Broadly defined, alpha represents the excess return of an investment relative to the return of a benchmark index. Over time, competition commoditizes alpha to a point where alpha disappears or becomes beta.
Traditional economic theory is a fragile, cloistered, and prosaic way of thinking about financial markets. Rational expectations of market efficiency treat alpha and beta separately: the expected return of an investment is linearly related to its risk. Conventional investment paradigms around risk/reward, capital asset pricing models and portfolio optimization are only useful when markets are at an equilibrium. However, equity risk premiums, arbitrage opportunities, and alpha-factors are non-stable and exist in the context of their market ecology.
Economics suffers from physics envy and pseudo-science. The partial differential equation in the Black-Scholes options pricing model is the solution to the heat equation! George Soros’ General Theory of Reflexivity and the Human Uncertainty Principle inoculated me from efficient market theology and allowed me to appreciate financial markets as a laboratory for human behavior.
I was eight when the 2008 Financial Crisis happened. The teachings of my greatest teachers have struggled amid the post-financial crisis environment of QE, which has contributed to an environment of low volatility. Unknowingly, I had insulated myself from my long volatility pedagogy and performed well. My high school schedule was a forcing function to go long on attractive tech equities.
I’m a believer that investing is no longer about investing (picking individual securities), but strategic positioning. My behavior-driven market orientation has evolved to understand the evolutionary dynamics of markets beyond evolutionary biology and evolutionary psychology. As Andrew W. Lo argues, markets are “financial evolution at the speed of thought.“Behavioral biases among participants in financial markets are not only a product of their internal cognition but their external environment that produces evolutionary traits. Market evolution is driven by competition, innovation, and adaptation.
Theodosius Dobzhansky famously says,
“Nothing makes sense in biology except in the light of evolution.”
Neomania is intrinsic to American culture. We hold a hierarchal attitude towards evolutionary processes. What’s new is seemingly better. This obscures analyzing investment ideas through the lens of habitat suitability. Ideas that seem useless or outdated are in fact, maladaptive to their current environment. Interestingly enough, many modern behavioral adaptions provide little or no direct benefit to adopters but exist on biological or social signaling via memetics.
Charles Darwin’s evolutionary insights provide a useful framework to approach the evolutionary dynamics of alpha-generation. Adaptive radiation is an evolutionary phenomenon that’s a particularly valuable lens to creating alpha, evading competition, and outcompeting other investor species. When adaptive radiation takes place via some form of natural selection, it features an opportunistic phase: a sub-population moving into a new habitat. The greatest asset managers can anticipate and benefit from the most significant dislocations in habitat and species phylogeny.
The ancestral roots of strategies, behaviors, and practices today are genetic offshoots of the protolanguages. The five protolanguages in financial markets are income, liquidity, volatility, value, and growth. Appreciation for the genotype of investment ideas instead of their phenotype empowers investors to manage risk better, understand market movements, and generate alpha.
However, it’s easy to ignore how evolutionary physics overdetermines market ecology and opportunity in the present. It’s evolutionary psychology for investors to say “the time is different.” Many believe the rise of quants and passive investors (who both now account for 60% of equity markets) has brought the end of theory. The signals and price action technicals that investors use seem no longer connected to security prices. Quality factor leveraged by value investors appears useless.
Today’s mandates around momentum, persistent premia, and repeatability are in vogue with today’s market and drive demand for systematic funds. However, looking underneath the phenotype of the new strategies— and recognizing the underlying grammars of these strateges versus the language used to express them—its simply inflated trust in growth, income, and liquidity in new flavors.
The expectation among investors for persistent novel sources of returns from systematic “tactical” and “smart” strategies should be scrutinized. Species risk can occur when an extremistan event eradicates a habitat and the subpopulation—without the devices of adaptive radiation, genetic mutation, and natural selection. Simply put, the investor species of today are giving too much weight to the stochastic process of the market, which is only legible and sensical when markets are at equilibrium.
With the ideas around adaptive and evolutionary markets, along with the fallible and reflexive nature of humans, what’s most interesting is the strategic interactions between market participants. I’m most interested in the next adaptive radiations that will occur when the bedrock assumptions for most investors become obsolete. And when the flora and fauna of the market ecosystem undergoes a climatic disruption.
Mark Twain once said: “The report of my death was an exaggeration.” As I noted above, the blue-chip discretionary macro funds I once idolized have struggled amid low volatility. There have been few sustained trends to express views on the direction of the global economy through currencies, interest rates, and commodities.
But I believe there are key trends that will cause a dramatic shift in the market. Recent advances in technology (energy) and geopolitical changes with China are two of the most significant secular trends that will likely bring an end to the financial system predicated on petrodollars. This will have profound repercussions on global financial markets. Rising corporate debt, less liquidity, low interest rates, and high levels of leverage will restrain the Fed’s ability to utilize economic levers. I am also concerned about the increased fragility of our financial system and the global economy’s dependency on a less than attractive Chinese macro environment.
At the end of 2018, many see the “clouds of a possible recession.”What they don’t see is the seasonal change. For example, the popularity of exotic and risk alpha-generating strategies like portable α (also known as “inscrutable risk grenades” and “synthetic Russian roulette” during the financial crisis) remain popular. Even in emerging asset classes, like crypto, the desire to financialize poorly misunderstood assets illustrates the short-memory of investors. I noted this in “Synthetic Cryptoassets: Did Everyone Suddenly Forget 2008?” The ruthless evolutionary system amplifies our evolutionary bugs if we don’t check them. Evolution always wins.
I used to think about alpha-generation around a monopoly on an idea, strategy, factor, information, or advantage that against other market participants where the odds are in your favor. However, I now believe alpha-generation is about process and values towards markets.
Capitulation is when investors can’t take advantage of a promising opportunity due to losses, lack of dry powder, or recency bias. When the inflection moment happens (if it already hasn’t), investors want to be long volatility. And when everyone recognizes the seasons have changed, volatility and value strategies will be back. But by then everyone will be too late… and the best will already be there.
I haven’t been engaged in financial markets since August of last year. I have been thinking about alpha-generation in VC firms (not seed funds) lately since I am strongly considering joining and anchoring myself to an exceptional one. If you’re interested in chatting about the ideas around evolutionary α as applied to venture, feel free to reach out to me.