Byrne's Eye View

Until it is satisfied, that is, when the program is subsequently suppressed, research suggests. In one 2006 study, for instance, researchers had Northwestern University undergraduates recall an unethical deed from their past, like betraying a friend, or a virtuous one, like returning lost property. Afterward, the students had their choice of a gift, an antiseptic wipe or a pencil; and those who had recalled bad behavior were twice as likely as the others to take the wipe. They had been primed to psychologically “cleanse” their consciences.

Once their hands were wiped, the students became less likely to agree to volunteer their time to help with a graduate school project. Their hands were clean: the unconscious goal had been satisfied and now was being suppressed, the findings suggest.

The New York Times on subtle signals.

A while ago, Roger at Information Arbitrage complained that the 130/30-style hedge fund (130% of assets long, 30% short), was a disaster waiting to happen:

If the manager is really great at picking shorts, which is really the hardest part of the long/short game, then why would they choose to play in a pool that is limited to being only 30 short? Answer: they wouldn't. They would go to a place where they could use their shorting skill to its fullest, namely, in a real hedge fund, not some bastardized, watered-down version. So, basically we're talking about adverse selection in action.

Conversely, what of the skilled long-only manager who wants to try his/her hand at shorting to add a little spice to life (not to mention the ability to garner premium fees)? Buyer beware: this is a train wreck waiting to happen. The road is littered with managers who had strong returns in the long-only modality who tried to switch to a hedge fund that entailed shorting and got totally smoked. Why? The risk management principles (position sizing, number of bets, stops, liquidity, etc.) are fundamentally different on the short side than on the long side. There is no shame in not having this skill, but don't pretend that you can simply acquire it because you are a good long investor. Shorting is a different game - a dangerous game - that needs to be learned over time. Otherwise, you'd better have some strong glue at your disposal since it is almost certain that you're going to get your face ripped off.

One nice advantage of 130/30 is the intrinsic hedge of betting on both directions. But I've been reconsidering that. If diversifying only works when you diversify by paradigm, 130/30 doesn't reduce risk at all; it just lets you express the same investment thesis in two directions. If you think hard assets are going to outperform intellectual property, you won't reduce risk by buying gold and real estate while shorting Google and Microsoft; you'll just double your exposure to the same idea (and ensure that any extraneously right thesis you have -- about the market's direction, or inflation) will be canceled out by these bets.

I can easily imagine a 130/30 value investor getting slaughtered in '99. It's one thing to have your long positions lose 20%; it's another entirely to see that money flow into dot.coms that go up 200%. Similarly, a tech-focused investor betting against bricks and mortar would have lost money on the long and short halves of the portfolio in 2000-20002.

It's easy to claim that a hedge fund investor would actually hedge, but I'm not so sure -- how many investors can really entertain two contrary theses (and how many can assume that that's what they're doing, when they're really leaving their main theory unstated)?

The New Yorker has a fantastic, tragically flawed article on mimicking hedge fund returns. Give it a read.

The article makes a few good points, which I will herewith make about The New Yorker. The average hedge fund (or magazine) has pretty average returns (or writing), but the best hedge funds (or magazines) have lots of cachet, and can charge high fees (or subscription prices plus ad rates) while gathering lots of ad dollars (or subscribers). But wouldn't it be easier to offer the same asset distibutions (same average number of sentences, adverbs, and punctuation marks) for a much lower fee?

That's roughly the argument behind products that offer to simulate hedge funds: that if you want to get the same returns as ESL, or Renaissance Technologies, or Centaurus, you just need to buy the same mix of assets -- the same way that if you want to paint like Picasso, the only thing you have to do is buy blue paint and move to Paris.

It's a bizarre misunderstanding of what hedge funds (as opposed to asset allocators) do. A hedge fund isn't a vehicle for getting exposure to assets with a particular set of statistical attributes: it's an attempt to generate excess returns by exploiting mispricings, which (in theory) shouldn't belong to or correlate with any asset class.

