I recently came across a YouTube video that compiled rules that Peter Thiel believes lead to business success. For those who don’t know, Peter Thiel is a cofounder of PayPal, a venture capitalist who invested in Facebook in its early stages, and is currently worth in excess of $2 billion. I find his contrarian points of view fascinating and very much in line with Greyfeather’s innovative technological approach to investment management. In a series of three blog entries, I would like examine Peter Thiel’s rules in the context of investment management.
Trends are overrated
“All trends are overrated. If you think about current trends in technology: health care IT software, education software – overrated; SAS enterprise software – really overrated; big data, cloud computing – if you hear those words, you need to think fraud, you need to run away as fast as you possibly can… These buzz words are sort of like a tell in poker that people are bluffing and that the business is undifferentiated… The buzz words tell you that it is one company of a category that is undifferentiated from the others in that category that are symptomatic somehow of a lot of competition and a bad business idea.” ~ Peter Thiel
It is useful to think of investment management as consisting of two components: where alpha is found and how alpha is extracted.
Let’s start with where alpha is found. This is the search for market inefficiencies that hedge fund managers exploit in order to achieve excess returns. The most common examples are value investing, finding companies for which the company’s intrinsic value exceeds its market cap and buying its stock, and momentum investing, which seeks to capitalize on continuing trends in a security’s price movements.
Are these the trends to which Peter Thiel objects? Certainly not. These market inefficiencies are well established and the basis of many successful strategies. The only problem with relying on these sources of alpha (and other established market inefficiencies) is that they are limiting… rarely is new ground broken. That’s a big part of the reason that Greyfeather’s deep neural networks (DNNs) are so important. A DNN is a unique type of artificial intelligence that is able to study market data and finds inefficiencies for itself. Will it pick up on value and momentum properties that are predictive of future stock performance? Of course. But it won’t stop there. The DNNs will also find and exploit inefficiencies not widely known, giving it a distinct edge on its human competitors.
Let’s move on to how alpha is exploited. For many years, alpha was extracted on a purely discretionary basis. When to enter or exit a position and the size of the position was left to the trader’s intuition. Needless to say this approach led to inconsistencies in execution. And so the quantitative trader was born! The quant was still identifying market inefficiencies for himself, but meticulously defined the rules of executing his strategy such that those rules could be turned into computer algorithms that would execute without human inconsistency. Quants were desperate to keep their now computerized systems secret, leading the industry to coin the term black box. A black box is a generic name given to a quant fund’s trading algorithms. From the outsider’s perspective, certain data goes into the black box, securities positions come out, and no one knows what happens in between. Of course, the fund’s strategists and computer programmers know. What goes on in the black box is very precise, very orderly, and yet very ordinary. A black box can execute according to the rules with which it is programmed, but cannot think or learn for itself.
Are quant strategy and black box buzz words that Peter Thiel says should cause us to run the other way? Absolutely! These words indicate that a fund is just one in a category, meaning the fund has endless competition and is not truly innovative.
There is nothing more irritating to us than when Greyfeather is (inaccurately) described using these buzz words.
Greyfeather uses a very specific technology not being widely applied to investment management. Greyfeather is not a quant fund, but is rather an artificial intelligence based fund. We don’t have a mysterious black box, but rather DNNs that learn from market data and exploit inefficiencies unknown to much of the competition.
Don’t dwell on the past
“I don’t think there’s much you can learn from failure… It’s typically over determinant… Why did you fail? It’s typically five separate reasons: (1) you worked with the wrong people, (2) the idea was bad, (3) timing was wrong, (4) there wasn’t a monopoly, (5) the product didn’t work. OK! Next time I’m working with different people – you are likely to fail again… Failure is not something we can learn very much from – I think that’s a myth I would challenge. What I think you should do when something goes badly wrong - you just keep going, you do something else, and you don’t dwell on the past.” ~ Peter Thiel
By April 2016, 85% of hedge funds were below their high water marks. By the end of 2016 the hedge fund industry had seen four straight quarters of net investor withdrawals. Warren Buffett believes that investors should avoid hedge funds altogether because, on average, their returns do not justify their high fees. The established business model for hedge funds is clearly broken.
But how are investors, who are seeking superior capital appreciation with protection from downside volatility, responding to these disappointing results? The approach had been – let’s find the smartest people with the most elite hedge fund experience and the best track records.
On average, that hasn’t worked. Yet it seems that is the approach most investors are comfortable with.
It is time to try something else. Investors are typically so focused on the past – the investment management industry as it currently exists – that they are reluctant to try something new.
You are the entrepreneur of your life
“You are the entrepreneur of your life. You can decide what you’re going to do, what you’re going to prioritize… You can start anytime you want.” ~ Peter Thiel
We at Greyfeather Capital have a difficult task: to get hedge fund allocators to start looking for alpha the way successful venture capitalists look for the next great business – through genuine innovation and, specifically, through cutting-edge technological advancement.
The hedge fund space is crowded. It is crowded with discretionary traders who think they understand how markets work. It is crowded with quant traders who think they understand how markets work and use computer code to execute their vision. It is not, however, crowded with technologists.
Former Fed chairman Paul Volcker recently said that the ATM was the only financial innovation he can think of that has improved society. Wow! Talk about an indictment. Yet a status quo mentality seems ingrained in most investors. They look at the investment landscape as it currently stands, find the strongest competitors within the game, and send them their money. Reasonable – but recent hedge fund performance indicates that it hasn't worked that well.
Investors should remember that it is never too late to move forward with high tech innovation rather than the inertia of the status quo.
Here is a link to the video