BOXX: Access Options Funding Rates in an ETF

In the last week of 2022, Alpha Architect launched the BOXX etf. Depending on your needs, it is a promising alternative to T-bills – but the thing that’s so cool — BOXX is doing the same trades option traders do to manage their cash!

Background

In the summer of 2022, I watched an episode of Show Us Your Portfolio, where professional investors discuss how they personally invest. This episode featured Wes Gray the founder of Alpha Architect.

  • Show Us Your Portfolio: Wes Gray (YouTube)

  • How I Invest My Own Money: Robust to Chaos (blog post)

    After appearing on the show Wes actually wrote out an in-depth blog post explaining how and why he invests the way he does. Notice the thoughtful appreciation of his constraints and goals, then see how he matches them with a portfolio.

I’ve gotten to know Wes over the years and found his framework deeply resonant with my own thinking. I called him to discuss certain aspects of it in more detail.

While discussing the portfolio, he told me about the upcoming BOXX ETF knowing I’d geek out on the options bit. Not to mention that the ETF is sub-advised by former colleagues from my SIG days.

Now that the ETF has been on the market for 9 months and garnered a critical mass of assets (>$400mm AUM), I feel comfortable explaining how it works. Before I get to that let’s discuss the value proposition to investors.

Features

The attraction here is straightforward, tax-efficient cash management:

You will understand why it’s t-bill risk and t-bill return without actually holding t-bills when we walk through the mechanics of its trade. But the thing that should pop out at you is:

You can get this type of product in an exchange-traded format –an ETF. So you don’t pay taxes until you sell (unlike mutual funds), you can hold the ETF in a vanilla brokerage account or tax-advantaged account like an IRA or 401k (if your plan allows it). You could even use it as one of the components in an automated ETF rebalancing program like you can build with Composer.

I’m going to pause here because I don’t want to rehash research that is already well-done. Nomadic Samuel wrote a great explainer of the ETF:

BOXX ETF: Review Of The Strategy Behind Alpha Architect 1-3 Month Box ETF (Picture Perfect Portfolios)

There’s a section of the explainer I want to zoom in on:

Well, the Moontower reader is gonna understand how this thing works in a moment. A “box” trade is covered on day 1 for option brokers and trading trainees.

How Box Trades Work

Before my additions, I’ll point you to Wes’ in-depth explanation of box spreads:

Box Spreads: An Alternative to Treasury Bills? (Alpha Architect)

This is a great option explainer. He walks through it just like I would.

  1. Shows that buying a call and selling a put on the same strike is a synthetic future position. Just think of it this way…if you buy a 100-strike call and sell a 100-strike put in the same expiry month, then at expiration, no matter what happens, you will buy the stock for $100!

    Why?

    • If the stock is above $100, you exercise the call
    • If the stock is below $100, you get assigned on the put
  2. If you buy the synthetic future with a $100 strike and short the synthetic future with the $110 strike you will make $10 at expiration with certainty, you have locked in $10 at expiration. Of course, the cost of such a payoff today is not zero…that would be free money.
    The cost of a riskless $10 in say 1 month’s time is just the present value of $10.

    Think of a t-bill. A t-bill is just a zero coupon bond that says at maturity you receive $10. You might pay $9.95 for that today. You will make $.05 profit guaranteed for outlaying $9.95 today.

    This implies a yield or T-bill rate of .05/9.9 = .5% (or an annualized 6%)
    A box is the simultaneous buy and sell of synthetic futures for the same expiration date with different strikes. The difference between the strikes is like the face value of zero-coupon bond.

    The premium you pay for that expiration payoff implies the yield to maturity, the same way the price you pay for a T-bill implies the rate you receive.

Wes’s more detailed explanation with my highlights:

Wes reiterates the entire basis of Law of One Price which stipulates that 2 instruments with the same cash flows will offer the same return in present value terms.

My old professor, Dr. Eugene Fama, is sure markets are efficient. And if two assets earn a similar return, it must be the case that the risk of these two assets is very similar. And now that we’ve determined that box spreads earn similar returns to treasury bills (often higher!)

“Often higher?”

Wes drops a hint — the box rates are often higher than the t-bill rates.

This isn’t crypto land where you can just say anything you want. Wes is operating in a highly regulated SEC compliance environment. You don’t overpromise. And he doesn’t need to — if box rates and t-bill rates lined up perfectly the value proposition of the ETF still shines through.

But this is where my experience can add some color. I’m not surprised the box rates are higher.

“Kris, why would the box rates be higher?”

When you study options pricing and Black Scholes you learn that the risk-free rate is used to discount the payoffs to present value. In practice, options market makers don’t just deal with a single rate. There are at least 4 rates that matter:

  • Stock long rate: the cost to finance long shares
  • Stock short rate: the interest you receive on the cash raised by a short sale. Sometimes referred to as the “rebate”. In hard-to-borrow stocks you often pay interest to be short!
  • Option long rate: The cost to finance option premium that you’ve outlayed
  • Option short rate: The interest received on debit option balances

The clearing firms that custody and finance trading accounts are for-profit businesses — they earn a spread on the long rate vs the short rate. Same as banks.

In general:

  • the cost to borrow money is going to be the SOFR rate + the clearing firm’s margin
  • the interest received on cash balances is the T-bill rate – the clearing firm’s margin

SOFR rates are derived from overnight loans collateralized by Treasuries, therefore they trade very tight to t-bill rates. The bulk of the financing spread is simply the clearing firm’s margin.

If t-bill rates are 6% and the clearing firm’s margin is 50 bps per side, then the clearing firm is willing to lend to the trader at 6.5% and pay 5.5% on cash balances.

The key insight: Market makers cannot freely borrow and lend at a single risk-free rate as theory assumes

At any given time there is likely some market maker that is cash-heavy and earning say 5.5% while another is paying 6.5% to finance long share or option positions. The box market is a way for them to increase or decrease their cash balances! If you are long lots of option premium and paying 6.5%, you can sell a box spread which allows you to lay off premium in exchange for cash. You might sell that $10 box for $9.95 effectively borrowing cash knowing at expiration you will owe $10.

This is smart — you are refinancing your position from paying 6.5% to the clearing firm to borrowing from the options market for 6%!
The point is that there is no real voodoo here — boxes allow market makers to re-finance their positions with each other effectively cutting out the banks.

If the rate prevailing in boxes is typically higher than the t-bill rate that tells you that the options world is a net owner of shares/option premium because the box rate is clearing at a slightly higher rate than t-bills imply.

I have mentioned that so much of options trading is not fancy ideas but mundane business considerations. Like keeping your financing under control. Boxes and their siblings, reversal/conversions, have active liquid markets. There are brokers who deal in them all day. At a large enough options shop, there is a trader who deals in them all day. It’s analogous to the treasury department at a bank, charged with minimizing funding costs.

The BOXX ETF is a legitimate innovation allowing non-option investors to buy box spreads. This allows them to lend at box rates. To supply liquidity to the options market which is a net borrower.
Caveats

  • Funding spreads aren’t necessarily 50 bps per side. It depends on the client’s riskiness and how big an account they are. When I had a small private backer the funding spread was multiples of the funding spread I had at SIG or the hedge fund. The wider your funding spreads, the more inclined you are to trade box spreads so you can tap into the market rate and cut out the clearing firm’s margin.
  • Your counterparty in box trades is the exchange clearing house. These are very strong credits. You face that risk any time you trade options. Wes addresses that in his article.
  • BOXX holds European-style options so there is no early exercise risk.
  • BOXX is tax efficient. In fact, it can be more efficient than owning state-tax-exempt t-bills but this is something for you to work through with an advisor. It depends on your specific situation.
  • In general, derivatives markets, governed by the invisible hand of intense arbitrage pressures embeds funding rate very close to Fed Funds (ie short term t-bills) rates. When you buy an SP500 futures contract you are getting leveraged exposure since you only need to post cash margin at a fraction of the full notional value. This inherently levered position means you are borrowing. However, it is the most cost-effective form of borrowing because the rate is inherited from arbitrage by the most well-capitalized traders who can afford to lock in risk-free profits with the smallest possible margins. The team at Return Stacked Portfolio Solutions wrote a simple explainer post reviewing the mechanics — The Cost of Leverage

Extra for Option Masochists

It’s hard to overstate just how deeply tied funding concerns are to vol trading.