The WSJ ($) gets in on it too, noting that

Some experts doubt even that goal. A recent study of cloning by researchers at France's EDHEC Business School showed that most clones generally did a poor job of mimicking the returns of hedge funds.

A possible reason: Hedge funds are adjusting their portfolios all the time, whereas factor-model clones are based on previous years' hedge-fund returns, says Lionel Martellini, a co-author of the study.

"Diversification" is generally accepted as a good idea, and asset managers seem to have some idea of how it works, but when I read about why and how people diversify, it sounds like they're embracing the form without considering the meaning. The point of diversification is simple: if at all possible, one should construct a portfolio so that any negative affect on returns due to an unpredictable event will be offset by positive returns due to the same event. Somehow, people understand this when they buy contracyclicals like Altria and Campbells to offset a portfolio of cyclical consumer products. So they can diversify by industry -- but what people seem incapable of doing is diversifying by paradigm.

This is most relevant in technological businesses, but only because they change quickly. In 1980, it was obvious that computers would either be used in most homes, or not -- large companies like IBM and DEC were an implicit bet on the status quo; smaller companies like Apple (and Commodore). A portfolio with a heavy weighting in DEC and IBM could get more real diversification without any change in what's traditionally seen as diversification by swapping one mainframe company for a PC manufacturer. It's diversifying against changes in an industry instead of diversifying by industry.

In 2007, it's obvious that people will either pay for software or not. If they do keep paying for software, Microsoft and Oracle and salesforce.com will stay successful. If they don't, hardware will be more valuable (Sun and Apple will benefit) and support will be more important (so Red Hat will be worth buying) -- and building a computer business will be a lot easier (so Google and Amazon will have cheap startups to buy and more agile competitors to avoid -- neutral overall, but increase their volatility).

Investing means pursuing the highest return on money invested by looking for the highest return on data obtained: to the extent that you can make a problem irrelevant through hedging or diversification, you ought to -- because being an asset allocator is hard enough without having to be a futurist and a lobbyist and a geologist as well. Diversification needs to be more than a quantitative measure of the expected variance of a portfolio given some (wildly unrealistic) estimates of asset correlation: it should be the science of minimizing the amount of time an investor needs to spend pondering the fundamentally imponderable future.

I work at 40th and Lexington. Did you hear about 41st and Lexington?

I heard something that sounded like thunder and didn't stop; looked out the window and saw a geyser of mud go up fifty feet and not abate; within a couple seconds my coworkers and I had ditched the office (and our phones, hence the blog entry).

I got out of the building fast (as did everyone else): never have I been happier to live in a city of big steps and sharp elbows. Just try to imagine a place that could be evacuated on foot this fast.

I just heard about an interesting strategy: make a tender offer for less than the market price, and hope investors sell without doing any research. It's slimy, but it's clever: shareholders are automatically informed of these offers, whereas they aren't always informed of the market price.

This creates an interesting little arbitrage opportunity: since an offer like this would probably make prices temporarily volatile and temporarily lower, it might make sense to write short-term puts on any stock afflicted by this scam.

I wrote up and filmed a quick pitch for a startup idea I've been kicking around for a while. The video is hosted on vator.tv, which is an interesting idea: it's a site for 'elevator pitches' (what you'd say if you stepped on to the elevator with a VC). Mine runs a little long (and it's just a short version).

Here's the summary:

Uncertainty about future events makes us all part owners of a portolio of event derivatives. Event derivatives are simply bets on the outcomes of future events -- one common example is a political future, which might represent a bet on the probability of a given election outcome. One option might return $1 per unit if Hilary Clinton is elected, and nothing if she is not. This is not only a way for political junkies to speculate and political outsiders to hedge their risks -- it's an easy way to calculate the probability that an event will actually occur.

