How to beat the market: a hedge fund manager writes…

A book by hedge fund manager Paul Marshall takes on the sector’s critics to argue it is possible to beat the market

Against the Chicago School

Marshall targets the conceptual underpinnings of the passive case, the theories of efficient markets developed by the Chicago School which imply that investors should simply track markets rather than try to beat them. In their purest form, he argues, the School’s theses manifest a post-Enlightenment overconfidence that real world social systems, with all their infinite complexities, can be modelled in abstract frameworks.

Measuring active fund performance

Purists aside, most passive advocates would accept many of Marshall’s observations: the EMH is intended to model reality rather than capture it. But they would simply note by way of response that the facts don’t lie: active funds do not have a good record of beating the market, their returns tending to converge with the market portfolio over time. What metrics, then, do active proponents offer to to quantify their claims that they can outperform it?

Identifying opportunity

So how does a well resourced fund like Marshall Wace spot opportunities in the first place? The firm’s funds are structured according to Benjamin Graham’s observation that ‘in the short run the market is a voting machine, in the long term it is a weighing machine’. Its quant funds are in the voting machine game, seeking gains by anticipating investor sentiment and emerging market trends. Its fundamental managers are in the weighing machine business, taking what seems to be a classic value investment approach, seeking to identity stocks that appear to have been misvalued, with unstable prices tending in a particular direction. For Marshall ‘the two approaches exploit market inefficiencies over different time horizons.’

Concentration versus diversification

Marshall moves on from discussing how securities are selected to how they should be organised at the level of the portfolio. Concentrated portfolios, focused on a narrow set of carefully chosen securities, have the potential to yield higher returns than more conservative diversified portfolios. That said Marshall acknowledges diversification — ‘that rare beast — a genuinely helpful innovation to have come out of the Chicago School’ — as an essential technique for measuring the prospect of returns against risk. But he argues diversification can be used to absolve managers of responsibility for selecting a good set of assets in the first place: the principle improves the risk characteristics of bad as well as good assets. As Buffet puts it: ‘Diversification is protection against ignorance. It makes little sense if you know what you are doing.’

Managing radical uncertainty

Marshall devotes the book’s longest chapter to another somewhat insoluble issue: risk management in the face of uncertainty. Marshall embraces the notion of ‘radical’ uncertainty — against Bayesians for whom all probabilities should in principle be measurable — defined by John Maynard Keynes and Frank Knight, who distinguished between known risks which can be probabilised and unmeasurable uncertainties, events that simply cannot be foreseen according to any metric. The concept has been discussed at length in the recent book Radical Uncertainty (2020) by Mervyn King and John Kay, who argue that in ‘a world of radical uncertainty there is no way of identifying the probabilities of future events and no set of equations that describes people’s attempt to cope with, rather than optimise against, that uncertainty.’

The virtues and dangers of conviction

Marshall’s concluding remarks emphasise the virtue of conviction for successful investment, to be continually renewed ‘by re-examining every assumption, every thesis, discarding some and doubling down on others.’ Again, there are particular dangers for large funds inclined to ‘star structure’ models, where confidence can soon degenerate into hubris. Partnership structures and regular review of performance data offer safeguards: ‘as each of us is wrong on at least 45% of our trades, the data, used correctly, is a guarantor of humility’



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