If my stock long rate is much higher than yours then calls will have a lower implied vol to me than to you. Likewise puts will look more expensive than you. If I had a long stock position I’d want to swap it for a long synthetic futures position by doing a “reversal” (buy call, sell put, sell stock). If my rate was much lower than the market I’d want to “convert” (sell call, buy put, buy stock).

See You Think You’re Trading Vol…But Are You Even?

Every option trader has used revcon.xls to price the exact carry on a position down to the T+1 settlements for options and T+2 for stock. They’d be counting days like fixed income traders.

Box spreads are the simplest arbitrage identities in the options market. They are the basis of figuring out what a put spread is worth by knowing the call spread value.

BOXX is a really neat product allowing equity investors to tap into the borrow/lend markets that were once fenced off to option participants. And the option participants are happy because an already deep market is getting deeper.

On Active Management and Private Investments

Suppose you go to a brick-and-mortar coin dealer in your town and buy some gold. How confident are you that it’s real?

Pretty confident, I’d guess. You should be. By having a shop with non-negligible overhead and in-person transactions the dealer is signalling trustworthiness. Plus some percentage of the customers are going to be paranoid doomers who will assay a sample for purity. If it’s fool’s gold, there’s a good chance they’ll raise hell on Nextdoor and the dishonest dealer will lose business.

In asset management, the valuable thing to be mined is alpha. Consistent outperformance for a given level of risk. A true edge. Mining for alpha is conceptually similar to mining for gold. For a given extraction price there’s a limited supply. Part of that extraction price includes a return hurdle — there must be a profit margin to make the effort worthwhile. This is why markets will never be fully efficient and are said to be efficiently inefficient. 

However, spotting fool’s gold in active management is definitely not straightforward. Track records are prone to survivorship bias — if you flip 10,000 coins and keep the ones that turn up heads, about 10 coins would remain after a decade. You still wouldn’t “hop on a call” with these coins. The problem is even more diabolical. The shrewdest investors are usually well-resourced. They are like a metallurgy expert who would have separated the real stuff from the fool’s gold before you get a look. And since there’s some probability that the alpha is fake, investment fees should clear at a level that discounts the probability that it’s fake. No star manager is selling their alpha in a 40-Act fund (this is a basic “market for lemons” argument).

This is a stylized equilibrium. There are exceptions but the burden of proof is on the promoter. Remember, alpha is zero sum — there must be losers for there to be winners and if you don’t have a good reason for why a winner wants your money then you’re tossing rings at a carnival. You’re gonna spend $50 to win a $5 panda that you’ll throw out in a week. Worse yet, you won’t throw the investment out, you’ll just keep paying for its upkeep while it sheds lint all over your portfolio.

Byrne Hobart, recounting some amusing research, states how reality differs from the equilibrium (emphasis mine):

Chengyu Bai and Shiwen Tian have a study showing that more attractive fund managers get promoted faster but have worse returns . A good model of asset management is that skilled managers gather assets until their fees roughly equal the alpha they generate. It’s not a stable equilibrium for someone to be able to get rich by passively moving money out of an index fund and into an active manager’s fund, and managers like having money. So, in general, skilled managers raise more money (or charge higher fees) until their after-fee returns approach what someone could get elsewhere. Unskilled or unlucky managers find a different line of work. But this model describes an asymptote, not the state at any point in time; even if it’s true, there will be some emerging managers who are putting up good returns but not getting enough credit for it, and others who either have a good pitch or a lucky year or two and can over-raise accordingly. (And, of course, some managers are not purely money-motivated, and keep their firm at a size that’s appropriate for whatever they like most, whether that’s turning over lots of rocks in nanocap stocks—a rewarding activity at the moment!—or funding private companies that are barely past the idea stage.) If there’s some factor that makes it easier to raise money (being good-looking can keep you out of jail for longer, so it makes sense that it would apply in other places), then those managers will raise more than they should. The good news for anyone who isn’t strikingly attractive but does want to make money in investing is this: alpha only exists if there’s someone worse than you on the other side of the trade, so beauty bias in fundraising means better returns for everyone else.

In the equilibrium version, managers with alpha choose their investors strategically for some synergistic benefit OR they charge fees that slide most of the alpha money to their side of the table. As Byrne says, that equilibrium is an asymptote that we never quite arrive at. Some managers are overearning while others are underrecognized and underearning compared to the value they create.

This is also why the general rule of long investor letters quoting Roman emperors are bad signs. True killers don’t ramble and only move at night. Of course, a star doesn’t just emerge a killer, he or she arrives there. So identifying one before they reach the height of their bargaining power can be a lucrative trip (if you can find them before the pods do)

I could just invoke the Yogi Berra “I don’t want to be part of any club that’ll have me” line and if readers internalized that they’d save themselves some fees as well as the inevitable “are these just sugar pills” moments of doubt.

But there’s always some overachiever who believes the wire that binds effort to outcome in a low-signal process is tighter than it is. Let me offer some thoughts.

Heuristics for Choosing An Active Manager

In the cheeky article Proprietary Trading: Truth and Fiction, notable quant Peter Muller drops an evergreen table:

As a basket, those managers penning flowery investor letters quoting Roman stoics would be nice candidates for the short leg of a strategy (there should be a borrow market for private LP stakes. That might even make Twitter fun again). When I look up the website for a firm and find a landing page from 1998, that’s exciting. Lowkey goated.

That said, animal spirits are a thing and junior killers might want to have their name on the door regardless of how much their employers offer them. When they go out on their own there’s a small chance you cross paths with them before they reach the height of their bargaining power.

Potential Drawbacks of Private Investments

Trust

Public markets benefit from transparency. Law, regulation, and customs contain recourse and precedent. Boards are accountable. Reputations matter. There are blemishes but considering how much money and risk are regularly trafficked in modern capital markets you would expect some error.

Private markets are caveat emptor. Trust is a matter of transparency and alignment which go hand-in-hand. Even with a rigorous diligence process professional allocators can find themselves bamboozled. Now move down the chain. If a syndicate is corralling small retail checks on the internet, it’s worth asking some questions that go beyond strategy and performance.

