The universe of hedge funds - Column

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I am not very good at putting. In truth, I am hopeless at putting, and so it's not surprising I should read Dave Pelz's Putting Bible, a 394-page book by Dave Pelz on putting.
I am not very good at putting. In truth, I am hopeless at putting, and so it's not surprising I should read Dave Pelz's Putting Bible, a 394-page book by Dave Pelz on putting.

Whether it helps me or not is yet to be seen, but Pelz provides a good description of why learning to putt well is difficult. He says that to learn from your mistakes requires immediate, accurate and reliable feedback. Golfers don't always get this and hence develop habits and behaviours that often make them less likely rather than more likely to sink their putts.

He quotes a story from one of his students. Scientists were studying how pigeons learn to feed themselves from pellet dispensers. In one cage of pigeons, several pellet dispensers released one pellet every time a pigeon stepped on a release lever. Within two days every pigeon in the cage had learned how to feed itself: hit the lever and get a pellet.

In a second cage of pigeons there was the same number of pellet dispensers. However, these dispensers worked differently. Sometimes they released a pellet when the lever was touched. However, sometimes when the lever was touched nothing would happen and sometimes they released pellets randomly. In time, some of the pigeons thought when they chirped a pellet was released, some pigeons thought it was when they lifted their wing, while others thought it was when they turned around in a circle. In two months none of the pigeons had learned to feed themselves and it was amusing to watch their strange behaviour, hoping to get a pellet.

Investment management has a similar feedback mechanism to the second cage of pigeons. Outcomes are significantly affected by random events and hence do not always provide reliable feedback. Claims of investors, investment managers and the media all add to the noise. What are the investment management behaviours equivalent to chirping, lifting a wing and turning a full circle?

The first and potentially most dangerous behaviour is to invest according to past performance. There is evidence individuals tend to purchase more growth assets after market upswings and avoid them after downturns, causing the average equity fund investor to earn less than the average equity fund.

If this strategy is dangerous, reversing the strategy might seem sensible. Investing in companies whose market values have recently fallen and selling those whose market values have risen will outperform if market value changes tend to reverse in subsequent periods. The danger is that companies whose market values have recently fallen will fail rather than recover, and this is more likely to happen if general economic conditions deteriorate. The best strategy is to focus on future performance from the start.

Another dangerous behaviour is mistaking market performance for stock selection skills, or, as the saying goes, "confusing brains with a bull market". Australian equities (the S&P/ASX300) have returned 21.7 per cent, 26 per cent and 24 per cent in the past three years to June 2006, adding more than 90 per cent since July 2003. Investors in small cap stocks have done even better and geared investors with, say, $100,000 plus borrowings of another $200,000 would have more than tripled their initial investment, even after borrowing costs. In this environment, it is easy for investors to delude themselves into thinking they have good stock selection skills. Most of their stock selections have turned to gold and this looks like an easy way to make money.

While total performance is what matters to investors, just like the total score matters to golfers, good stock selection skills imply an ability to consistently earn higher returns than those available from the overall market. Calculating performance relative to the market is a much more reliable feedback measure of stock selection skill than is total return.

Lastly, many investors are overconfident of their tactical timing abilities. Tactical tilts can include moving from cash to equities, altering the currency hedge on overseas assets or moving from bonds to cash when interest rates appear likely to rise.

Peaks and troughs such as the collapse of US tech stocks in 2000, the Japanese equity market reversal in 1990, and the Australian dollar appreciation after reaching a low US$0.49 in September 2001, always look more obvious in hindsight. Identifying these before the fact is much harder. New information can change the outcomes and timing is difficult to get right. Currently, there are claims oil prices will reach $100 a barrel, $50 a barrel or both. It's going to be obvious when it happens.

Investors developing their investment strategies, golfers trying new putting techniques and the pigeons learning to feed themselves in the second cage all face unreliable feedback. Distinguishing between valid signals and random noise is harder than it appears.

Here's hoping that understanding this will improve my putting. Good luck to you on investment strategy. The pigeons are on their own.


The universe of hedge funds - Column
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