Felix Salmon

Back in October, Andy Zaky put out his sixth “buy” recommendation on Apple stock. The first five — in July 2006, November 2008, August 2010, June 2011, and May 2012 — all did spectacularly well, and all hit his price target within the time span he specified. Zaky was a first-rate Apple analyst, quoted by me and many, many others; as Philip Elmer-DeWitt says, he had “a series of spot-on predictions”, of everything from Apple’s earnings, to its iPhone sales, to — of course, its stock-price movements.

Smart and accurate Apple analysts are in high demand, and Zaky, quite sensibly, decided to monetize his gift. In June 2011 he put his blog behind a paywall, charging first $49 per month and then, in June 2012, $200 per month. With 700 subscribers, that meant a six-figure income per month, just by selling access to his detailed Apple analysis and trading recommendations.

Unlike most analysts, however, Zaky soon discovered* that his subscribers actually followed his recommendations — to the letter, in many cases. They weren’t using his analysis to inform their own decisions, they were outsourcing all of their decision-making to Zaky, simply placing the trades themselves. And so Zaky made a fateful decision: in that case, he might as well start his own hedge fund.

Bullish Cross Asset Management was launched in late 2011, and by November 2012 some 28 investors had invested a total of $10,607,815 with Zaky. And had lost it all. For Zaky, it turns out, was a truly dreadful fund manager: the kind of guy who not only put all his eggs in one basket, but the kind of guy who would also desperately double down upon incurring trading losses. With that kind of a trading strategy, even someone who’s right 85% of the time is going to blow up pretty quickly.

Zaky of course feels bad about this, and says he wants to make his partners whole, and “make things right”. But that would involve investing money, and investing money is clearly something Zaky is incredibly bad at. It’s easy and facile to sneer at analysts, saying that if they were actually any good at their jobs, they’d be making ten or a hundred times as much money by actually investing, instead of just putting out recommendations. But the fact is that analysis and investing are two very different skillsets, and while Zaky was very good at the former, he was very bad at the latter.

There’s no particular shame in that; sometimes you only learn your limitations by trying and failing. But the most astonishing part of the Andy Zaky story is not that he set up a tiny hedge fund which failed. Rather, it’s the lemming-like way in which the subscribers to his newsletter lost a mind-boggling sum of money — quite possibly well over $1 billion.

Elmer-DeWitt has heard from 36 former subscribers to Zaky’s newsletter; between them, they lost a whopping $92.5 million. Just one of them claims to have lost $50 million, or five times the total assets of Zaky’s hedge fund. If you ignore that one outlier, the rest of the subscribers have still lost an average of $1.2 million apiece — vastly more than the $380,000 or so invested by the average partner in Zaky’s hedge fund. And if you include the $50 million outlier, then the average loss rises to $2.6 million. Multiply either number by 700 subscribers, and it’s easy to see how total losses could reach the billion-dollar mark.

Reading Elmer-DeWitt’s original story, it’s clear that many of those investors were incredibly unsophisticated. And probably their self-reported loss estimates should be taken with a pinch of salt: they’re probably calculating their losses from their mark-to-market high point, rather than from the amount of cash they invested into trading Zaky’s recommendations. Still, this story is clear proof, in case any were needed, that you don’t need to qualify as a sophisticated or wealthy investor in order to engage in ridiculously risky trading strategies.

The Zaky story is depressing for another reason, too. The subtitle of his blog is “The Power of Compounded Returns in Holistic Quantitative Modeling” — it looks impressive, but it’s ultimately meaningless, and it naturally appeals to the ignorant. It can’t have taken Zaky very long to work out, on a subconscious if not a conscious level, that the best way to develop a reputation, and to build up his subscriber base, was to be as aggressive as possible in his calls, and to try to maximize both returns and risk. No one was going to pay him $2,400 a year to outperform Apple stock a little bit: these people were greedy, and wanted to shoot the moon. As such, they only have themselves, rather than Zaky, to blame for their losses. In fact, by creating a strong incentive for Zaky to ramp up the risk quotient in his calls, they probably helped turn a first-rate analyst into a busted investor: Zaky’s behavior, in some sense, was his subscribers’ fault.

Zaky, it’s clear, had much more value to the world of investing when he didn’t have skin in the game than when he did. That might be hard for a former trader like Nassim Taleb to understand, but the fact is that investing creates all manner of psychological feedback loops, which have to be managed with discipline. If you can’t manage those feedback loops, you’ll blow up — but at the same time, absent those feedback loops, you can still be a very perspicacious analyst.

Why did people take money they couldn’t afford to lose, and invest it in high-risk options strategies playing a single stock? Why did one person invest 50 million dollars in such strategies? And why did any of them trust a kid with no investing track record? It seems incomprehensible to me. But as Larry Summers famously said, “there are idiots. Look around.” You think a billion dollars is a lot to lose on Apple stock? Well, Macau’s casinos took in $3.4 billion of gambling revenues just last month. There will always be gamblers, and gamblers will always lose money. But it’s easy to see why Apple’s executives have historically paid as little attention as possible to the antics of the stock market.