  1. Am I a client or just a customer? How valuable is this relationship to the GP? An extreme example of this is the crypto staker — an anonymous source of capital in a murky market. Illegal immigrants are easy targets for scammers because what are they going to do? Call the cops? You can see the parallel.
  2. What’s the extent of principal-agent problems or conflicts of interest? Does the GP own a brokerage firm as an outside business? Is your PE manager raising a fund to buy stakes in its other funds? Too obvious? What if PE funds raise money to buy stakes from other PE funds, but they all started doing this? When I was in the pits, floor brokers were allowed to trade for their own accounts but not against their own orders. So you know what happens? The brokers show the juiciest orders to other brokers first before showing the market-makers. And what do you think will happen when those other brokers get a juicy order? Again, you should see the parallel.
  3. Why did they find me instead of raising institutional capital? The answer to this doesn’t need to be nefarious. Institutional capital is expensive to raise both from a box-checking/pedigree point of view and the nature of long sales cycles for large checks. They can also be demanding LPs whose rigid discipline might be meddlesome and misguided. (That said, the best institutional LPs, perhaps rare, can actually level up a manager by sharing practices they see in other funds and generally being insightful). But if the syndicate that found you just sees you as a cheap source of capital, you’d want to know that. If their primary skill is audience-building then the most tempting monetization path can be to raise a bunch of money and flip a coin. You don’t want your GP’s superpower to be gathering eyeballs when they’re supposed to be investing.
  4. Here’s a wonky one. You are an investor in a fund that charges 2%. Would you rather they ran the strategy at 30% volatility or 15% volatility? The answer is you’d rather they run the strategy at the higher volatility and you allocate half as much. Your proposition is unchanged but you pay half as much in fees. The GP prefers you don’t understand this. There’s a similar misalignment for traders and portfolio managers who do not get a percentage of the total firm p/l but get paid on their individual p/l. Those traders are equivalent to LPs. They want maximum volatility and little diversification because their compensation is a call option. If the firm is diversified, the trader faces “netting risk” where they might make money but another part of the firm loses money. The GP collects their fee and there’s no net return to pay the winners. This is the “basket of options is worth more than an option on a basket” idea. In this example, the trader and the LP are in similar positions and neither is fully aligned with the GP.

I don’t mean to make you feel like private investments are spellbound by dark arts. These issues are usually not issues — until times get tough. But that’s when you care the most because of the next topic.

Liquidity

Private investments are less liquid. Lockups, redemption notice periods, possible gates. Depending on the strategy much of this is unavoidable. But illiquidity is brutal. It hamstrings your ability to rebalance and tax-loss harvest.

Behavioral arguments for tying up your money as forced savings or “protecting you from yourself” are overfit, ignorant of counterfactuals, and coincidentally convenient to the people who promote them. The cost of illiquidity is visible and confirmed by market prices (on-the-run vs off-the-run Treasuries). Liquid collateral literally earns you a lower cost of funding. If you want to get nerdy about it see How Much Extra Return Should You Demand For Illiquidity? where I offer at least a qualitative framework for how to value it as an option.

Entanglement

What if the private investment goes well? Is this the equivalent of beginner’s luck in blackjack? Did you learn anything or just gain confidence?

When performance slides it’s hard to foresee how the manager will respond. They are below the high watermark, is the morale low? Are employees quitting? Bad times will come. Are you going to stick through them or add more?

In Repetition Economics, I frame the problem in the context of another industry oozing with snake oil:

If you start taking vitamins, do you have a plan for determining if they are “working”? Or have you signed up for a perpetual liability with an unclear benefit?

Gary Basin explains this concept more broadly in Action Echoes:

Rather than seeing this temptation as a one-off event, view it as repeating over and over into the future. Imagine the decision you make this next time also deciding how you act in similar future situations. Your actions echo into the future. Every “bad” move has consequences later in the game. Sure, you can sometimes find ways to dig yourself out of a hole. But it’s helpful to realize that every move you make contributes to your eventual position.

Reframing a decision as a bundle of future repeated actions gives a more accurate view. The goal is not to entirely avoid urges but to reframe them in a way that best accounts for their consequences. Any single temptation is not unique! The actions you take now will establish patterns that determine your future.*

Private investments are partnerships with people. You are subscribing to some very difficult future decisions when you write that check. When we add up all these drawbacks, the reasons to step out into the world of privates need to be incredibly compelling. With all these Family Feud X’s buzzing your accredited investor dreams I suppose it’s only fair to discuss some of the benefits.

Benefits of Private Investment

True Differentiation

You are invested in a business; not stock pickers

This is the holy grail. You get access to a strategy that is nothing like beta. If it acts like beta but simply outperforms it’s hard to size up because of its correlation to the rest of your portfolio and probably your employment. But if you find something that poses as an investment but is actually a business oscillating between making steady money and occasionally tons of money then you found the thing worth blasting through all the orange cones for. It’s only a matter of time before the world catches on to your discovery, but if you take a chance on the team early, they will reward you by not pushing you out as they grow.

The approach here is looking for quirky stuff where the team is strong but for any number of reasons are unable to attract the attention of suits and have no interest in soliciting the masses.

Authentic diversification

There are assets that are overpriced on a line item basis but because they are uncorrelated with beta that can improve an overall portfolio (vol, commodities). You will tend to notice massive dispersion in the returns of the active managers in those classes. This means there’s space on the field for them to justify their fees by being skilled players and having relationship moats. [It also means there isn’t a benchmark that anyone cares to hug because the benchmark itself has a tenuous grip on anything relevant to mainstream investment thinking. Start explaining a managed future benchmark to an equity investor over drinks and they are definitely answering the staged bail-out call.]

Relationships

In How I Misapplied My Trader Mindset To Investing, I wrote:

I appreciate that people can find an edge in their respective domains. I was spoiled by trading. Expiration cycles, large sample size, and a lack of beta meant edge, positive or negative, reveal you faster. Investing is a more wicked domain. My default belief is still that edge is rare and mostly unavailable to me. Storytellers can hide in the randomness and low signal-to-noise. And I’m not fully immune from them anyway. Still, I believe if you filter well, the number of times you get burned will just be the cost of doing business. Any private investment has to satisfy my doubt as to why I should be invited. And once invited, I am mostly judging character and ability. This is admittedly an act of faith. I’m pattern-matching to successful traders I’ve seen. I’m comfortable betting on people. Not because I even know if I am good at this, but because I think there are more ways to fail forward. If I constrain my risks at the sizing level I can more easily enjoy the positivity that emerges from partnering, helping, and believing in one another. It’s more holistic than a spreadsheet.

In a recent interview with Meb Faber, Ted Seides articulated my wife and my feelings exactly:

Most of the [private] investments are actually people that I’ve known for a long time. I don’t have investments with the big brand-name people. Part of that, for me, is an angle on active management, and certainly, this style of active management that I think is completely lost in the active-passive debate, which is the relationship aspect of it. Because I can give money to a manager, and yes, I will get the returns that come from that, but who knows what else is going to happen, both potentially financially and also just in life, right? There’s so much optionality that comes from having great relationships with people. It’s one of the reasons why it was easy for me to have a bias towards sticking with managers. I can’t stand ending those relationships with people I respect and think are smart. And I’ll happily, like, take a little bit of a financial hit in the short term if I think it’ll keep going for the long term.

More helpful reading before you take the plunge

Byrne’s concept of equilibrium is powerful even if we believe that the marketplace is constantly trending towards, but never settling into that equilibrium. Efficiency is a fractal problem. It takes effort to find alpha, and it takes effort to find managers who find alpha.

At equilibrium, I contend that there is a Paradox of Provable Alpha:

If an external edge is provable, it doesn’t exist for you. either you won’t be admitted to the club or the price will negate the advantage.

The paradox casts an inescapable conclusion — you will need to rely on judgment more than track records to find managers.

The following are all outstanding reads to augment your judgment:

Letter to a friend who just made a lot of money (Graham Duncan)

This is one of the best things I’ve read on delegation. To allocate “decision space” use a qualitative formula:

credibility = proven competence + relationships + integrity

Excerpts

Identify what you’re good at and how you’re going to use that strength

Our founding client, the CEO of a large home builder, is fond of saying that it’s common for people to make money like professionals and then invest it like amateurs. Warren Buffett says that if you don’t know who the dumb money at the poker table is, you’re the dumb money. In order to avoid being the amateur or the dumb money, I would first try to establish what you and people who know you well believe you have a lot of credibility in doing.

Delegating “decision space”

General Stan McChrystal, who together with his chief of staff, Chris Fussell, led the U.S. military’s Joint Special Operations Command, observed that their job in running all of the special forces units in Afghanistan was to assess the various team captains’ credibility and then give them the appropriate amount of “decision space” based on that assessment. To allocate decision space they used a basic formula: credibility = proven competence plus relationships plus integrity.

