Moneyball For Hedge Funds

By Rob McCreary

Business and sports understand the importance of a scorecard. But what if CEOs only got the final earnings number, or if Jordan Speith’s only input for improving his game was his 18-hole score instead of fairways hit, greens in regulation, sand saves and putts? Similarly, what if Mookie Betts only input was his final batting average or Corey Kluber only knew his year end ERA?

You Can’t Improve Something You Can’t Measure

Most sports and most businesses understand you cannot improve without measuring each aspect of performance. In business we look at a balance sheet, an income statement and a cash flow statement to give us different views of overall performance. In baseball hitters and pitchers have coaches, sabermetrics, video, and heat maps to help players understand strengths and weaknesses- both their own and their opponents.

It has even come to a point where three Major League hitting coaches for the Cardinals, Pirates and Mets have no pro baseball experience at all, but they are really good at data.

In this era of data analytics how can there be a multi trillion-dollar industry that mostly looks at results and, to my knowledge, only recently started looking at the behavioral tendencies of its best players? It is like telling Jordan Spieth he has moved from #1 in golf to #40 without menti-ning it might be his putting. More importantly, wouldn’t that industry be a target rich environment for the right set of coaches?

Zero Alpha For The Last Ten Years!!!

That industry is  hedge funds and notwithstanding endless data on buying, selling and sizing trades for each manager and each trade there has been little analysis of behavioral tendencies that add or subtract from manager ALPHA- their demonstrable outperformance against an index. In “Managing Equity Portfolios” Michael Ervolini, founder of Cabot Research describes how his firm marries data analytics based on proprietary software to the behavioral tendencies of the best investment managers. He has discovered pros underperform just like the rest of us because of the way our brains are wired to override even the most disciplined approaches to investing:

  • Regret Aversion-initial sizing is small and manager won’t add
  • Endowment Effect- overvaluing stocks we own
  • Risk Aversion- harvesting gains too early
  • Loss Aversion- hold losers too long
  • Avoidance of Pain- selling temporary losers that later bounce back

These days the active managers need some Alpha or to use Austin Powers characterization they need to get their” Mojo” back.” Here is a look at the hedge fund’s Alpha by decade. Notice the most recent 10 years circled in red show ZERO ALPHA:

Cabot has targeted the high end managers for its data analytics and Ervolini’s sales pitch is compelling. How would you like to improve your batting average by 20% or your greens in regulation by 15%?  How about increasing a 7% investment return by 100-200BPS?

Bottom line book review- this is Kahneman & Tversky meets Billy Beane for the hedge fund industry. The book is an excellent read for any serous investor. What shocks me, however, is why active managers are among the last athletes on the planet to get help- after all they are managing almost $1.4 Trillion of our money.

An even more important question to ask Mr. Ervolini is whether computers can be programmed to avoid behavioral tendencies that subtract from manager ALPHA? If algorithmic trading can consistently avoid all the human frailties like “endowment effect” and” loss aversion” maybe the hedge fund industry will continue to experience drawdowns?

Rob McCrearyMoneyball For Hedge Funds

Comments

  1. P.W. Adams

    Rob– You continue to cause profound introspection and useful team analysis.

  2. Nick howley

    I assume the returns are net of fees ? I think it is a VERY unusual hedge fund that ., over any extended time , can beat the index by enough to cover their fees . On the upswing they will often beat a bit because in my view they leverage the rising market more than they tell and of course then give that back on the downturn.

    Just arent worth the fees

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