very interesting post. Just out of curiosity, with an approach like the one you mention for the PWB strategy do you think that selectively adjusting the beta exposure according to the way the market is going as an adaptive mechanism (ie. surfing the positive phase with higher beta allocation) could still produce relatively uncorrelated returns on the aggregate if you reduce the exposure in period of negative phase?
Cheers
QF
Hello QF – good question, but no, the beta bias for PWB will be consistently positive enough, that (eventually) the positive correlation is going to come out. In my backtests, PWB Fast ran around +30% and Slow around +45% month-to-month.
But to your point, if you used something that was changing long/short bias very frequently (like YK) to determine beta, correlation would be closer to zero over time.
michael
That is an interesting perspective that I wouldn’t have expected as a fellow strategy developer. Thanks for sharing.
Cheers
Derry
Hey was your retention rate also higher for the original MarketSci strategies and do you notice any fluctuation in retention based on the economy?
Cheers
Derry
RE to Derry: I’ll answer the second question first.
Subscriptions are running in line with norms. Managed accounts are much different today than in the past because the developers who are leading the pack are constantly changing, but nothing that looks to be tied to the economy. We’ve been doing some capital raising lately and that has been very tough in this economy.
As to your first question, it’s hard to answer. Most of the time I ran the original MarketSci strategies I didn’t have this blog or any way to reach out to smaller individual investors, so I don’t know that I can draw a connection to retention rates now. Anecdotally I feel like it’s more or less the same.
michael
incredibly interesting study. As a psychology major and new system developer this actually makes sense. People would rather feel they beat everyone else rather than make consistent profits. It reminds me of the bargain shopper. As long as someone feels they got a better deal than everyone else they are happy regardless of the fact the purse still cost $2500.
thanks for the great study
Probably another one of the investor irrational behaviours (ps: on that topic, check that website, it looks very good: http://www.behaviouralfinance.net/ )…
I’m faced with the same sort of dilemna when I think of potentially developing/selling my strategies for (retail) investors as a new “online/blogging avenue”: it seems that Trend Following as a strategy, despite having an edge, fails to really attract investors (as shown by many start-up CTAs finding it extremely hard to raise sufficent AUM to cover their costs).
As an investor, Trend Following makes sense, but paradoxically, it might not as a fund manager/system marketer (if you’re not Bill Dunn, John Henry, Bill Eckhardt, etc.)… On the other hand you can see people like John Meriwether starting a fund and raising large AUM only to blow up every few years…
I suspect (and this was probably your line of reasoning with this pairs trading program?) that instead of developing a “good” strategy and waiting for customers to come, one might want to try and identify what the potential customers want and develop a strategy that fits their requirements (even if it’s not as good) – when you think about it, it’s the basis for entrepreneurs: identify a customer need and fulfill it with a product. Intellectually, it’s hard to getting round to accept to develop something that does not provide “good value” (ie in the worst case example, a simple option selling program with a very smooth equity curve would probably attract capital and fees for the manager – until it eventually blows up “a la LTCM”)
RE to Jez:
I don’t want to give the impression that I’m building strategies solely with month-to-month performance in mind. Yes, MTM performance is important for keeping investors/subscribers, but the overall track record is important for getting them in the first place. So I think there needs to be some middle ground there.
From my experience I think what attracts new investors most is looking at an equity curve and seeing a steadily increasing gap between the program and some benchmark. That “growing gap” doesn’t necessarily come month after month, but gives that impression when viewed from 30,000 feet.
The change comes when the investor begins following the program and becomes more granular in their focus. There month-to-month outperformance becomes important.
Just my $0.02.
And don’t get me started on big HF names blowing up and then resurrecting overnight. It sickens me, but that’s the name of this often silly game.
michael
I love it! And congratulations on the new strategy release Michael. Best, Jeff P.
You’re saying you can’t eat relative returns. True, but maybe not entirely true. If you lose 1% and the market drops 10%, and this is then followed by a decrease in the cost of living by more than 1%, then how far behind are you?
I consider one of my most important measures of performance to be my monthly performance. I never even thought to include the market returns in this list comparison. I look at my trading as a business, and I am in the business to make money. I’ll admit I care about relative performance, but very little as compared to absolute performance. Fortunately for me I have no one to please but myself, so I don’t have to compromise my strategies based on others irrational beliefs.
don hit it on the nose and frankly anything else is pure BULLSHT!
Don did hit it on the nose for the INDIVIDUAL investor. Unfortunately some of us are responsible for more than just our own satisfaction.
Name any product and I’ll bet you a dollar to a dime that compromises had to be made by the folks who actually developed it, the engineers, R&D, archictects, etc. to appease the end consumer’s irrational needs.
I could just do things my own way, investors be damned, but then we wouldn’t have nearly the same investor-base we have now. What purpose did that serve? Were investors made better or worse off?
So no, it’s not bullshit. It’s business.
michael
michael, I too used to mange money and had some success. with all do respect, as soon as you manage a money mgmt firm to please others, you’re screwed. you’ll make bad decisions and comprimise your own sense of what’s right. manage your business as if all the money were yours and you’ll be fine. try and please others and you’re on the road to ruin.
RE to Steve: I agree and I disagree.
The whole reason I started trading “mechanically” way back when is that I knew I couldn’t trust myself (with even my own money) to trade with “discretion”. Fast forward to today when I’m responsible for more than just myself and that holds double-true. I never let a given trade be swayed by the winds of my own biases or anyone else’s.
In that sense I agree with you.
Where I disagree is in how I design these strategies in the first place. I tailor these strategies to (try to) meet what investors want. For example, if all I had to worry about was myself, I might increase the leverage on YK because I think over the long-term terminal wealth will be increased and I have enough confidence in the strategy to weather the rough spots.
But I know that the market won’t support that increase. It won’t support the increase in volatility or drawdowns. So in that sense, no I disagree with you.
As a mechanical trader, I design for investors, but I trade in a vacuum.
michael
@Mike
This is quite exactly what I was alluding to in my earlier comment…
I was thinking of many “big names” Trend Followers: some of them try and achieve big gains (and typically with Trend Following, this means large drawdowns too) but they are not as “succesful” (in terms of AUM) compared to a Transtrend, BlueTrend or a Dave Harding/Winton, which clearly target lower volatility (and therefore absolute returns)… and manage billions in AUM as opposed to 100′s millions for the “big hitters”.
btw – a link to a 15min interview from Dave Harding (where he mentions that they are dropping their return target to 8-10%, because their customers would be “happy” with it in the current environment..):
http://www.hedgefundsreview.com/hedge-funds-review/news/1649591/video-interview-david-harding-founder-managing-director-winton-capital-management