*Update: Mick Weinstein points me to an unbelievably hubristic Zaky post from October 2011, which helps explain why people were following him so slavishly. There’s a whole section called “Bullish Cross Model Portfolios: The Importance of following our Models to the Letter”:

We’ve repeatedly mentioned over and over again that closely following the various Apple-based model portfolios to the letter is very key. That when we make a decision with regards to these portfolios, that decision is very carefully calculated and delicately executed to contemplate nearly every scenario that the market can throw at us. If you decide to deviate from the model, you’re likely to run into problems…

I could put out 10,000 pages of material and that wouldn’t even come close to scratching the surface of what goes into my decision making process. There is no way for me to practically reduce all of my knowledge, experience or reasoning abilities to the written word…

It is completely unreasonable to expect me to reduce every single thought or reason behind every decision we make to the written word. No one could do that… There is so much in terms of experience that there is simply no practical way I can teach people everything.

The equity markets is very much as complicated as the human body and it would be like asking a physician to teach you to practice medicine in a few months. When we make a decision, we try to do the best we can to give the core reasons behind that decision. But you should understand right now that (1) there’s very little that is lost on me, (2) there’s very little that you’ve thought of that isn’t already on my mind.

For 95% of people, this kind of thing is a huge red flag, saying “stay well away from this guy”. But for the other 1%, it’s weirdly comforting.

Andrew Ross Sorkin and Jim Surowiecki both had lunch with Warren Buffett recently: with this book, unlike the last one, Buffett is taking an active role in the book tour. And he’s staying on-message. Here’s Surowiecki:

The investing world is dominated by a manic-depressive style, in which the average mutual fund turns over nearly its entire portfolio every year. Yet Buffett has prospered by ignoring all this. As an investor, he’s known for his patience—he says that he likes holding stocks “forever”—and he prefers a few big bets to an endless number of small ones. “If you go from flower to flower, you have to find a lot of flowers to make a lot of money,” he told me. “There aren’t that many great ideas out there.”

And here’s Sorkin:

Warren E. Buffett was sitting across from me over lunch at a private club in Midtown Manhattan last week, lamenting the current state of Wall Street, which promotes a trading culture over an investing culture and offers incentives for brokers and traders to generate fees and fast profits.

“The emphasis on trading has increased. Just look at the turnover in all of the stocks,” he said…

Mr. Buffett, 82, is famous for investing in companies that he sees as solid operations and essential to the economy, like railroads, utilities and financial companies, and holds his stakes for the long run.

The heart of this is unexceptional: as every personal-finance columnist will tell you, trading costs just eat into your returns, you will almost certainly buy and sell at the wrong time (since you can’t time the market), and a buy-and-hold strategy doesn’t just save you time but also saves you money.

But there’s also another implication here: that a disciplined, fundamentals-based buy-and-hold strategy can outperform all the whiz-kids. (Sorkin: “When I asked, for example, if there were any private equity investors that he admired, he flatly replied: “No.””)

I’d love this to be true, but at heart I’m deeply skeptical that any strategy can consistently outperform, over decades. Buffett famously avers a distaste for being judged on Berkshire Hathaway’s stock-market returns, preferring to use its book value as a measure, but the fact is that Berkshire has underperformed the S&P 500 for the past 1 year, 2 years, 3 years, and 5 years. At some point, Berkshire still outperforms, but I’m not sure where that point is: I’m having difficulty finding a suitable total-return index so that I can be sure that I’m including the effect of reinvesting the dividends which the S&P 500 pays out but Berkshire does not.

To put it another way, the Buffett legend rests in large part on the hypothetical returns that you would have received if you bought Berkshire Shares decades ago, which very few people actually did. Buffett is a hugely successful investor, and there are a handful of early investors whom he also made extremely wealthy. But even Buffett himself has been saying for years that his future returns won’t be as good as his past ones.

All strategies eventually run out of steam. Some have longer legs than others: the fundamentals-based investing philosophy of Buffett, which he inherited from Ben Graham, worked for decades, while the clever excess returns that academics find hidden in the market tend to disappear as soon as they’re published. And in the world of quantitative investing, even unpublished strategies have ever-shortening shelf-lives.

The same is true outside the investing world, too, as the Obama campaign discovered with its fundraising emails. A good one would work — and then it would stop working, and a new one would have to be used. Alexis Madrigal draws the obvious conclusion:

Any detailed social media primer I give you would be out of date by the time I could finish writing it. Any operational headline writing strategy would stop working if everyone used it. Everyone clamoring for your attention on the web is trying to strike that perfect mix of familiarity and novelty. And that means the content techniques that work are necessarily recursive. You change what people like by doing whatever you do. Which then requires that you do something else, which then changes their tastes again.

To generalize: anything which works will eventually stop working, and the less intuitive it is, the more quickly it will stop working. Buffett had a good run, but at this point there’s really zero reason to believe that his kind of fundamentals-based value investing still gives anybody an edge. (On the other hand, simply being Warren Buffett does confer an edge: he gets to see a lot of opportunities which are unavailable to anybody else.)

