The Success Equation, Untangling Skill and Luck

The Success EquationWe like to read around here – and just recently got done with one that has been on the wishlist (it’s more like a… when the kids are quiet for 10 minutes and there’s not a client dinner or conference in town or presentation for a business deal – as time permits list, but I digress) for quite some time: Michael Mauboussin’s, “The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing.”

The title caught our eye right away, being in the business of untangling luck and skill to a certain extent in helping clients identify and invest in alternative investment managers. The question at the end of the day is whether the impressive track record a client is considering investing in is the result of skill, or whether it is luck. If you’re a chess player – or even tennis, it’s nearly all skill. If you’re a hockey player… it’s way more luck than your agent would care to admit.

 

And what about an investment manager?  How much of that track record is skill versus luck. The manager themselves usually portrays it as skillful, and charges as if it were entirely skill – but even the most successful of managers have to admit there is some skill in there. How much, and what questions should you be asking to determine the role of skill and luck are the parts of Mauboussin’s book we’re most interested in.

Here’s his handy graphic breaking down the major sports, slot machines, roulette, and trading in the stock market on a pure luck to pure skill continuum.

New Picture

Mauboussin tells us that where skill is the dominant factor, history is a useful teacher, but where luck is the dominant force, history is a poor teacher. And that the type of feedback you get is a good tool to measure how much luck there is in your endeavor. On skill side, there is a very close relationship between cause and effect; but feedback on the luck side is often misleading – where good decisions can lead to failure and poor decisions lead to success in the short run (due to luck).  For more on the latter – read anything by Nassim Taleb, who’s made a career pointing out that a lot of the skill you see in the world (the banker, insurance company, option trader, etc) is nothing more than the result of 1 out of a million people destined to be quite lucky.

Essentially – what worked in the past may not work in the future on a heavy luck endeavor (such as investments), which I guess the regulators knew long ago when they made it a requirement to put the ‘past performance is not necessarily indicative of future results’ disclaimer on investment documents.

To measure the effect of luck, he introduces us to the James Stein estimator and the ‘shrinkage factor’ (straight out of Seinfeld), shows us how reversion to the mean is highly dependent on how much luck is involved, and discusses how even when you know how much skill there is – you’re in trouble because skills deteriorate (he quotes a source as saying the peak age for matters of finance is 53, and after that our skills start to deteriorate).

We enjoyed two parts in particular.

One, the discussion of ‘the paradox of skill’, which he explains: as skill improves, performance becomes more consistent, and therefore luck becomes more important. Mathematically, if the variance in skill becomes smaller than the variance in luck – luck becomes the dominant factor. In his own words:

“When everyone in business, sports, and investing copies the best practices of others, luck plays a greater role in how well they do.”

He shows stats supporting this from baseball, where all of the hitters have gotten better, but the rough averages have remained the same. Why? Becasue the pitchers have gotten better too!  But the interesting part of this to us is in the investment realm, and more importantly – the alternative investment realm. The discussion sure gets you thinking about our modern world of global markets, derivatives, and mangers earning billions; and whether the world has become so skilled in analyzing and trading them – that any performance is due mainly to luck, and due for a healthy reversion to the mean?  It makes us think of all the money in systematic trend following, and whether there is a real world experiment in the ‘paradox of skill’ happening there before our very eyes. Are any variations in the performance of trend follower A versus Trend Follower Z due to luck? Are they outperforming due to luck in including Coffee in their list of markets – luck in risking 0.25% per trade and getting an extra Hog trade versus the guy who’s model was risking just 0.20%? And so on.  Are those differences skill, or luck?

We also enjoyed Mauboussin’s discussion of the ‘dumb money effect’, which we know as emotional investing, or getting in at the highs, and out at the lows (see our discussions on it here, here, here). He shows some stats calculating it costs investors 1% in returns each year, and that institutional investors  have foregone $170 Billion in value over a couple decades because of this dumb money effect.

