The Lucky and the Skillful, The Contrarian and the Reckless

A few days ago, I wrote a post entitled "The Sociology of Quant Investing - Is There A Moneyball for PMs?", as I pondered the luck vs. skill debate. Today, there's an excellent article from aiCIO which tries to answer that question. Naturally, this sentence caught my eye: "Stan Altshuller intends to be the Billy Beane of hedge funds." Having read the description of Altshuller's process, I salute his intention, but I don't really understand how or if the process works. Presumably he doesn't want to share proprietary details. Kenneth French, appears to be skeptical of a quantitative approach: “Either before or after the fact, it’s an extremely difficult statistical problem." "If you insist on hiring an active manager,” he says, “at least get someone cheap.”

This makes excellent sense. Unfortunately, manager selection (or asset allocation) doesn't always appear to be sensible. There are two main reasons for this. First, the clear difficulty of quantifying manager skills leads some to lean on reputation. Better, as Keynes says, to fail conventionally than to succeed unconventionally. Second, asset allocation, for some, takes on the form of conspicuous consumption, i.e. the spending of money on and the acquiring of luxury goods and services to publicly display economic power. If you invested in Paulson pre-2008, not only did you make a lot of money, you probably got a frisson of excitement from sharing that fact at a bar (or a cocktail party - I guess Paulson investors don't go to bars the way I do.) 

What's needed is a theory of deviance in investing. To succeed spectacularly, one must be unconventional, and therefore be deviant. The folks at aiCIO seem to agree: "According to
Martijn Cremers, a finance professor at the University of Notre Dame, a measurement of active share—the portion of a portfolio that’s unique from the benchmark—can help further differentiate competence from chance. “Active share ignores returns completely,” Cremers says. “It only looks at holdings and can serve as a complementary measure to tracking error volatility.” The concept derives from the basic premise that a fund can only outperform a benchmark if it’s different, and quantifies the proportion of the portfolio skill that is actually applied and contributes to said outperformance." 

Of course, just because deviance is a prerequisite for success does not mean that all deviants will succeed. Some ideas are stupid for a reason, and some mavericks will blow their funds up. It seems to me that the tools for separating the lucky from the skillful, and the contrarian from the reckless, still have a long way to go.