World Puzzle

This story has been retold many times, but the following narrative, excerpted from Gary Keller's The ONE Thing, is my favorite:

One evening, a young boy hopped up on his father's lap and whispered, “Dad, we don't spend enough time together.” The father, who dearly loved his son, knew in his heart this was true and replied, “You’re right and I’m so sorry. But I promise I’ll make it up to you. Since tomorrow is Saturday, why don’t we spend the entire day together? Just you and me!” It was a plan, and the boy went to bed that night with a smile on his face, envisioning the day, excited about the adventurous possibilities with his Pops.

The next morning the father rose earlier than usual. He wanted to make sure he could still enjoy his ritual cup of coffee with the morning paper before his son awoke, wound up and ready to go. Lost in thought reading the business section, he was caught by surprise when suddenly his son pulled the newspaper down and enthusiastically shouted, “Dad, I’m up. Let’s play!”

The father, although thrilled to see his son and eager to start the day together, found himself guiltily craving just a little more time to finish his morning routine. Quickly racking his brain, he hit upon a promising idea. He grabbed his son, gave him a huge hug, and announced that their first game would be to put a puzzle together, and when that was done, “we’ll head outside to play for the rest of the day.”

Earlier in his reading, he had seen a full-page ad with a picture of the world. He quickly found it, tore it into little pieces, and spread them out on the table. He found some tape for his son and said, “I want to see how fast you can put this puzzle together.” The boy enthusiastically dove right in, while his father, confident that he had now bought some extra time, buried himself back in his paper.

When I put the man together...

Within minutes, the boy once again yanked down his father’s newspaper and proudly announced, “Dad, I’m done!” The father was astonished. For what lay in front of him — whole, intact, and complete — was the picture of the world, back together as it was in the ad and not one piece out of place. In a voice mixed with parental pride and wonder, the father asked, “How on earth did you do that so fast?”

The young boy beamed. “It was easy, Dad! I couldn’t do it at first and I started to give up, it was so hard. But then I dropped a piece on the floor, and because it’s a glass-top table, when I looked up I saw that there was a picture of a man on the other side. That gave me an idea!

“When I put the man together, the world just fell into place.”

Running Money

“My goal is no longer get more done, but rather to have less to do.”

— Francine Jay

Small Prop Shop vs. Big Hedge Fund: Running lean or charging full-steam ahead?

Small is Beautiful: Key operational advantages of a small prop shop (compared to a big hedge fund or a giant index fund).

It's all relative: “Full-spectrum investing” explores the design space for new investment vehicles (Image Credit: Andrew Lo).

What if a perpetual alpha fund can be organized and operated in such a way that it can deliver on the following 8 attributes: high Sharpe ratio, zero transparency, high liquidity, monitored risk exposures, few controls, just enough capacity, hyperactive turnover, and tiered fees, while preserving the key operational advantages enjoyed by a small prop shop? Don't you think this may be an interesting area of the design space to explore?

“Things which matter most must never be at the mercy of things which matter least.”

— Johann Wolfgang von Goethe (1749-1832)

Perpetual Alpha

All good things come to an end: But why can’t good things be made to last?

Since inception, the iconic Nevsky Capital, a long-short global equity fund, has posted an impressive cumulative percentage change in $ terms of 1,213% over its 15-year lifespan from September 2000 to December 2015. The manager of Nevsky Fund, Martin Taylor, was shutting down the fund at the end of 2015, and returning all of the $1.5 billion capital to fund investors.

In his final letter to fund investors, Martin Taylor cited persistent challenges in the current market environment which led to such a decision. For over 21 years, a "broadly unchanged process" (i.e., one that marries the top down forecasting of key macro-economic variables with the bottom up forecasting of company earnings) had worked well for them. Until it doesn't anymore. What are we to make of this? Why can't alpha be made to last?