I see the task of managing a pool of one family’s or foundation’s capital as essentially that same exercise — assess people’s credibility on a given activity, and then give them the appropriate amount of decision space based on that assessment.

What you need to do is assess your own credibility and that of potential partners, and then decide how to divide up the decision space over your capital. It’s important to take your own ego out of it and assess your own comparative advantage with clear eyes. Warren Buffett gave his entire savings to the Bill and Melinda Gates Foundation to manage his charitable giving; he had a quiet ego and saw that they could do it better than he could ever realistically do himself. Bill Gates owns a ton of Berkshire Hathaway because he knows that Buffett is much more credible on making investments than Gates will ever be himself.

The bottom line is that giving your team captains both autonomy and accountability is critical.

The no-man’s land, which we see people fall into all the time, is where the capital owner wants to have one foot on the playing field and one foot off, suggesting ideas to the manager of the capital without having to execute them. That puts the manager in a uniquely bad position: if they pursue the investment and it doesn’t work, they get the blame; if it does work, the owner gets the credit. Several prominent family offices have gone through way too many CIOs to count because of this dynamic; now no one credible will ever again take the job because they correctly realize that it’s a “tails you win, heads I lose” proposition.

Figure out how you’re going to build trust with your manager

Assessing credibility and building trust is a skill, and it’s learnable.

I have a question I ask candidates when I’m hiring them for a skill set I don’t have: “if you were going to hire someone to do this, what criteria would you use?” The answer is often wildly different for apparently similar people with similar backgrounds and reveals what they believe to be critical based on their experience.

When it comes to a CIO to manage your capital, I would answer that question with the following criteria:

A) Someone who can provide evidence that they have good “taste” in people; has an ability to assess other people’s credibility and give them the appropriate amount of decision space; and attracts the top talent by exuding an attitude of abundance about fees and opportunities, an implicit message of “let’s compound our capital together”

B) Someone with a “quiet” ego who is pragmatically focused on making money for you (and themselves, assuming they have incentive compensation), not on scoring style or status points or constantly proving to you how smart they are — as Taleb puts it, deep down they want to win, not win an argument

C) Someone who is conservative by nature; hates losing money with a passion but, paradoxically, can still take “good” risks; and has that unusual mix of aggression and paranoia

Believability In Practice (Cedric Chin)

Excerpt

The technique mostly works as a filter for actionable truths. It’s particularly handy if you want to get good at things like writing or marketing, org design or investing, hiring or sales — that is, things that you can do. It’s less useful for getting at other kinds of truth.

I started putting believability to practice around 2017, but I think I only really internalised it around 2018 or so. The concept has been remarkably useful over the past four years; I’ve used it as a way to get better advice from better-selected people, as well as to identify books that are more likely to help me acquire the skills I need. (Another way of saying this is that it allowed me to ignore advice and dismiss books, which is just as important when your goal is to get good at something in a hurry.)

I attribute much of my effectiveness to it.

I’m starting to realise, though, that some of the nuances in this technique are perhaps not obvious — I learnt this when I started sending my summary of believability to folks, who grokked the concept but then didn’t seem to apply it the way I thought they would. This essay is about some of these second-order implications when you’ve put the idea to practice for a longer period of time.

Looking for Easy Games — How Passive Investing Shapes Active Management (Mauboussin)

This paper, especially page 29, shows dispersions of return in various asset classes. This is a clue to where an active or private manager can justify their fees.

Matt Levine’s Nerdcall

The undisputed heavy-weight champ of finance writing is Matt Levine. I’m 4 bid on how many chuckles you’ll get per letter. I wouldn’t sneak-read his stuff during a meeting — there’s always literal LOL risk.

But it’s not just the humor. Matt Reustle and Dom Cooke, hosts of Making Media, put their finger directly on Levine’s appeal in their recent interview with Levine.

Matt. R: [00:53:12] He has basically carved out this category where when you see certain things hit the tape, you say to yourself, I can’t wait for Matt Levine’s interpretation of this. And that’s such a symbolic thing that I think many people probably strive to have, and he clearly has achieved them. I love that.

Dom: [00:53:30] I think it’s stronger than that as well. It’s not even like I want to hear what he’s going to say. It’s, I need to know what I should be thinking about this topic. And he’s the guy that I trust. Tell me what I should be thinking about it. And there are a few people in that account in different topics or verticals, and he’s definitely there in finance for a lot of people.

The interview is a lot of fun and the hosts stand out for asking great questions. Stuff you really want to know.

🎙️Matt Levine – Wall Street’s Art Critic (Making Media)

A couple of my observations:

1) The nerdcall. Matt recognized that weird, complex deals and concepts appeal to technical people broadly — whether they are in finance or not.

Very early on, my sense was that there is an expectation that weird complicated niche topics have only weird niche audiences and that doesn’t seem true. I think my readers, some of them are people who work in fairly technical areas of finance are like finally, I get to read about this fairly technical or like, I get to read about this adjacent technical area of finance that I find interesting because I work in a different technical area and I like technical stuff.

A lot of my readers work in tech and they’re like, “I don’t share anything about finance. I share about finance, I’m not that interested in it, but I like when you talk about complicated things. It’s like the aesthetic appreciation of systems and complexity and the moving parts of the economic drivers of deals.

My impression is that there are a lot of people in the world who want to read about structures and there is not a lot of writing. So they go, great, I get to read about the derivative, fabulous. So I don’t know, that’s sort of the answer to your question. If I were to explain a complicated thing it is going to be fine, like those are going to be good.

This overlaps with my observation of game nerds. I pulled this from an interview with game designer Raph Koster:

Finding real world systems and abstracting them or boiling them down to their essence isn’t actually a very common skill. Games can teach people how to do this. The idea involves setting constraints, modeling real systems, and allowing people to experience them within a game context to understand them deeply. It provides an opportunity for individuals to experiment with these systems, unlike in real life where, for example, you only get one shot at lifetime earnings. Playing a game that emulates this system offers lessons.

I believe that game-playing trains your systems thinking and reading Matt Levine does too. It’s a lot of “how would you expect this to behave at equilibrium and under what assumptions, but we actually observe X so what assumptions are broken or what did the model fail to consider that is true now but wasn’t before”. I give a few game examples in Lessons from Game Designer Raph Koster.

2) Matt explains the benefits and costs of the growing trend of “creators” becoming the farm team for the journalism world. He namedrops a great example —

kyla scanlon

(fun fact Kyla’s newsletter is the single largest Substack referrer of Moontower subs. Thanks Kyla!)

Levine:

I was just reading Matthew Yglesias this morning, talking about how the journalism career path that used to be, like a small town newspaper to a big city newspaper to The New York Times. And now you started a blog covering national politics and you move to The New York Times.

And I think from my entire time in media, the old model had been replaced by the model of you start at Gawker or Gawker, in particular, became like the feeding ground for media organizations. And now blogs have declined and creator stuff has increased and like Bloomberg works with Kyla Scanlon who’s this great financial content creator. And yes, totally, that’s the future.

I just think it’s easier for people now to just go to a place, you can talk about whatever that has a national or international platform and then they do stuff. And if this stuff gets traction, they’re like, we don’t need to work your way up. Obviously, there is something lost there. We’re like the advantage of being trained at a small town newspaper is you learn to report.

I find it helpful in my career that I started by doing law and banking. So that what I came with when I started writing was not just attitude and style. And there’s a risk, if the training ground for media is starting a YouTube channel when you’re 18 or starting a TikTok when you’re 18, then people will come in with less training, either in reporting or in a substrate that they’re talking about. The upside is that then you come in with the skills that are helping you to building an audience, there’s a trade-off there. I don’t come in with reporting skills, really.

