Benn Eifert, managing partner of San Francisco hedge fund QVR Advisors, has published a guest post on Noah Smith’s Substack site, “On bullshit in investing”. There is a great deal of timeless wisdom in this short piece.
[A]s Warren Buffett once said, “Only when the tide goes out do you discover who’s been swimming naked.”
The recent sell-offs in equity markets and the crypto sector have revealed a lot of naked former “investment geniuses”. Eifert notes:
The investing industry is ridden with bullshit. The most common and insidious form is over-optimism: offers of tantalizing risk/reward that defy any notion of reality, often based on misinformation or deception. Less common but even more dangerous are outright frauds.
The problem is inherent to the product. Most consumer goods – apples, hotel rooms, laptop computers – are tangible objects or services that you can see, taste, feel, or experience, so you can judge how much they are worth to you. Investments represent claims about some future probability distribution of monetary outcomes which are not literally verifiable. The best an investor can do is form a reasonable judgment about the uncertainty around those claims, based on historical evidence and details about the mechanics of how those claimed outcomes are generated.
The packages can be familiar, fresh, or exclusive. Highly speculative futuristic investments are wrapped in ETFs or SPACs. Ponzi schemes are dressed up as sophisticated options strategies (Madoff) or technological revolution (Terra/Luna). Sophisticated institutional hedge funds masquerade as arbitrage when they simply sell catastrophe insurance. Both retail and institutional investors are targets.
He cites some notable examples.
However, this inherently ambiguous futurism also lends itself to bad behavior. For example, mutual fund manager Cathie Wood claimed that ARKK’s research showed imminent breakthroughs in artificial general intelligence could accelerate GDP growth from 3-5% per year to 30-50% per year. This is preposterous; the fastest sustained economic growth rates in any country in history are closer to 10%, or close to half that for advanced industrialized nations. Meanwhile, she projected compound rates of return over 50% for her portfolio of popular speculative technology companies, presumably in part based on research like that AGI bit. For a five-year period this implies a 7.6x gain, wildly implausible on an ex-ante basis. This is an example of wild over-optimism and misleading or deceptive investor information. Her mutual funds have generated hundreds of millions of dollars of risk-free fee income for herself while destroying billions of dollars of investor capital in abysmal dollar-weighted returns. Meanwhile, investor inflows into ARKK have continued at a rapid pace.
The Allianz Structured Alpha funds managed tens of billions of dollars of money on behalf of conservative pension funds and foundations. They ran a complicated option-selling investment strategy purported to produce equity-like returns with low risk, hedged against a market crash. The strategy generated considerably higher total returns than any comparable limited-loss option selling strategy like the CBOE CNDR Index. It turned out they were using leverage and simply lying about buying insurance against a market crash while providing doctored risk reports to investors and management. The fuse was lit. They blew up spectacularly in March 2020. The key warning was a complex strategy delivering much better results than reasonably expected based on its description, without performance attribution data that could possibly have been reconciled. The most unsettling part of this horror story was how such a large scale deception could occur under the nose of trusted brand-name asset management firms.