I believe that there is an enormous opportunity to create a market that allows participants to define their own event futures and transact with trusted third parties. To begin, I'd offer four broad market categories:

• Voting rights markets: finance boils down to two activities: it's the the science of turning future uncertainties into present certainties through stocks, bonds, futures, and derivatives; and it's the art of seperating ownership and control. The historical connection between voting rights and equity ownership is more or less accidental, and is fluid due to scale (no IBM shareholder has a serious chance to influence IBM's future) and circumstance (those voting rights don't do much good if the company misses an interest payment on its bonds). I believe that there should be a simple, standard means of trading share voting rights independent of economic rights, so control can be valued independent of a company's economic future.

• Trust markets: the primary barrier to commerce is trust in counterparties. You can have a barter market without trusting the people you're dealing with, but once currencies and long-term obligations come into play, trust is essential. There ought to be a middle ground between letters of recommendation and Moody's ratings -- a quantifiable measure of the odds that a given indivudal or institution will meet its obligations. And there's no better way to set up such a measure than via prediction markets.

• Technology futures: all web 2.0 startups are essentially a bet on Moore's Law. They presume that the cost of hardware will continue to drop, to the point that small groups can focus on rapidly developing features rather than on honing high-performance code. They need a way to hedge that bet -- as does every business relying on a current paradigm or hoping for a new one.

• Meta-markets: although there are many prediction markets available already, few of them offer any hedge against their own failure. For example, a Tradesports portfolio wouldn't be worth much if US regulators confiscated the gains -- and a Hollywood Stock Exchange bet would be hard to cash out if the servers crashed on Oscars night. I'd like to offer a market that lets users hedge against the failure of other markets. Not only is this service valuable, but it's most valuable to 'power users' eager to push these markets to their limits.

The theme of each of these opportunities is that we face risks, and that when we think of these risks as derivatives, it's easy to see that we can and should be able to hedge our bets or double down. Like index futures and mortgage-backed bonds, this is not so much a new market as an old market that can become a larger one with a bit of standardization. Unlike those markets, this is an opportunity of unlimited scale, in which everyone has a stake.

Trader: One who is lucky, humble, or broke.

If you don't know which you are, you're not going to like the answer.

I just read a bizarre article attacking profit-seeking companies for seeking profits by hiring employees who weren't born in the United States. "The Vanishing American Programmer" is fascinating to me: this is a point one can seriously make about, say, an American firm hiring non-Americans, but not a white-founded firm hiring black employees, or an Ohio-based company hiring someone who moved in from Michigan. It's even more illuminating to imagine this argument being made by an outsider: it's easy for American programmers to see that they're better off if well-qualified candidates aren't allowed to compete for their jobs, but I don't think those same programmers would demand that their homes not be built by Mexican laborers, or decide that they won't accept Special Relativity as a viable theory until someone less immigranty than that Einstein fellow formulates it.

To Norm Matloff, a professor of computer science at the University of California at Davis, such efforts to use loopholes in immigration laws that were supposed to give Americans and legal residents first crack at high-tech and other jobs is "absolutely outrageous."

The real goal is to hire "cheap labor," charges Dr. Matloff.

Well, yes. Dr. Matloff has discovered the root of the conspiracy: these companies are trying to make money, not to ensure that their payroll consists only of people born in one of fifty states (and possibly a commonwealth or two). Notice that these executives are basically honest; they rarely make philanthropic arguments about how the third world is younger and poorer than America (not to mention bigger), and thus that they're redistributing jobs from less worthwhile comparatively rich people to hardworking poor people.

The video was lifted from the law firm's website and put on YouTube by the Programmers Guild, a nonprofit group with 1,500 members, most of them older than 40, and many of whom can't find jobs in their areas of expertise.

I'm in the business of finding jobs for programmers, and I can state pretty clearly that age is not a relevant factor in hiring someone, but that age is a factor in determining what their "areas of expertise" are. Businesses change, and high technology businesses change pretty quickly. Someone educated twenty years ago was trained to solve some problems that no longer exist. It's true that people with obsolete skills will be more likely to find employment if their potential replacement are legally enjoined from competing, but that view has been the butt of jokes for a few hundred years now.

