You’ve Been Brainwashed Into Believing In Relative Return
- Posted by Leigh Drogen
- on June 22nd, 2012
Rule #1: Don’t lose money.
Rule #2: See rule #1.
Those were the first two things I was taught by David Geller on my first day as a trader at Geller Capital.
For some of you that may seem obvious. Don’t lose money, of course, who the hell would think otherwise.
For those mentioned above, you most likely already know that when we actually look at the universe of market participants, you’re in the minority, the very very small minority.
Fact is, most market participants engage in relative return strategies where losing money is part of the game. Why? Because somewhere along the way, in order to make huge assets under management fees, large asset managers realized that it was easier to make people believe that their job was to beat an arbitrary benchmark than actually make money for their clients. By doing this, they were able to trade around the margins, and collect their fees whether they did well or not.
How did this happen? Well, it came about via the efficient market theory, which we now know to be complete garbage. Yes, it won a Nobel Prize, so did Obama (that’s not a political jab, you get the point). The asset managers took this defunct theory and used to to make people believe that your goal should be to outperform some average of assets in the same universe (stocks in an index). Their marketing machines went into overdrive when Americans got a bit wealthy and wanted a piece. And it worked for a while, because it’s easy to push this way of thinking when the economy and or the market are surging year after year.
Until it doesn’t.
I agree with all the literature that says the average guy should not be investing in long only mutual funds that attempt to beat their benchmarks. The evidence is pretty irrefutable, after fees it’s almost always a bad deal.
What I definitely do not agree with, is the idea that instead, the average guy should be investing in an index.
Where on gods green earth was it every written that relative return investing, putting yourself at the mercy of an index of assets was the default investment strategy? Who thought this up?
What is this really? This is praying that the average of the price of a bunch of assets will appreciate over time. This is gambling.
When someone says that a long/short strategy is riskier than investing long term in an index, I laugh. I laugh really hard, because they haven’t given any real thought to that belief in a logical way.
If you are investing to beat a benchmark, and not to make money, or better, not to not lose money, I would take a long hard look at why that is. And don’t come back and tell me that you don’t have access to really good absolute return managers so therefore you are left only with relative return or indicies. The absence of a good solution is no excuse for sticking with a bad one, that is not a valid argument. You do not have to be in the market, no one is forcing you, you’re being brainwashed by the TV into thinking you do, it’s their job to do that, to take your money.
Asset allocation is nothing but a suped up way for them to take your money and be able to say it wasn’t our fault you lost it when the market goes down. They give you all these stats on how active management doesn’t beat the indices, and they are right, but no one every explained why you are competing against some index did they? Is that the word of god that this is how everyone is measured.
I don’t run money for other people under Surfview Capital anymore, I’m focused on building Estimize, but here’s what I used to say to my clients and perspective clients.
We are going to shoot for a return of 10-12% a year, after fees.Based on our strategy we should be able to do this in any kind of market, straight up, straight down, or sideways. And because we have a natural long bias, when the market is really good, we should be able to make a good deal more that 10%. But we’ll always be focused on not losing money, because god forbid we lose 30% right before you decide to retire, or want to buy that yacht, what the hell did the other 5 years of good returns matter for? We’re going to go completely to cash in markets we have no edge in, and we’re going to trade on margin in markets that we are extremely confident in. We’re going to stick to our strategy and focus on making money, not some random benchmark. You’re hiring me to make you money, you are not hiring me to beat an arbitrary number.
And some people didn’t like that, and they did not become clients. And for the ones who did, we went out and crushed those expectations during the two years I ran Surfview, at 30+% returns both years, with low volatility. We never had a draw down more than 4%.
My case against passive index investing is not that you won’t likely make money over time. The average returns of various asset classes are likely to revert to their means over the course of 30-40 years. But there in lies the rub. For most people who don’t have any real money to invest until their 30’s, that gives about 30 years to let the averages work. And if you are not actively managing risk, you could end up having to exit that passive investment at the end of a huge draw down, as was the case in ’08. And I’m not even factoring in long stretches which could coincide with the latter half of your investing period where those averages are well below their mean, as equity has been for the past two decades. You might be willing to leave that all up to chance, but thank you very much I will not.
Just remember, relative return is a construct of a business model, there is nothing that says you must engage in it. In some cases you will want to be directly correlated to an index, or group of indices, but that has to be an active decision as part of a broader risk management strategy. If an index loses 15% in any year, and you lost 12%, you didn’t win, you lost a lot of money for your clients, and you broke rule #1.
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Leigh Drogen is the founder and chief investment officer of Surfview Capital, LLC, a New York based investment management firm employing an intermediate term long/short momentum strategy. More »
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