Firearms Versus Bow and Arrows

“Every stock market system with an edge is necessarily limited in the amount of money it can use and still produce extra returns.” – Ed Thorp

In the decade after Ed thorp launched Princeton Newport Partners, the fund gained 409%, annualizing at 17.7% before fees and 14.1% after. Not bad for a market neutral portfolio. Over the same period, the S&P 500 annualized at just 4.6%, including dividends. When Thorp was running his strategy, his competition was, well, there really wasn’t any. He described what he was doing as “like firearms versus bows and arrows.”

The models his computers ran were so far ahead of their time that in his twenty years at the helm, they didn’t have a single losing quarter. Well, that could have just been luck right? Wrong. Here’s a simple way to separate luck from skill: If each of the 7.2 billion people on the planet flipped a coin, we should expect one lucky person would land on the same side of the coin 33 times. Flipping a coin 80 times and landing on the same side every time, the odds of that happening are 0.000000000000000000000082718%, one in I literally don’t even know how to calculate this. Jack Schwager once said of Thorp’s remarkable performance: “the odds of his track record being luck are one million times less than the odds of picking a random atom in the entire mass of the earth, and then picking that same atom a second time.”

Thorp shutdown PNP in 1988, but formed another partnership four years later, which he would operate for a decade. In his last year, 2002, he paid his brokers $14.3 million. Their average trade size was $54,000 and they were placing a million bets a year, or one every six seconds. He said, “Returns, although respectable, had declined in 2001 and 2002. I believed this was due to the huge growth in hedge fund assets, with a corresponding expansion of statistical arbitrage programs.”

Thorp, author of Beat the Dealer and later Beat the Market, only placed a wager or made a trade when he felt, no, knew, that the odds were in his favor. “The surest way to get rich is to play only those gambling games or make those investments where I have an edge.” He was deeply realistic about how competition eroded profits and was a fan of Benoit Mandelbrot who once said, “Winning strategies tend to have a brief half-life.” His success attracted a lot of competition. He was the first limited partner in Ken Griffin’s Citadel, and passed on seeding David Shaw, because their strategies were so similar.

When the godfather of quantitative investing hung up his cleats for good, hedge funds were still a relatively small corner of the market. For all the talk of CalPERS and Harvard and investor redemptions, a recent CNBC article states that hedge funds just passed $3 trillion in assets for the first time ever, a 25 fold increase since 1997.

Three trillion dollars. That’s Such a crazy large number that it’s hard to comprehend exactly what that even means. Here’s an easy way to think about it; One trillion is a billion, one thousand times. So there are the equivalent of 3,000 different billion dollar hedge funds.

Here’s another “wow that’s a lot of freakn money”- $3,000,000,000,000 is twice as the big as the market cap of every energy stock in the S&P 500.


Since 2007, $1.5 trillion has gone into index funds and over the same time,  8,912 hedge funds have been liquidated and 10,199 new funds were launched. The drumbeat of peak hedge funds and peak indexing, two things that can’t simultaneously be true, is getting louder every day. I actually believe that this conversation will continue for the rest of my investing career. Here’s why:

There are a lot of very wealthy people in this country; 145,000 U.S. households are worth more than $25 million. Wealthy people don’t want to be average. They expect to pay for and receive the best.

As of 2015, the 100th largest college endowment had $813 million in assets and the median endowment was $59 million. Not all of these assets will be happy with market returns. Many will pay for the opportunity to do better than an index. Others will pay for strategies that aim for lower but steadier returns, regardless of market direction.

At 20 basis points, on average, Vanguard’s clients pay $6 billion in fees. At 2%, hedge fund clients pay $60 billion in fees. Ed Thorp estimates that 20 percent of profits adds another $50 billion in fees. That seems high, but let’s say that just 1% of the $3T captures a 20% performance fee, that alone is equal to the $6 billion in total that Vanguard clients pay. Jack Bogle called this arithmetic, not calculus and he’s right, there is virtually no mathematical way that the hedge fund industry can do better than index funds over time. But is this even a worthwhile comparison? Should the “hedge fund industry” be bench marked to stock market beta? I mean, yea, if they’re running a long only equity strategy, fine. But what does market neutral, stat arb and commodities have to do with the S&P 500?.

I understand and even think it makes good sense that institutions and wealthy people should diversify across not just asset classes, but across strategies as well. What they probably should change is the way they think about hedge funds. Firing a market neutral manager after a 290% advance in stocks seems like a foolish thing to do. If 90% of your money is in traditional risk assets, view the 10% in alternatives as insurance, as something which you expect to be a cost most years. But make sure that you or your committee deeply understands the strategy, so that you’re not constantly assessing their viability every quarter.

Bottom line for most investors: There are too many hedge funds and the fees are still too high, rendering the pursuit of alpha as a mostly a useless exercise. Last year Morgan Housel observed that hedge funds outnumber Taco Bells (1.6:1). This is insane. Most of these managers don’t have an edge. They can’t consistently know more than the person on the other side of the trade. Take it from Ed Thorp, who literally invented this stuff.


A Man For All Markets

“You need to know enough to make a convincing, reasoned case for why your proposed investment is better than standard passive investments such as stock or bond index funds. Using this test, it is likely you will rarely find investments that qualify as superior to the indexes.”

“Most market participants have no demonstrable advantage. For them, just as the cards in blackjack or the numbers at roulette seem to appear at random, the market appears to be completely efficient.”

“Whether or not you try to beat the market, you can do better by properly managing your wealth.”

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