You’ll have to excuse quantitative fund manager Cliff Asness. In Grant’s Interest Rate Observer, Asness refers to what he describes as “the idiot trade.” No, Asness wasn’t referring to his recent episode of foot-in-mouth disease on Bloomberg TV with Stephanie Ruhle. This was when Ruhle, a former Wall Street brokerage executive turned anchorwoman, called Asness on the table for what she termed a “sexist line.” (Asness said to Ruhle, “You’re giving me that look that I get when I talk to women about quant stuff.”)
Cliff Asness: “Idiot trade” is trend following
No, the “idiot trade” to which Cliff Asness was likely referring in the Grant’s piece is managed futures trend following, an algorithmic trading strategy uncorrelated to the performance of the stock market. Trend following is really a smart trade that doesn’t require much human thought — trading algorithms make the decisions.
Rather odd was it that Cliff Asness was even being considered by the value-orientated Grant. Mixing fundamental orientated investment minds with quantitative traders is somewhat like using sexist 1980s college undertones when communicating on business television in 2014: it’s not pretty, but it makes for an entertaining spectacle. Such was the case with the Grant’s / Asness interview, if you knew what to look for.
Value investing is finding an undiscovered stock before others find it, trend following is finding the hot stock after it has been discovered and profiting from its growing popularity
Calling Asness a “money maker,” Grant struggled in understanding the core precept of a trend following strategy, something not all too uncommon from value investors who buy low and sell after success. Cliff Asness explained that he follows a “momentum” strategy that buys what has been going up and sells what has been going down. And here’s the kicker: it is all done based a mathematical formula. This statistically-driven strategy (buy high, sell higher) wins just over 50% of the time. The key to the strategy is not found in win percentage, but rather size of win, where trend following has statistically excelled. In 2008 managed futures was up near 20%, but many pure trend following strategies have struggled since.
Managed futures is considered a “skill” trading strategy because it identifies market environment and makes calculated bets regarding the future direction. The term “skill” strategies should be highlighted here because today’s much discussed High Frequency Trading “strategies” are algorithmic, but not necessarily “skill” based. With many of these firms exhibiting a win percentage near 99% and a significant win size, today’s “HFT,” as it is known, is based on receiving information milliseconds faster than the general public and then frontrunning orders with a technical speed advantage. This is not “skill,” it is about the right connections – both technical and otherwise – and knowledge of how to game the system. This is the shark tank value investor Grant was entering.
After getting over the hurdle of a mathematical formula making decisions to buy high and sell higher, Grant moved into interesting and familiar an area quantitative traders such as Cliff Asness are known to eschew in their decision making: fundamental analysis.
Is there a bubble today?
Jim Grant asked “Is there a bubble today?” Grant has traditionally made this case, but Cliff Asness wasn’t entirely playing along. Asness said that, by his strict definition, a bubble was something where there was no chance of working out of the problem. Cliff Asness noted there is a difference between a bubble, which you can’t escape, and a bad bet. The market might only have a 20% chance of escaping the Fed induced quantitative easing cliff upon which it is headed, for instance, but that’s not a bubble. It might be a bad bet, but not a bubble.
Then the conversation moved on to another hot topic. When considering efficient market theory, Cliff Asness addressed the popular notion that the government somehow “has investors back.” They don’t have our back, Cliff Asness said, pointing out the most horrific example of improper risk disclosure being made today. For the government or US Fed to imply they have investors back is like guaranteeing success in making investments — not a good idea, in fact a topic that can get those in the financial service sector in trouble.
Believe it or not, markets are still bigger than US government institutional meddling. It’s just a matter of when they exert their power again.