In January 2007, six months before the introduction of the iPhone, Steve Jobs said: “Every once in a while a revolutionary product comes along that changes everything.” There is little doubt the impact the smartphone has had on society, politics and business. It has also had an impact on alpha. You can see it in the historical returns of hedge funds since that day or through the rapid AUM growth in the quantitative and commoditized beta space. Each year that has passed since the launch of the iPhone, the barriers to entry for algorithmic-driven strategies have decreased, leading to increased competition for fundamental alpha from machines.
As in all industries, more competition from computers has led to fewer inefficiencies. For investors, this competition has resulted in a world with a scarcity of GARP (growth at a reasonable price) and an abundance of GAUP (growth at an unreasonable price). Hedge funds had another difficult year in 2018. Discretionary hedge funds had a tough time but so did many of the quantitative and commoditized beta funds. This leaves everyone now asking: Where is the alpha going forward?
I see a critical need for what we call behavioral alpha, a trading and investing methodology for a more uncertain environment that requires faster decision-making and other important adaptions, including patience and leveraging deeper emotional intelligence.
Making smart use of behavioral alpha
Due to the rise of populism around the world and intellectual property battles between China and the U.S. that have fractured trust between the two economic powers, we are seeing an unwinding of globalization. The majority of the quantitative money managed today is dependent on the past to be predictive of the future. With this unwinding of globalization, the historical data will cause a garbage in, garbage out result. Managers will need to be more predictive in their approach.
For this reason, over the next few years more and more news stories will be about funds that are focused on “man plus machine,” rather than “man versus machine.” Computers will always be more efficient than humans in certain aspects of investing and portfolio management, but humans still have the advantage in making predictive decisions — particularly when the world is less certain.
As China and the US force the global supply chain to adjust to the new world, there will be more volatility, more dispersion oscillation and more risk to companies with the wrong capital structures — in a landscape characterized by much less liquidity. To survive in this uncertain environment, successful investors must be emotionally intelligent liquidity providers in order to take advantage of the behavioral alpha opportunity this environment will provide.
This opportunity exists because most investors and quant strategies are momentum based or liquidity takers. Behavioral alpha combines a Bayesian approach of risk-reward with a Buddhist philosophy of mindfulness and awareness. Unlike fundamental alpha, behavioral alpha demands more and quicker decisions. It focuses on sizing, speed of entry and exit, folding, patience, the willingness to be contrarian and the ability to admit when you are wrong. It involves being self-aware of any investment biases and remaining emotionally balanced. It is art, not science, in a world of investors who are schooled as scientists.
With behavioral alpha as their key methodology, the successful managers will develop, hire and measure the potential effectiveness of their talent based on three key criteria: How self-aware are they? How curious are they? How much are they driven to be accountable and take responsibility for their mistakes rather than blame others or exogenous forces?
If behavioral alpha sounds tiring, it is — which is why many are struggling with it. Riding trends and cycles has been much easier. Humans and computers both like to extrapolate past trends into the future; but now more than ever, this relationship between man and machine will be necessary to navigate waters that are much less certain. As Daniel Kahneman wrote in Thinking, Fast and Slow: “The idea that the future is unpredictable is undermined every day by the ease with which the past is explained.” The human brain loves certainty, and computers use the past to predict the future. But those who don’t adapt to this new normal and incorporate the tenants of behavioral alpha risk the consequences.