This joke of an argument has a perfect punchline:

John Miano, who runs his own programming firm, says such offshoring is "the latest fad." He notes that nearly all the world's software was developed in the United States. American culture makes programmers here efficient and innovative, he says, and offshoring over the past decade hasn't saved US firms any money.

He cites American culture as a justification for rejecting upstart competitors. America is a country of upstarts -- the entire Nasdaq 100 consists of companies that existed to take away jobs from less qualified employers by being more agile and less up-to-date, and nobody out there will claim that we'd all have more jobs (and be better off) if the Nasdaq 100 companies hadn't started up in the first place. Arguing against outsourcing may be an argument that, in the short term, favors Americans, but it's an argument that contravenes American culture and ideals.

During the summer of 2002, I worked at a wholesale onion company answering phones, keeping records, and basically acting as a buffer for the management. One thing always bothered me about the job: onion prices were pretty volatile, and everyone (supermarkets, restaurants, farmers, and wholesalers) spent a lot of their time panicking about where prices would go next. It seemed pretty obvious that everyone would sleep better if they'd just hedge their risks, so I asked around to see why there wasn't an onion futures market, and if perhaps my employer wanted to expand his operations in that direction.

As it turns out, there's a simple explanation:

On August 1, 1955 the futures contract for Golden Globe onions opened at $2.40 for a 50 lb bag. Soon the price was up to $2.75, whereas normally onions traded at about $1 per 50 lb bag. This high price signal drew in an avalance of onions to Chicago. As the onions started arriving the price dropped each day by its 50 cent limit. But it did not drop fast enough to cut off the flow. By the end of the contract period in March the price dropped to 10 cents per 50 lb bag and closed at 15 cents. This was about the price of the bag that held the onions so onions were virtually worthless. They were dumped into Lake Michigan.

Those who were hurt by wide fluctuations in onion prices tended to blame those fluctuations on futures trading. The National Onion Association called for a ban on futures trading in onions. In 1958 a law was enacted in Congress to ban futures trading in onions. It was challenged as unconstitutional but the courts upheld it.

That's right: we can have markets in everything -- except onions, by law -- and we can thank Gerald Ford and some panicky traders a couple generations back for it.

(This onion datum, by the way, was prompted by some Googling after this fantastic WSJ ($) article on futures exchanges noted that "Some contracts have been banned after they were associated with market disruptions. Futures contributed to a celebrated Dutch mania of the 1630s, when tulips became fashionable in European cities and speculators bet wrongly that prices would keep soaring. Futures traders appeared to gain control of the U.S. onion inventory in the 1950s, the Maine potato market in the 1970s and soybeans in the 1980s.")

The Wall Street Journal reports ($) that WisdomTree's fund family is underperforming their competitors. In general, it's not a major news story when a fund (or fund family) underperforms -- statistically, some do each year and most do overall -- but WisdomTree's situation is atypical.

First of all, they're ostensibly in the business of running index funds, which don't focus on striving for outperformance. Most indices are assembled with a few automatic rules and (possibly) human interaction for border cases. They outperform active managers, because algorithms are typically harder to fool and less likely to get excited or depressed. WisdomTree decided to juice their funds by having them emphasize high-dividend, low price/earnings stocks and other categories that typically outperform.

Unfortunately, they picked the one time in history when this would be a spectacularly bad idea. When they started, low P/E, high-dividend stocks were concentrated in the housing and finance sectors: two sectors cyclical enough that their earnings are, in the aggregate, more volatile than their stock prices. Usually, they cycle out of sync, but thanks to low interest rates (and possibly the petrodollar illusion), they both had peak earnings just as WisdomTree ramped up their marketing efforts and talked up their new approach.

The upshot of all this is that WisdomTree's first crop of investors got a rude introduction to the science of avoiding cyclicals at the peak of their cycles, which they'll end up reading as a reason to avoid index funds. Fortunately, WisdomTree's backers are doing even worse than their customers. There's justice in the market, after all.