Levine is validating a trend that traditionalists ignore at their own peril — public proof of work is a gate-keeper bypass. [Mark Andreesen discussed the nuance around this in the context of whether one should go to college.]

The trend is not without trade-offs but it’s also not going away. I’d bet on it accelerating. If a resume and references are your only proof of work that’s effective because there are plenty of opportunities that don’t require more. But writing, building, and creating publically are a lot of additional “interview-like” data points that expand the surface area of opportunity. But it’s work. There are no shortcuts anyway, you work one way or the other. (Reminds me of maintenance costs for a home — you can defer them and one day you’ll pay for it with a lower selling price or you can accrue them as they come).

If you’re drowning in info, a trusted source, curator, and really, a second brain, like Levine is saving you time and attention. Media companies understand the value of this. Many brands understand this. The marketing departments of the remaining companies will catch up. And in a world drowning in info, everything is sales. More value will accrue to trust. Feels like one of those big trends that is happening in the background that you can align with to your advantage.

Moontower #199

The undisputed heavy-weight champ of finance writing is Matt Levine. I’m 4 bid on how many chuckles you’ll get per letter. I wouldn’t sneak-read his stuff during a meeting — there’s always literal LOL risk.

But it’s not just the humor. Matt Reustle and Dom Cooke, hosts of Making Media, put their finger directly on Levine’s appeal in their recent interview with Levine.

Matt. R: [00:53:12] He has basically carved out this category where when you see certain things hit the tape, you say to yourself, I can’t wait for Matt Levine’s interpretation of this. And that’s such a symbolic thing that I think many people probably strive to have, and he clearly has achieved them. I love that.

Dom: [00:53:30] I think it’s stronger than that as well. It’s not even like I want to hear what he’s going to say. It’s, I need to know what I should be thinking about this topic. And he’s the guy that I trust. Tell me what I should be thinking about it. And there are a few people in that account in different topics or verticals, and he’s definitely there in finance for a lot of people.

The interview is a lot of fun and the hosts stand out for asking great questions. Stuff you really want to know.

🎙️Matt Levine – Wall Street’s Art Critic (Making Media)

A couple of my observations:

1) The nerdcall. Matt recognized that weird, complex deals and concepts appeal to technical people broadly — whether they are in finance or not.

Very early on, my sense was that there is an expectation that weird complicated niche topics have only weird niche audiences and that doesn’t seem true. I think my readers, some of them are people who work in fairly technical areas of finance are like finally, I get to read about this fairly technical or like, I get to read about this adjacent technical area of finance that I find interesting because I work in a different technical area and I like technical stuff.

A lot of my readers work in tech and they’re like, “I don’t share anything about finance. I share about finance, I’m not that interested in it, but I like when you talk about complicated things. It’s like the aesthetic appreciation of systems and complexity and the moving parts of the economic drivers of deals.

My impression is that there are a lot of people in the world who want to read about structures and there is not a lot of writing. So they go, great, I get to read about the derivative, fabulous. So I don’t know, that’s sort of the answer to your question. If I were to explain a complicated thing it is going to be fine, like those are going to be good.

This overlaps with my observation of game nerds. I pulled this from an interview with game designer Raph Koster:

Finding real world systems and abstracting them or boiling them down to their essence isn’t actually a very common skill. Games can teach people how to do this. The idea involves setting constraints, modeling real systems, and allowing people to experience them within a game context to understand them deeply. It provides an opportunity for individuals to experiment with these systems, unlike in real life where, for example, you only get one shot at lifetime earnings. Playing a game that emulates this system offers lessons.

I believe that game-playing trains your systems thinking and reading Matt Levine does too. It’s a lot of “how would you expect this to behave at equilibrium and under what assumptions, but we actually observe X so what assumptions are broken or what did the model fail to consider that is true now but wasn’t before”. I give a few game examples in Lessons from Game Designer Raph Koster.

2) Matt explains the benefits and costs of the growing trend of “creators” becoming the farm team for the journalism world. He namedrops a great example —

kyla scanlon

(fun fact Kyla’s newsletter is the single largest Substack referrer of Moontower subs. Thanks Kyla!)

Levine:

I was just reading Matthew Yglesias this morning, talking about how the journalism career path that used to be, like a small town newspaper to a big city newspaper to The New York Times. And now you started a blog covering national politics and you move to The New York Times.

And I think from my entire time in media, the old model had been replaced by the model of you start at Gawker or Gawker, in particular, became like the feeding ground for media organizations. And now blogs have declined and creator stuff has increased and like Bloomberg works with Kyla Scanlon who’s this great financial content creator. And yes, totally, that’s the future.

I just think it’s easier for people now to just go to a place, you can talk about whatever that has a national or international platform and then they do stuff. And if this stuff gets traction, they’re like, we don’t need to work your way up. Obviously, there is something lost there. We’re like the advantage of being trained at a small town newspaper is you learn to report.

I find it helpful in my career that I started by doing law and banking. So that what I came with when I started writing was not just attitude and style. And there’s a risk, if the training ground for media is starting a YouTube channel when you’re 18 or starting a TikTok when you’re 18, then people will come in with less training, either in reporting or in a substrate that they’re talking about. The upside is that then you come in with the skills that are helping you to building an audience, there’s a trade-off there. I don’t come in with reporting skills, really.

Levine is validating a trend that traditionalists ignore at their own peril — public proof of work is a gate-keeper bypass. [Mark Andreesen discussed the nuance around this in the context of whether one should go to college.]

The trend is not without trade-offs but it’s also not going away. I’d bet on it accelerating. If a resume and references are your only proof of work that’s effective because there are plenty of opportunities that don’t require more. But writing, building, and creating publically are a lot of additional “interview-like” data points that expand the surface area of opportunity. But it’s work. There are no shortcuts anyway, you work one way or the other. (Reminds me of maintenance costs for a home — you can defer them and one day you’ll pay for it with a lower selling price or you can accrue them as they come).

If you’re drowning in info, a trusted source, curator, and really, a second brain, like Levine is saving you time and attention. Media companies understand the value of this. Many brands understand this. The marketing departments of the remaining companies will catch up. And in a world drowning in info, everything is sales. More value will accrue to trust. Feels like one of those big trends that is happening in the background that you can align with to your advantage.

Money Angle

I’m working on some investing education stuff for some friends and family. That led me to resume work on MoontowerMoney.com, a series where I explain how people should approach investing. The target audience I keep in my head is a fictional friend who has accumulated some savings, is not in finance, and has no process. Someone who keeps bouncing from one stock tip to another. Or doesn’t have a cohesive understanding of what the “investing problem” even is.

The goal of the series would be to either help them realize they can manage their own savings in a way that is mentally organized or maybe just realize they should hire a financial advisor.

I’ve shown many people in the past 6 months how to log onto Vanguard to simply buy t-bills. They didn’t know this was a thing. This ignorance is normal and understandable. Many people with savings don’t know how finance and investing work and many others find thinking about it a chore they’d rather ostrich.

This series is a 101 for understanding the nature of markets and risk and ultimately taking the reins in a coherent way that doesn’t require much maintenance.

This week I published the next section:

❓Where do investing returns even come from? (Moontowermoney)

 

Money Angle for Masochists

Just a few screenshots for your ponderance:

By @EMinflationista:

I’ll never be allowed on a crony committee:

 

Stay groovy ☮️

Notes from RenTec CEO Peter Brown on the GS Podcast

Podcast: Goldman Sachs Exchanges: Great Investors

Raj Mahajan, global head Systematic Client Franchise interviews  Renaissance Technologies CEO Peter Brown on July 27, 2023

I grabbed some excerpts from the transcript for future reference.

I include my own commentary here and there.

