Hedge-Fund ro­bots and dis­gusted CEOs

The Pak Banker - - OPINION - Matt Levine

IFEEL like there were maybe a cou­ple of decades when "al­pha" and "beta" were use­ful terms for talk­ing about in­vest­ing per­for­mance, but now we are reach­ing the end of that golden age:

"We are now re­al­is­ing that a lot of what we thought was al­pha is ac­tu­ally an al­ter­na­tive form of beta," says Yazann Rom­ahi, the head of JPMor­gan As­set Man­age­ment's quan­ti­ta­tive in­vest­ment arm. "This will trans­form the hedge fund in­dus­try."

"The ba­sic re­turn of a mar­ket is known as 'beta' in fi­nan­cial jar­gon," writes Wig­glesworth, but ob­vi­ously that can't quite be the sense in which Rom­ahi is us­ing the word. The mod­ern sense is that "beta" is any­thing a com­puter can get you, while "al­pha" is any­thing it can't. (More for­mally "beta" is the set of co­ef­fi­cients of what­ever re­gres­sion you hap­pen to like to de­scribe the con­nec­tion be­tween risk fac­tors and re­turns, while "al­pha" is the residue; as you find more fac­tors to shove into your re­gres­sion, more of the world be­comes ex­plain­able by those fac­tors, and the residue gets smaller and smaller.) You can have high­risk strate­gies and low-risk strate­gies and high­per­form­ing strate­gies and dumpy low-per­form­ing strate­gies and they can all be "beta." For a hedge-fund man­ager to set her­self a goal of gen­er­at­ing "al­pha" now seems pos­i­tively quaint. (Sim­i­larly, crit­i­ciz­ing hedge-fund man­agers for not achiev­ing "al­pha," as mea­sured against some risk-fac­tor model de­signed to repli­cate hedge-fund strate­gies and min­i­mize residues, seems a bit un­fair.)

Any­way one hedge-fund strat­egy that seems to have been solved is merg­ers-an­dac­qui­si­tions ar­bi­trage: For in­stance, Yin Luo, the chief quant at Deutsche Bank, says the sin­gle big­gest de­ter­mi­nant of whether a deal com­pleted is its age. In other words, the longer it drags on the less likely it is to go through. But he has iden­ti­fied a mul­ti­tude of fac­tors that af­fect the M&A strat­egy's suc­cess rate, us­ing the same sta­tis­ti­cal tech­niques that doc­tors use to de­ter­mine how long a can­cer pa­tient has to live. As is of­ten the case with quants, they are con­fi­dent that their math­e­mat­i­cal ap­proach pro­duces bet­ter re­sults than hu­man in­tu­ition. The tra­di­tional M&A ar­bi­trageurs are "good but of­ten not very ac­cu­rate. Our model has ac­tu­ally proven more ac­cu­rate than the ar­bi­trage funds", Mr Luo says.

The coun­ter­ar­gu­ment is of course that th­ese mod­els are based on his­tor­i­cal re­gres­sions, and if the re­la­tion­ships change in the fu­ture, the hedge-fund-repli­cat­ing strate­gies will break down. "They all fail mis­er­ably when the mar­ket regime shifts," says a fundof-funds in­vestor and quan­ti­ta­tive fi­nance pro­fes­sor. This coun­ter­ar­gu­ment would have more force if there was a lot of ev­i­dence that, as his­tor­i­cal re­la­tion­ships change, non-quan­ti­ta­tive hu­man hedge fund man­agers are par­tic­u­larly good at chang­ing their strate­gies. But it seems like lots of peo­ple also man­age to fail mis­er­ably when the mar­ket regime shifts.

One thing that we some­times talk about around here -- yes­ter­day, for in­stance -- is the no­tion that in­vestors who meet with a com­pany's ex­ec­u­tives can gain in­sight into the com­pany's fu­ture per­for­mance by in­ter­pret­ing the ex­ec­u­tives' "body lan­guage." I al­ways sort of half-think that "body lan­guage" is a eu­phemism for, like, the ex­ec­u­tives just tell the in­vestors what the next quar­ter's mar­gins will be or what- ever. But, no, ap­par­ently "body lan­guage" is a real thing and even com­put­ers can no­tice it:

James Ci­con thinks they can. A fi­nance pro­fes­sor at Univer­sity of Cen­tral Mis­souri, Ci­con built soft­ware that an­a­lyzed video of the faces of For­tune 500 ex­ec­u­tives for signs of emo­tions like fear, anger, dis­gust, and sur­prise. The emo­tions, he found, cor­re­lated with profit mar­gins, re­turns on as­sets, stock price moves, and other mea­sures of per­for­mance at the as­so­ci­ated com­pa­nies.

Al­though fear, anger, and dis­gust are neg­a­tive emo­tions, Dr. Ci­con found they cor­re­lated pos­i­tively with fi­nan­cial per­for­mance. CEOs whose faces dur­ing a me­dia in­ter­view showed dis­gust-as ev­i­denced by low­ered eye­brows and eyes, and a closed, pursed mouth-were as­so­ci­ated with a 9.3% boost in over­all prof­its in the fol­low­ing quar­ter. CEOs who ex­pressed fear­raised eye­brows, widened eyes and mouth, and lips pulled in at the cor­ners-saw their com­pa­nies' stock rise .4% in the fol­low­ing week. Dr. Ci­con pointed to psy­cho­log­i­cal re­search to ex­plain why in­vestors in­ter­preted neg­a­tive emo­tions as a sign of pos­i­tive move­ment in share price. "Fear is widely rec­og­nized as a pow­er­ful mo­ti­va­tor. Thus it is not sur­pris­ing to find that a CEO who ap­pears fear­ful un­der in­ter­ro­ga­tion is per­ceived by the mar­ket as a CEO who will work harder to in­crease firm value," said the pa­per, which was co-au­thored by Steve Fer­ris of the Univer­sity of Cen­tral Mis­souri and Ali Akansu and Yan­jia Sun of New Jersey In­sti­tute of Tech­nol­ogy.

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