Why do we do it?  We’re hardwired that way, with Mauboussin showing a survey where 2/3rds of respondents admitted they tend to rely more on judgement when analysis becomes more complex, and how we tend to give disproportionate weight to whatever has happened most recently, buying when at all time highs and getting out when at lows, causing some specific losses:

“Individual investors consistently earn results that are 50-75 percent those of market itself due to bad timing.”

And if this dumb money effect is so prevalent among individual investors and institutional alike – should we really expect our managers to be immune from it? It’s not too hard to imagine an investment manager doing their own version of the dumb money effect – changing a model around after a streak of losses, adding more markets on a model which is doing well to expand its exposure, and so forth. This is the danger to perceived skill – where changes meant to help actually result in pushing the inevitable reversion to the mean back further.

You can’t help but feel a little hopeless upon finishing the book – and realizing just how much of investing (and life) is due to luck instead of skill. But the lesson to be learned shouldn’t be to pack it in and put your money under the mattress. The lesson for us is to realize luck’s part, to realize that impressive winning streaks are just that – streaks. That depressing losing streaks are just that – streaks. And that some luck (or lack thereof) means reversions to the mean, so avoid getting in at the tops and out at the bottoms.. avoid the dumb money effect. The lesson for us is that process matters a lot more than outcome in the short run, and that the more you base your investment decisions on the recent past, the more likely you are to be disappointed.

 

Bad Year for Commodities, Whether in ETFs or Futures

Here’s our monthly look at the various commodity ETFs and how they track a simple strategy of buying December futures and rolling them annually. Plus, a comparison to Ag Traders and an overall commodity index.

Some Notes:

  1. Only 4 on the commodity contracts we’re tracking are positive on the year, suggesting that buying and holding a commodity market no matter the exposure, would be enough to make you cringe.
  2. For the first time this year,  buying and holding futures contracts (on average) are outperforming their etf counterparts.
  3. While the Long/Short AG Trader’s Index looks pretty impressive sitting there at +4% or so (compared with -13% for $DBC, the all commodities ETF), it’s been a rough couple of months for the Ag Trader’s as Grain markets have bounced back from yearly lows. If looking for smart commodity exposure, there’s no better time than now to look at the Ag Traders (in our opinion).

(Performance as of 10/31/2014)

Commodity ETF Over/Under Performance 2014

Commodity
Futures
ETF
Difference
Crude Oil$CL_F
-13.14%
$USO
-13.28%
-0.14%
Brent Oil$NBZ_F
-19.49%
$BNO
-22.25%
-2.76%
Natural Gas$NG_F
-11.02%
$UNG
-1.98%
9.03%
Cocoa$CC_F
6.90%
$NIB
5.95%
-0.95%

Coffee$KC_F
56.54%
$JO
63.59%
7.06%
Corn$ZC_F
-16.36%
$CORN
-14.09%
2.26%
Cotton$CT_F
-17.82%
$BAL
-18.95%
-1.12%
Live Cattle$LE_F
25.96%
$CATL
20.20%
-5.76%
Lean Hogs$LH_F
10.72%
$HOGS
1.43%
-9.29%
Sugar$SB_F
-10.26%
$CANE
-6.94%
0.99%
Soybeans$ZS_F
-7.81%
$SOYB
-6.48%
1.33%
Wheat$ZW_F
-16.88%
$WEAT
-19.59%
-2.72%
Average-1.05%-1.23%-0.17%
Average without Coffee-6.29%-7.12%-0.83%
Commodity Index $DBC-12.98%
Long/Short Ag Trader CTAs4.59%

(Disclaimer: Past performance is not necessarily indicative of future results)
(Disclaimer: Sugar uses the October contract, Soybeans the November contract.)
Long/Short Ag Trader CTA = Barclayhedge Ag Traders Index

Alternative Links: Trend Following, Managed Futures, and CTAs

Trend Following:

A New Anomaly: The Cross-Sectional Profitability of Technical Analysis – (Han, Yang, Zhou)

How Trend Following at its core is quite simple – (Top Traders Unplugged)

Predicting market direction is silly – (Michael Melissions)

Performance:

CTAs push on higher in October with more positive returns, says Newedge – (Hedgeweek)

Despite Volatile October, North American Hedge Funds Up 5.2% YTD – (Valuewalk)