Turns out that alpha is rather ephemeral even for high-frequency traders, according to Jacob Loveless: “Imagine every day you have to figure out a small part of the world. You develop fantastic machines, which can measure everything, and you deploy them to track an object falling. You analyze a million occurrences of this falling event, and along with some of the greatest minds you know, you discover gravity. It’s perfect: you can model it, define it, measure it, and predict it. You test it with your colleagues and say, ‘I will drop this apple from my hand, and it will hit the ground in 3.2 seconds,’ and it does. Then two weeks later, you go to a large conference. You drop the apple in front of the crowd...and it floats up and flies out the window. Gravity is no longer true; it was, but it isn’t now. That’s HFT. As soon as you discover it, you have only a few weeks to capitalize on it; then you have to start all over.”

Alpha Decay: The one problem that we are now trying to solve... (Image Credit: Andrew Lo and Macaulay Culkin).

“HFT was measurably harder by 2010. Most of our models at that time were running at half-lives of three to six months.”

— Jacob Loveless (“Barbarians at the Gateways”, 2013)

Since alpha is hard to come by, might it be worthwhile to reconsider the possibility of creating passive portfolios based on replicating hedge fund exposures to risks? Earlier research by Andrew Lo and Jasmina Hasanhodzic of MIT had examined just such a possibility, based on using a linear regression technique to identify common factors. However, the actual performance results of such “replication funds” in the real world were somewhat disappointing, and had not matched expectations. For example, the Diversifying Strategies fund, which was launched in 2009 and managed by AlphaSimplex, performed poorly over a three-year period during 2011-2013, especially when compared against the S&P 500 performance benchmark in a rising stock market. The fund was subsequently shut down in 2014. The strategy of replicating the returns of hedge-fund techniques had its limitations. Whether by linear regression or other techniques, it was again found that the real world financial markets are not so easily modeled after all.

Academic Arbitrage: A renewable source of alpha? Can you still find free money on the street if you look hard enough?

Let’s think about the problem in a slightly different way, and ask: Is there a renewable source of alpha that traders can tap into? It so happened that David McLean of the University of Alberta and Jeffrey Pontiff of Boston College examined a total of 72 market anomalies (i.e., good old-fashioned money-making opportunities!) that appeared in academic journals between 1972 and 2011. They found that average returns went down 35% after publication. They also uncovered evidence that traders jumped in to exploit anomalies following publication, with trading volumes rising, and with short interest increasing for stocks on the wrong side of arbitrage opportunities. Curiously, the anomalies again start to produce improved returns after a few more years. It appears that traders have rather short attention span, and very likely have moved on to the next thing.

Same thing as usual, only different every day.

Just One Thing: How are we even related? I've always been a rational chimp and a loyal Mac user!

Here is an interesting question to consider: How might a “perpetual alpha fund” be organized? Does the trading firm do the same thing as usual, only different every day? Or does the trading firm do just one thing, the same every day but evolves along the way? What new framework do we need?

If this question sounds hard, then how about something a tad bit easier: How might a “perpetually flying paper airplane” be constructed? Here is an “instructable” that teaches how to build the “paper airplane that flies forever” and a video that demonstrates its perpetual flight characteristics along MIT’s famed “infinite corridor”:

No Magic: A shift in perspective is all that is needed.

Theoretically, this airplane will fly for as long as you continue to walk with and guide it (Image Credit: “The Coke and Mentos Guys”).

“I’d rather write programs to write programs to write programs than write programs to write programs.”

— Richard Sites

References:

1. Loveless, Jacob (2013, October 16). Barbarians at the Gateways. ACM Queue, Vol. 11, Issue 8. Retrieved from: http://queue.acm.org/detail.cfm?id=2536492
2. Lo, Andrew, and Hasanhodzic, Jasmina (2006, June). Attack of the Clones. Institutional Investor's Alpha, 54-63. Retrieved from: http://jasminah.com/Papers/Alpha_Pub_smallSize.pdf
3. Hasanhodzic, Jasmina, and Lo, Andrew (2007). Can Hedge-Fund Returns be Replicated?: The Linear Case. Journal of Investment Management, 5(2), 5-45. Retrieved from: http://alo.mit.edu/wp-content/uploads/2015/06/CanHFReturnsReplicated2007.pdf
4. Copeland, Rob, and Zuckerman, Gregory (2014, August 3). How Individual Investors Can Invest Like a Hedge Fund. Wall Street Journal. Retrieved from: http://online.wsj.com/articles/how-individual-investors-can-invest-like-a-hedge-fund-1407106285
5. Lahart, Justin (2013, September 13). Arbitraging Academia. Wall Street Journal. Retrieved from: http://blogs.wsj.com/moneybeat/2013/09/13/arbitraging-academia/
6. Moyer, Liz (2014, August 8). Taking Stock of Automated Advisers. Wall Street Journal. Retrieved from: http://online.wsj.com/articles/taking-stock-of-automated-financial-advisers-1407519771