Newsflash: Money is a big factor in what people choose to do

Raj Mahajan: Seems that you were right at the vanguard of the machine learning movement in 1993. So, why did you leave an exciting career at IBM for a small financial company in Long Island that no one had ever
heard of?

Brown: …Three things happened. First, Bob had a second daughter accepted to Stanford. But he couldn’t afford to pay for her to go to Stanford on his IBM salary. So, she had to go to the agricultural school at Cornell, which offered scholarships to New York State residents. The second thing that happened is we had a daughter born. And a third thing was that Jim then offered to double my compensation. After that offer, I came home. I took one look at our newborn daughter and realized I had no choice in the matter. So, the decision to leave computational linguistics for a small hedge fund that no one had ever heard of was made purely for financial reasons.

Examples of Emotional IQ

[Kris: The EQ vs IQ thing is a false dichotomy. I suspect they are actually positively related but when we look at outliers on either dimension there is a major Berksons Paradox effect. RenTec has the reputation of being the true “smartest guys in the room” in the IQ/STEM sense of the word. And yet, multiple times in this interview I am struck at how people-savvy they have been. Which makes perfect sense to me. In a domain where the competition constantly learns and psychology plays an enormous role this is exactly what you expect. Only the naive who believe that investing is physics as opposed to biology cling to Spock-like caricatures of effective quants. Here are several excerpts demonstrating an deep understanding of human behavior]

Selling an approach to employees

Brown: At the end of 2002, Bob and I also took over the rest of the technical side of the firm, which included the trading of currencies, bonds, options, and futures. Now, our plan was to use the equities code that we and others had developed to trade these other instruments. But we recognized they would not be so great for morale to tell, say, one of the futures researchers, “You know all that code you spent the last decade of your life developing, guess what, we’re going to throw it out.” So, we had to spend quite a bit of time getting everyone to buy into our plan. To do this we used an approach that I learned from a biography I’d recently read of Abe Lincoln, which was to get them to come up with our plan themselves. Now, that took some time, but eventually it all worked out. 

Jim Simons weighing the input to manage a risk crisis

See below: 2007 — “Quant Quake”

Jim Simons reading a situation shrewdly

Brown:  In the fall of 2008, the whole financial system was stressed. So, we were concerned with the stability of our counterparties. So, we spent a lot of time with those counterparties and examined their CDS rates and so forth. I remember at one point, two senior executives from some firm we did business with came into our New York City office to meet with us. They assured us that the funds we had in our margin account were safe with them. And I was inclined to believe them. Why not? But after the meeting, Jim said, “Peter, they wouldn’t have come to our office. They wouldn’t have requested the meeting unless they were in real trouble. It’s time to get out.” So, we did. And Jim was right because shortly thereafter, that firm just disappeared. 

Examples of automation and innovation within RenTec

Brown: When we got control of the New York office, the first thing I did was to walk around that office, find out what everyone was doing. And what I found was that many people were doing jobs that could be automated. So, we set out on a massive campaign to automate our back-office operations. We moved from checks and wires to SWIFT and ACH. We replicated counterparties margin calculations. We built a large legal database that could be accessed by computers to fill out regulatory forms. We brought in AI systems to automatically read and pay invoices. We automated the treasury department so that cash and margin needs could be managed by computers instead of humans. My point of view was that Stony Brook produces a huge list of transactions and New York City produces monthly statements, K1s, and government filings. And I just didn’t see why humans need to be involved in the process of translating trades to monthly statements. Now, 13 years later, we’re not done yet. And I’m embarrassed to admit that we still even have a few people who use Excel. But we’re getting there. In fact, I was told recently that we’ve eliminated 97 percent of the spreadsheets that had originally been used in the company.

Stories about risk management

March 2000 — Dot Com

Brown: Let me start with March of 2000 when the dotcom bubble burst. We were doing extremely well back then. And we had large positions in the internet stocks. They were traded on NASDAQ. At one point the head of risk control came to me and said he was worried about the size of our NASDAQ positions. But I told him not to worry, the computer knew what it was doing. Then we took a big loss one day. So, I worked through the night trying to understand what was going on. The next day we took another big loss. And I, again, worked through that night. So, now it’s the third day and I hadn’t slept for, I don’t know, 48 or 50 hours. And I was sitting in a meeting with Jim and a few others when the head of production knocked on the door and asked to speak with me. I walked out of the meeting, and he told me we were down again by a large amount. So, I walked back in the meeting, and I must have turned white or something because Jim took one look at me and said, “It doesn’t look good.” Now, not having slept the previous two nights, I remember thinking I’m not sure I can get through this. But I really didn’t have much choice in the matter. And so, we got back to work and eventually we did get through it. A couple days later I went into Jim’s office and told him that I’d screwed up in not appreciating the risk we were taking and said that if he wanted me to resign, I would resign. But he responded, “Peter, quite the opposite. Now that you’ve been through such a stressful losing period, you’re far more valuable to me and to the firm than you were before.” Now, that response really tells you something about Jim Simons.

2007 — “Quant Quake”

Brown: When that happened, I was on vacation, and I was on a very long flight back to Newark Airport. And the moment the plane landed, my phone went nuts with all kinds of texts and missed phone calls. So, I called into work when it was going on and I got Kim, Jim’s assistant. And she said, “Jim wants you to get back here as soon as you’re physically able.” So, I raced out. I found a taxi, leaving my family to fend for themselves at Newark Airport. And pushed the driver to drive as fast as he could from Newark to Long Island. I ran into my office, and I found Jim, Bob, Paul Broder, who was head of risk control, all holed up. And the office was full of cigarette smoke. I could barely breathe. And then there was this, I remember seeing this, 16 oz cup full of Jim’s cigarette butts. And I’m thinking, like, why do they have to do this in my office? And they were all staring through the haze at the computer screens trying to figure out what was going on. And Jim was interpreting every little wiggle and various graphs. He was really scared. And he wanted to cut back and hard. Paul also wanted to cut back. Raj, I’m sure you know, the head of risk control always wants to cut back. Because he doesn’t get paid to make money. He gets paid to make sure you don’t lose money. 

And Bob, you know, Bob’s always very calm. But he wasn’t against cutting back. But I looked at the data and saw that the model had these enormous predictions, the likes of which I had never seen before. It was clear to me what was going on. People were dumping positions that were correlated with their own positions. And they were driving prices to ridiculous levels. I felt they had to come back. I argued that we should not cut back. That this was going to be the greatest moneymaking opportunity we’d ever seen. And if anything, we should increase our positions. But it was three against one. And so, we continued cutting back. But I succeeded somewhat because we cut back at a slower pace. And then at one point, miraculously, the whole thing came roaring back. And indeed, it was an incredible money-making opportunity. Now, what we learned from that was to always make sure we have enough on reserve to just hang on. Later, when Jim was about to retire, I reminded him of this period and asked if he was concerned that I was going to be so aggressive that I was going to blow the place up. But Jim responded that the only reason I was so aggressive was because I knew he was determined to reduce risk, another example of Jim’s insight into human nature. 

What RenTec does differently

Brown: I guess there are some firms that make it their business to learn how others make money and try to learn their secrets. That’s not our style. We just hire mathematicians, physicists, computer scientists with no background in finance and no connections with Wall Street. 

A few principles we follow:

  1. Science

    The company was founded by scientists. It’s owned by scientists. It’s run by scientists. We employ scientists. Guess what, we take a scientific approach to investing and treat the entire problem as a giant problem in mathematics.
    [Kris: In chatting with a friend who has proximity to RenTec, I learned of this a few years ago. I was intrigued by how they felt quite comfortable incubating highly promising individuals by offering a well-paying collegiate atmosphere that offered an alternative to traditional academia. It feels like just another instance of what I call risk absorption. RenTec is a highly efficient “bidder” for the risk of a scientist’s effort panning out. They can build a portfolio of talent in the form of a skunkworks knowing that they can scale important discoveries across their trading. Not unlike how a military R&D department might think of investments in scientists.