In turn, that means that even looking for an edge is nearly always an exercise in disappointment. Most people who aspire to outperforming the market won’t. Is there any good reason to believe that you’re in the minority of people who will? Not really. Buffett is in that minority, but to state the obvious, you are not Warren Buffett. He might be approachable and folksy, but beware anybody who makes it look easy. It’s not easy: it’s really hard. And even Warren Buffett can’t consistently outperform the market any more, despite the fact that he has access to hundreds of billions of dollars from Berkshire Hathaway’s policyholders, which he can invest in a tax-sheltered manner.

As I said last week, stock-market investing is at heart a modestly expensive upper-middle class men’s hobby. Buffett is idolized within those hobbyist circles, and by America more generally: he’s just as assiduous about massaging his public profile as he is about picking companies. And admiring Buffett is fine. The problems arise when people try to emulate him.

Would you like to take a free online university course which teaches you the basics of quantitative analysis and also helps you manage your money so that you get high returns with low risk? Of course you would. Let me introduce you to Computational Investing, Part I, taught by Tucker Balch, Ph.D., on the Coursera website.

Under “Recommended Background” we’re told that “the primary prerequisite is an excitement about the stock market”. And there are two recommendations under “Suggested Readings”, including All About Hedge Funds : The Easy Way to Get Started, by Robert Jaeger. (Apparently it “explains how any investor can take advantage of the high-potential returns of hedge funds while incorporating safeguards to limit their volatility and risk”.)

This is a genuine university course: it’s the same one that Balch teaches at Georgia Tech. And so you’d expect a few disclaimers, at least, along the lines of “this is an introductory course, it’ll help you understand a few concepts, and maybe be the first step on the road to becoming a quantitative analyst yourself one day, but please, kids, don’t try this at home”.

You might expect such a thing, but you’d be disappointed. Instead, you get the exact opposite. Check out Week 4 (you might have to register; it’s easy and free) and then “Lecture Video 1.2: Response to Questions from Students”. According to Balch, the “number one most popular question” he gets asked is “Do I use these techniques to manage my own funds?”. He responds as forthrightly as he can:

The answer is yes.

Balch continues:

I have a number of different investments that I use these approaches for. With regard to my company, Lucena Research, we manage a few small funds as a way to test our techniques and validate them. One of them in particular I’ll show you in just a moment.

It’s far from clear how a student who has merely taken an online course might ever hope to replicate the returns that Balch manages to generate at Lucena (“Hedge Fund Technology for the Strategic Investor”). But in any case Balch does share with us a Lucena portfolio which “was developed specifically to be low risk”. It looks like this:

I look at this and I immediately get suspicious: there’s something quite Madoff-like about the way in which Balch’s returns go steadily up and to the right regardless of what the stock market is doing. Here’s how Balch explains what’s going on in there:

This approach was developed specifically to be low risk. It includes a basket of less than 20 equities that are traded about every 2 weeks. It’s 2X leveraged, meaning that half of the money is borrowed investment.

So this approach is a 2X levered fund with less than 20 stocks? Sounds very risky to me. But Balch shows us the numbers to prove that it isn’t:

The first thing to note here is that although Balch told us he was going to show us one of the “small funds” that he uses “to test our techniques and validate them”, this does not look like a real-money fund. There’s no indication, for starters, of what the borrowing costs are: if the fund is indeed 2X leveraged, how much does it cost to borrow $10 million on an ongoing basis?

Maybe those numbers are somehow incorporated into the returns — but then there’s the very odd section on “Transaction Costs”. The commissions bit makes sense: if you trade 10 times a week on average for 20 months, then that’s about 860 trades in all, and the commissions add up to about $20 per trade.

But then there’s the “slippage”, which doesn’t make sense. Commissions are real costs: they’re the amount of money you have to pay your broker to execute your trades. Slippage, on the other hand, is not a real cost, but rather a theoretical cost: it’s the difference between the official market price of a security, and the price you actually end up paying. It’s a way of taking a theoretical portfolio, which always trades at the market price, and adjusting the returns to make them more realistic. If you have a real portfolio, as Balch suggests that he does, then there’s no “slippage”: the slippage is built in to your actual returns.

So it seems that Balch, after promising to show us the returns that one of his “small funds” has generated, ends up doing no such thing. (And also, I don’t think that a $20 million fund would count as “small” for a college professor who tells us that most of his money is in his TIAA-CREF retirement account.) Still, he says:

This is a conservative approach which nets about 15%-20% per year. You can absolutely follow more risky approaches that’ll provide higher returns. This is the kind of approach I follow.

In other words, if you take what Balch is saying at face value, he’s managed to come up with a conservative investment strategy, which is levered 2-to-1, which generates returns of more than 15% per year, which he follows himself. And he encourages his students to try to do the exact same thing.

There are lots of courses on Coursera, and most of them aren’t as sketchy as this. But I do think that what we’re seeing here is the beginning of a serious problem with online universities like Coursera: you can never be sure about their quality control. And in general, if you’re taking a college course where the professor encourages you to lever up a small number of stock-market investments in the hope of getting low-volatility 20% returns, I’d advise thinking twice about that professor, and that course. Because it just doesn’t pass the smell test.