Autumn volatility puts managed futures top in class – (Financial News)

Positive returns drive ‘resurgent’ investor interest in managed futures – (CTA Intelligence)

Attain Funds October Performance – (Attain’s Alternatives Blog)

Commodities:

Corn multi-year lows and lower USDA forecast should feed bulls this winter and spring – (Almanac Trader)

Commodity Curves Bury Passive Investors – (Wall Street Journal)

Barron’s talks the sell off in Commodities without a single mention of long/short strategies (CTAs) – (Barrons)

CME Group reports a record open interest for NYMEX Brent Futures – (Metal)

Social Media:

Asset Class Scoreboard (where’d that stock loss go?)

The month’s Asset Class Scoreboard numbers is a perfect example of just how much noise is out there in the markets. If you were glued to your twitter feed in October, you may have been freaking out about the -5% drop, but someone who checks in monthly doesn’t even see it… October finished just fine for them after a somewhat rare stock market bounce.

And then there’s managed futures, which somehow amidst all the ‘trend following is dead’ commentary and articles about Paul Tudor Jones losing money – posted its third consecutive month of gains, and 6th out of the past 7 months, to find itself sitting in third place on our YTD scoreboard.  Of course, this is an index, not all managed futures programs are up. But just the same, it sure is nice to be around the upper tier for a while after spending most of the past few years towards the bottom.

PS – take a look at the buy and hold commodities trade, down double digits on the year as Crude Oil joined the commodity sell off in October, to join grains and metals which had done so in the month’s prior.

Table of Asset Class ScoreboardChart Asset Class Scoreboard(Disclaimer: past performance is not necessarily indicative of future results)
Source: All ETF performance data from Morningstar.com
Sources: Managed Futures = Newedge CTA Index, Cash = 13 week T-Bill rate
Bonds = Vanguard Total Bond Market ETF (BND),
Hedge Funds= IQ Hedge Multi-Strategy Tracker ETF (QAI)
Commodities = iShares GSCI ETF (GSG); Real Estate = iShares DJ Real Estate ETF (IYR);
World Stocks = iShares MSCI ACWI ex US Index Fund ETF (ACWX);
US Stocks = SPDR S&P 500 ETF (SPY)

Beef: Why there’s a Five Guys in your Town

It’s been a little over 10 months since we’ve looked at the Meat markets (Live and Feeder Cattle) hitting all time highs, and if you think that’s because the ascent has slowed down… think again.  It’s almost become S&P-like boring to talk about…. Ho hum, another all time high in Cattle today as the market has marched on and on this year. . Feeder Cattle is up 42%, while Live cattle is up 22% YTD. But it’s not just this year. The cattle markets have been in a consistent uptrend the past 4-5 years, more than doubling in price since 2010 {past performance is not necessarily indicative of future results}.

Feeder Cattle
Live Cattle(Disclaimer: Past performance is not necessarily indicative of future results)

Here’s where we’ll throw you a curve ball – because unlike the stock market, which is discounting what is excepted to be going on over the next 12-18 months, the cattle markets are factoring in conditions from 2 to 3 years ago. Puzzle me that one, futures markets affected by the past.  For further explanation, we turn to the Texas Department of Agriculture explaining that it was the drought all the way back in 2010 that’s pushing prices higher today, via the Texas Tribune.

At this point, the biggest impact of the drought has been on beef prices,” said Bryan Black, spokesman for the Texas Department of Agriculture. “The drought that began in the fall of 2010 forced cattle raisers in Texas, Oklahoma and elsewhere to reduce the size of their herds. As a result, beef production has declined, and that has pushed prices higher…. Donnell Brown, the owner of R.A. Brown Ranch, said he has had to reduce his 1,000-cow herd by 50 percent over the last three years.”

Shrinking production(Disclaimer: past performance is not necessarily indicative of future results)
Chart Courtesy: Wall Street Journal

What’s that reduction look like in numbers, the Wall Street Journal has a graphic, showing production (not sure that’s the word the cattle getting slaughtered would use) to hit its lowest year to year change since at least 2006, down 5.3%, to 24.4 Billion pounds.