  2. Collaboration

    Science is best done through collaboration. If you go to a physics department, it would be absurd to imagine that the scientist in one office doesn’t speak to the scientist in the office next door about what he or she is working on. So, we strongly encourage collaboration between our scientists. For example, we encourage people to work in teams. We constantly change those teams up so that people get to know others within the firm. We pay everyone from the same pot instead of paying different groups in accordance with how much money they’ve made for us and so forth.

  3. Infrastructure

    We want our scientists to be as productive as possible. And that means providing them with the best infrastructure money can buy. I remember when I was at IBM, there was this attitude that programmers were like plumbers. If you need a big project done, just get more programmers. But I knew that some programmers were, like, ten times or more productive than others. I kept pushing IBM management to recognize this fact. But it did not. I remember being in an IBM managers meeting and some guy from corporate headquarters was explaining how they created something called their headlights program. The goal of which was to identify the best programmers in the company and pay them 20 percent more than the other programmers. Now, I figured this guy from corporate was making, like, $300,000 a year. So, I raised my hand and suggested they increase the pay of their best programmers to $400,000 a year. And he was stunned. He said, “What? More than me? You’ve got to be kidding me. Well, if the guy’s Bill Gates.” I said, “No, Bill Gates was making, like, 400 million per year. Not 400,000.” Anyway, they just didn’t get it. We don’t make that mistake. We pay our programmers a ton in accordance with the value we place on the infrastructure they produce.

  4. No interferenceWe don’t impose our own judgment on how the markets behave. Now, there’s a danger that comes along with success. To avoid this, we try to remember that we know how to build large mathematical models and that’s all we know. We don’t know any economics. We don’t have any insights in the markets. We just don’t interfere with our trading systems. Yes, of course there are a few occasions where something’s going on in the world and so we’ll cut back because we think the model doesn’t appropriately appreciate the risk of what’s going on. But those occasions are pretty rare.
  5. Time

    We’ve been doing this for a very long time. For me, this is my 30th year with the firm. And Jim and others were doing it for a decade before I arrived. This is really important because the markets are complicated and there are a lot of details one has to get straight in order to trade profitably. If you don’t get those details straight, the transaction costs will just eat you alive. So, time and experience really matters. 

A word on politics

[Kris: Peter Brown is liberal and co-CEO Bob Mercer is famously conservative. I can say that coming from the trading world, the liberal perspectives are in the minority amongst the traders but less so amongst the academics.]

Raj Mahajan: Is it true that while Bob Mercer and you have different politics, you worked closely for nearly 40 years at IBM and Renaissance? 

Peter Brown: Yes. It’s true. Bob and I began working together at IBM 40 years ago. And for most of the time, we’ve had offices right next to one another. So, we’ve done a lot together. And we’re still really close. In general, I find no better way of building friendships than through the collective creative process of building something together. And I see no reason why politics should interfere with friendship. 

Man vs machine stories

1) My understanding is that you had nothing to do with finance until age 38 and, instead, began your career working on automatic speech recognition. How did that happen?

Brown: So, at one point during high school I learned about the Fast Fourier transform. And I thought this was about the coolest thing I had ever seen. Probably because I went to an all-boys’ school and had nothing better to contemplate. Anyway, for some reason I got into my head that with the Fast Fourier transform it should be possible to recognize speech. You just take the speech data, transform it into the frequency domain. Match it up against patterns for words. And presto, magic, HAL would be born. And this idea always stuck around in the back of my mind. 

Then when I went to college I majored in math and physics. But in my senior year I had to fulfill a distribution requirement. So, I took a course in linguistics. And one day in the back of that course I heard a couple students talking about some guy whose name was Steve Mosher who started a company called Dialogue Systems that was doing speech recognition. And I thought, wow, great, I remembered this idea from back in high school. After class I raced over to the physics library. That’s because this was before the internet, so you had to go to the library. And I looked this guy up. And I found a paper he’d written. And I tracked him down. Applied for a job. And he hired me. And when I was there, I just fell in love with the idea that through mathematics it might be possible to build machines that do what humans do. I just loved the idea of exposing human intelligence to be nothing more than robotic computation.

2) I recently heard that in a talk you give at Harvard Business School you mentioned that you had a role in starting up the Deep Blue project at IBM. Can you tell us about that? 

Brown: Wow. Okay. I had been at IBM for a year or two. And I was standing in the men’s room one day when the vice president of computer science, a man named Abe Peled walked up next to me. I thought to myself, now’s my chance. I turned to him and said, “Dr. Peled, do you realize that for a million dollars we could build a chess machine that would defeat the world champion? Think of the advertising value to IBM.” He turned to me, looking kind of annoyed, and said, “What’s your name?” So, I told him. And then he said, “Could you please let me finish up here?” And so, I thought, wow, I had made a big mistake. So, I apologized, and I high tailed it out of there as fast as I could hoping he’d forget my name even faster.

But a half hour later, he called me in my office and told me that if I wanted to build a chess machine, he’d put up the million dollars. I told him that I was occupied with speech recognition. I have three friends from graduate school who could build it. He said, “Okay, hire them.” So, we did. They built the machine. I named it Deep Blue. In the first match, the IBM machine was a very weak machine. Weak physically. You know, I think only one special purpose chip in it. And we lost. The final match, however, was a different story. IBM had a much, much stronger machine with hundreds of special purpose chess chips. IBM won that match and IBM’s stock jumped $2 billion afterwards. Of course, it fell back down later. 

Now, a few years ago I was asked to speak at the Harvard Business School. And when I arrived, outside the auditorium, I could see all these protesters. And I thought, oh no, why are they protesting me? What have we done? Is there something I’m not aware of? I really didn’t want to do that. But as I got closer, I could see they were all holding signs about investing in Puerto Rico. And I thought, what is this all about? I was totally confused because I didn’t think we had anything to do with Puerto Rico. Then it turned out that the speaker before me was some guy named Seth Klarman from some firm named Baupost. Evidently, that firm had some investments in Puerto Rico and the protesters were protesting him. So, I went in to see Klarman’s talk, or at least the end of Klarman’s talk, to find out what all the hullabaloo was about. 

At the end of his talk, someone asked him his thoughts on quantitative investing. I suppose it was a set up for my talk. I don’t know. And I carefully noted his answer which was, “To do what I do takes a certain amount of creativity and finesse that a computer will never have.” And all those Harvard Business School MBAs seemed to really like that response. So, when it was my time to speak, right after him, I began by pointing out that after defeating Deep Blue in the first match, Kasparov was elated and gave a press conference at which he said, “To play chess at my level takes a certain amount of creativity and finesse that a computer will never have.”I then went on to point out that two years later we crushed him. Now, I’m not sure that’s how things will evolve. But whether it’s speech recognition, machine translation, or building large language models, or chess, or making investment decisions, I continue to love the process of showing that human intelligence, intuition, creativity, and finesse are nothing more than computation.

[Kris: In defense of Klarman, like the pod shops, I don’t think RenTec is investing so much as trading. Marc Rubinstein writes:

Dmitry Balyasny, founder of Balyasny Asset Management, attributes the model to a trading view of markets as distinct from an investing view.

“[Its] origins go back to my origins as a trader and thinking about how to build out business around trading… It makes sense to have lots of different types of risk-takers, because you have less correlation, you could attack different areas, the markets, and have specialists in different areas.”

I’ve beat that drum in Trading vs Investing and with great humility in How I Misapplied My Trader Mindest To Investing. 

Addressing Brown’s obsession with “exposing human intelligence to be nothing more than robotic computation.”

