Monday, July 01, 2013

Confidence Crisis

I am in a reflective mood, navigating, what one might call say, a crisis of confidence. What is the root of this self-doubt? I am, you see, squarely in my middle years, and as I look out at the vast pool of talent that makes up the market, I am coming to the conclusion that, like the writer who realizes he will never write a great novel, that I am just not very smart by comparison. Nor clever. And this is humbling.

When I started out in the business, despite my knowledge of delta-hedging portfolios of options, I wasn't smart enough to dream-up of "portfolio insurance", nor implement or encourage its deployment in any way. Truth be told, I am often intimidated by Maths PhDs, self-conscious over my incapacity for visualizing anything but the most basic of quadratic functions (I hit "the conceptual wall" in Linear Algebra).  And I admit was jealous that I was unable comprehend the beautiful genius of mathematical formula's and risk-analysis validating highly-leveraged (and crowded) carry trades, on for example, the Japanese Yen in 1998. And heaven knows I didn't have the prescience (or wisdom) to ride the most rip-roaring and snorting of bull markets in internet and technology stocks, unlike so many other much-smarter-than-me investors.

It is apparent to me now that I wasn't clever enough to understand the intricate business models or the unmitigated allure supporting the "merchant energy" craze, so I was never  accused of being one of the smartest girls in the room, despite the untold billions flushed-away by Mirant, Dynegy, Calpine and Enron.  I am so slow that CDOs didn't even register with me until they were near their sell-by date, and never in a million years could I have been so wickedly sharp as to invent the idea of putting a wrapper on them to miraculously transmute a still-steaming pile of dung into scentless triple-A.

 In the markets and strategies that I invest  (quant equity long vs. short)  I almost certainly am one of the dimmer bulbs, blind to the opportunities that applying 10x (or yet higher!!)  leverage to crowded trades might afford my P&L, as it might have in the summer of 2007. Despite beginning my professional days in the bullion business, my feeble grey-matter could never have conceived of turning a gold-and-oil-heavy commodities basket cum "index" into a permanent portfolio allocation for pension funds across the USA - a genius ALMOST as brilliant as that which dreamed up the idea of encouraging housewives to buy a box of baking soda, take it home,  to immediately flush it down the toilet!

Lacking the requisite creativity, I missed the chance to design something really useful for humanity, like Payament Protection Insurance. I am still in awe of the risk-management intellect behind tail-risk insurance funds. The savvy required to make these attractive when implieds were already highly elevated (historically) and the market had already more-than-a-halved is humbling. I often wonder how I've managed to compete at all!  Then, if I wasn't feeling stupid enough, I just need to take one look at luminaries like Galleon, Diamondback, or SAC. Top ivy-league schools, minted MBAs. IB training programs. Couple of years at Och-Ziff or Perry. These guys are so smart, and have had such good returns they just seem to know what is going to happen before it happens! And to think that for all these years, I'd never dreamed of the games one might play with LIBOR!

But far-and-away, the smartest guys, the ones whose certitude, sound logical reasoning, and mathematical notation are (to me)  both most impressive and humbling to listen to are the guys (and they ARE guys for only guys can be this brilliant) touting risk-parity strategies. The engineers who've  championed them sound soooo clever, and have so many academic letters following their name, one would just have to be a dolt NOT to want to adopt it for your pension plan. Really, who could quibble with the formulaic logic that miraculously gifts you a levered long bond position when it's yield is as close to the ZLB as, ummm errrr, it's EVER been??

It should be comforting to investors everywhere that so many of our best educated minds and brightest talents have chosen to serve investors' interests with such forward-thinking creative imagination. The investment world thus appears meritocratic. In this hierarchy, simpleton's seem to get what they deserve. Looking back to history, to President Carter's "Crisis of Confidence" in 1979, his implied solution was imbued in "redemption" in the biblical sense. I cannot help but wonder whether investors today will discover the same solution with regards to risk-parity and its associated gamma-negativity.


Finster said...

I share your feelings on a humbler level. And I do like your sense of humour.

jm said...

Part of what you describe is what I call, "The Pension Pump".

The smart guys' modus operandi is to create "investment" opportunities that can be made to appear near-term as offering superior yield, such that pension fund managers will be forced to buy them lest they "under-perform" relative to others who do.

Since so many pension funds are clearly doomed if they can garner only the returns available from truly long-term-viable investments (quantitative easing having created an environment in which chaos ensues at even the slightest hint that returns on viable investments will ever be allowed to rise), their only choices are to honestly deal with that (clearly impossible), or to swing for the fences with the smart guys' "innovative" products.

Since not far down the road the smart guys' innovative products put the pension funds even deeper in the hole, the pension fund managers' need for the "investments" the smart guys can tout as offering high returns only increases, greater with each cycle of this "pump".