The ONE Thing

“What’s the ONE Thing I can do such that by doing it everything else will be easier or unnecessary?”

— Gary Keller ("The ONE Thing")

What's the ONE Thing I can do to get rid of a mouse such that by doing it everything else will be easier or unnecessary?

Since the gravitational potential energy of an upright domino is proportional to the fourth power of its size, a very small amount of input energy can be amplified quickly to knock down an impressively big domino. Starting with a 2-inch domino, and arrange for each successive domino to be 50% larger than the one before. Then the 18th domino would be as tall as the leaning tower of Pisa. The 23rd domino would tower over the Eiffel Tower, and the 31st domino would loom over Mount Everest by almost 3,000 feet. The 57th domino would practically be as tall as the distance between the earth and the moon! (Image Credit: Overflow).

“Find the lead domino, and whack away at it until it falls.”

— Gary Kelley ("The ONE Thing")

“I knew I had to transform Alcoa, but you can’t order people to change. So I decided I was going to start by focusing on one thing. If I could start disrupting the habits around one thing, it would spread throughout the entire company.”

— — Paul O’Neill (in “The Power of Habit”)

The following is an excerpt from the book by Charles Duhigg, The Power of Habit:

On a blustery October day in 1987, a herd of prominent Wall Street investors and stock analysts gathered in the ballroom of a posh Manhattan hotel. They were there to meet the new CEO of the Aluminum Company of America — or Alcoa, as it was known — a corporation that, for nearly a century, had manufactured everything from the foil that wraps Hershey’s Kisses and the metal in Coca Cola cans to the bolts that hold satellites together.

A few minutes before noon, the new chief executive, Paul O’Neill, took the stage. He looked dignified, solid, confident. Like a chief executive. Then he opened his mouth. “I want to talk to you about worker safety,” he said. “Every year, numerous Alcoa workers are injured so badly that they miss a day of work.

“I intend to make Alcoa the safest company in America. I intend to go for zero injuries.”

The audience was confused. Usually, new CEOs talked about profit margins, new markets and ‘synergy’ or ‘co-opetition.’ But O’Neill hadn’t said anything about profits. He didn’t mention any business buzzwords. Eventually, someone raised a hand and asked about inventories in the aerospace division. Another asked about the company’s capital ratios.

“I’m not certain you heard me,” O’Neill said. “If you want to understand how Alcoa is doing, you need to look at our workplace safety figures.” Profits, he said, didn’t matter as much as safety.

The investors in the room almost stampeded out the doors when the presentation ended.

Within a year of O’Neill’s speech, Alcoa’s profits would hit a record high. By the time O’Neill retired in 2000 to become Treasury Secretary, the company’s annual net income was five times larger than before he arrived, and its market capitalization had risen by $27 billion. Someone who invested a million dollars in Alcoa on the day O’Neill was hired would have earned another million dollars in dividends while he headed the company, and the value of their stock would be five times bigger when he left. What’s more, all that growth occurred while Alcoa became one of the safest companies in the world.

References:

1. Whitehead, Lorne (1983). American Journal of Physics, Vol. 51, p. 182. Retrieved from: https://popperfont.files.wordpress.com/2013/01/dominopaper.pdf
2. Keller, Gary and Papasan, Jay (2012). The ONE Thing. Bard Press.

3. Duhigg, Charles (2012, February 27). How ‘Keystone Habits’ Transformed a Corporation. Huffington Post. Retrieved from: http://www.huffingtonpost.com/charles-duhigg/the-power-of-habit_b_1304550.html