And now there’s a new factor – the high beef prices themselves… which can lead to more ranchers slaughtering the cattle they do have, to take advantage of the high prices, leading to less cattle and even higher prices. Although the flipside to that is also likely to happen. Just like money flew into the Dakotas to take advantage of high energy prices, money will fly into ranching in order to ‘produce’ more cattle and take advantage of the higher prices. Which will eventually lead to more supply… in turn pushing prices back down. It’s why commodity markets are cyclical – with those looking to profit from higher prices by growing more, drilling more, or birthing more cattle, ultimately causing the end of those high prices.

For now, we’ll just hope prices at our local hamburger joint don’t go up too high… Which come to think of it, might be another reason for high beef prices. The number of fast-casual burger spots in Chicago has increased a lot since the financial crisis, when restaurateurs decided on cheaper burger options over more expensive concepts (according to an article we read back in 2009/2010ish… that we just spent way too long trying to find… anybody got it out there?). There’s the national guys… Five Guys, SmashBurger, Epic Burger (our favorite), M Burger, and dozens of local entrants.  Now we’re getting hungry for a (more expensive) burger!

 

 

 

 

Attain Funds – October Performance

We launched a family of alternative investment funds earlier this year, and each month, we share its performance numbers and match them against its liquid alt counterparts (see below). To get the full platform report emailed monthly with commentary on how each fund made/lost money, full track records, and all the relevant stats – register here.

FundMonthYTDAnn DD
Attain Trend Following Fund+4.15%+14.10% -5.74%
Attain Relative Value Fund+1.80%+0.88%-6.46%
Attain Global Macro Fund-0.60%+3.33%-6.03%
Attain Short Term Alpha Fund-3.80%+3.22% -14.07%
Attain Ag Fund^(hypothetical)-11.83%-7.16%-11.83%
Liquid Alternative Comparisons
AQR Managed Futures Strategy I Mutual Fund (AQMIX)-1.04%-1.13%-6.42%
361 Managed Futures Strategy A Mutual Fund (AMFQX)+2.81%+4.42%-2.56%
Morningstar Managed Futures Mutual Fund Category^+0.73%+3.79%

^ = Morningstar Managed Futures Mutual Fund Category performance through November 5th.
Annual DD = The worst drawdown experienced by the strategy for the calendar year.

Disclaimer:  The return numbers herein include estimates of the full month performance for the previous month, and include assumptions for accrued fees, the effect of additions and redemptions, and other factors which may cause the final numbers compiled by the fund administrator to differ slightly. ^The Attain Ag Fund is awaiting seeding, and performance reflects the M6 Capital Mgmt. trading program performance multiplied by 1.5x and reduced by 1% annually for expected periodic expenses from fund operations. Regulations require performance adjusted for a leverage factor to be considered hypothetical performance and a hypothetical performance disclaimer to accompany such performance.

HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN; IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK OF ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL WHICH CAN ADVERSELY AFFECT TRADING RESULTS.

Please refer to each fund’s disclosure documents for more information. Past performance is not necessarily indicative of future results. Futures trading is complex and presents the risk of substantial losses. As such, it may not be suitable for all investors. There is no guarantee that any investment product will achieve its objectives, generate profits or avoid losses.

Alt Links: Word of the Week (Commodity Trading Advisor)

Managed Futures:

Bloomberg’s Word of the Week is a Commodity Trading Advisor – (Bloomberg TV)

Skip to 2:20 for Word of the Week

Managed Futures October Performance – (Attain’s Alternatives Blog)

Alts:

Alternative Strategies Gain Traction in College Endowments – (Think Advisor)

Futures & Miscellaneous

Kids Explain Futures Trading – (Wall Street Journal Video)

Pain in Trains Falls Mainly on Grain – (Wall Street Journal)

CBOE may cut VIX futures trading hours after glitches – (Reuters)

Liquid Alts:

Liquid alts get warning from SEC’s Norm Champ – (Investment News)

Are ‘Alternatives’ an Asset Class? Maybe Not. – (Wall Street Journal Blog)