In The Introspection of Illusions, author David McRaney parses opacity of the intelligence and preferences buried in our subconscious:

Psychologically speaking, users found it easy to access the feelings that prompted them to give those films one star or five. Explaining why they made one feel that way would require the kind of guided metacognition that the Netflix interface simply couldn’t offer. Even when you stepped away from the code and the spreadsheets and asked people in person, they might not be able to tell you. They could make a guess. They could attempt to explain, justify, and rationalize their feelings, reactions, and star ratings, but without a conversational tool, a back and forth to get past all that to something honest and perhaps previously unexplored, you ran the risk of precipitating a psychological phenomenon known as the introspection illusion which would likely result in yet another phenomenon known as confabulation. There’s an entire literature of books and papers and lectures and courses devoted to this side of psychology. To put it very simply, we are unaware of how unaware we are, which makes us unreliable narrators in the stories of ourselves. You are, however, amazing at constructing stories as if you did know the antecedents of those things when explaining yourself to yourself and/or others.

There are parts of us we can’t access, sources of our emotional states we can’t divine, and I find some strange poetry in the fact that, like us, the algorithms can’t always articulate the why of what we do and do not like. Yet, through millions of A/B tests slowly zeroing in on more and more successful correlations, the Netflix Recommendation Engine can produce a glimpse of something a bit like the sort of profound, soul-exposing knowledge earned via an intense introspection that we could never achieve. Something a few fathoms deeper than “I don’t know, it just wasn’t for me.”

Speed Round

1) Is it true that at one point you went to IBM to suggest that the statistical methods you were using in speech recognition could be applied to finance, and asked to be given an opportunity to manage some fraction of IBM’s corporate cash?

Brown: Yes. I think that was in 1993. But IBM corporate had absolutely no interest. So, instead we went to Renaissance where we did the same thing we had in mind for IBM, but instead with money Jim Simons had raised.

2) Is it true that since you first joined Renaissance you have spent nearly 2,000 nights sleeping in your office? 

Brown: Yes. My wife works in Washington DC. And my experience has been that when a husband and a wife work in two different towns, the husband commutes. Psychologically, if I’m going to be away from my family, I have to work. I sleep in my office when I’m in Long Island. 

For me, productivity-wise it’s really fantastic being able to spend nearly 80 straight hours each week with no interruptions except sleep thinking about work before spending three more normal days at home. Of course, I really miss my family. But the freedom to concentrate nonstop on work while surrounded by my colleagues is hugely valuable. And the job is so demanding, I really don’t see how I could do it otherwise.

[Adds this]  I’m just one of those types who can’t sleep. Not by choice. I just can’t sleep. So, I often am on the computer by around 2 am. And it’s true, I tend to send a lot of emails out in the middle of the night.

3) Is it true that you almost exclusively hire people with zero background and finance? 

Brown: Yes. We find it much easier to teach mathematicians about the markets than it is to teach mathematics and programming to people who know about the markets. Also, everything we do we figure out for ourselves. And I really like it that way. So, unlike some of our competitors, we try to avoid hiring people who have been at other financial firms. 

[Kris: The prop trading firms think similarly. My friend Joel talks about how Brown’s claim that it “is is easier to teach markets to mathematicians than it is to teach math to market experts, may seem dismissive to market-centric people but in reality is more of a statement about what “math” is at Renaissance.” He goes on to distinguish about levels of math but I latched on to this a more general observation:

Markets person isn’t a thing. Markets thinking is systems thinking and anyone from any discipline can learn that. From there go on Investopedia and learn how a zero coupon bond or share of stock works. start with a good, teachable mind then label the variables.

Math/STEM skills are legible markers of computational/rigorous thinking. Someone trained in the nitty gritty of assumptions, what follows, and so on. Making abstractions concrete.

If I’m generous it took a month of professional training for non-finance STEM grads at SIG to know everything finance grads would have brought to the table. But you can’t teach math and computer science in a month. 

Ultimately this is only part of the story of getting a great start in finance. There’s a Berksons Paradox once you are in the pool of high level finance employment where the math skills don’t correlate as much with talent. You get older and realize the dichotomy of being a math person vs a verbal person that you carried as an identity when you were young is bullshit. Skills in either are likely highly correlated. But maybe the right door or guidance wasn’t there to help you see that.]

4) What do you actually look for in applicants? 

Brown: Math ability. Programming ability. A love for data. A work ethic. And most importantly, the ability and desire to work will in a collegial environment.

5) How do you actually assess those qualities?

Brown: I think probably the same way other firms do. First, we get resumes. Those that look promising we give them phone interviews and we ask them for references. If those pan out, then we invite the promising applicants to give research talks. Talks like if you’re applying for a job at a university or something like that. And then we put them through a grueling day of solving problems in math, physics, statistics, computer science, and so forth at a blackboard.

6) Is it also true that your staff had to install mirrors in the corners of the office to prevent you from flying into people as you rode a unicycle around the office? 

Brown: Where did you get all these questions from? Yes, it’s true. Although, I don’t ride a unicycle anymore because at one point I crashed and the unicycle broke. 

How would you trade if you knew the future but not the path?

I saw a tweet:

Let’s set aside the obvious “just short bonds” response to a crystal ball that tells you mortgage rates are going to roof. While I’m not sure how volatile the 10-year note/MBS basis is, just shorting bonds would seem like the most direct and reliable trade.

The rest of the crystal ball portfolio underwhelms expectations. Ahh, a recurring parable in the “trading is hard” bible. Like if you knew what a stock’s earnings were going to be would you be able to make money? How do you know what the “whisper” number is or if the market is focused on guidance more than income for this quarter?

It also reminded me of 2 adjacent reads that cut to the heart of “how would you trade if you knew the future but not the path?”

  1. In Financial Hacking, a puzzle is presented:Assuming you could not trade options, how much would you pay to know the closing price of SP500 in one month?

    🧩Excerpts from the discussion

  2. Even God Would Get Fired As An Active Investor (AlphaArchitect)

Moontower #198

I saw this tweet from David:

Everyone understands this feeling.

I heard an interview recently that discussed the psychology behind this behavior.

I’ll cut to the link:

🔗David McRaney on EconTalk

Episode description:

To the Founding Fathers it was free libraries. To the 19th century rationalist philosophers it was a system of public schools. Today it’s access to the internet. Since its beginnings, Americans have believed that if facts and information were available to all, a democratic utopia would prevail. But missing from these well-intentioned efforts, says author and journalist David McRaney, is the awareness that people’s opinions are unrelated to their knowledge and intelligence. In fact, he explains, the better educated we become, the better we are at rationalizing what we already believe. Listen as the author of How Minds Change speaks with EconTalk host Russ Roberts about why it’s so hard to change someone’s mind, the best way to make it happen (if you absolutely must), and why teens are hard-wired not to take good advice from older people even if they are actually wiser.

The best teaser for the interview comes directly from it when McRaney says:

The incepting point of this book was someone in a lecture came up to me and asked about their father who had slipped into a conspiracy theory and they said, ‘What can I do about that?’

And, I told them, ‘Nothing.’ They said, ‘How do I change his mind?’ I said, ‘You can’t.’ And, I really felt, the second I said it, that: I don’t know enough about this to say something like that. I don’t even know if I believe what I just said, but I know one thing I don’t like this attitude I have about this issue. I should at least learn more about it.

And, if I was in that same situation today, I would actually be able to say, ‘Oh, here’s what you should do. Here’s what you should say.’ I no longer believe anyone is unreachable. I no longer believe anyone is unpersuadable.

In conversations that don’t work out the way we think, we blame the other side. We say, ‘They’re dumb. They’re mean. They’re evil. They’re ignorant. They are unreachable, unchangeable, stuck in their ways.’ These are all things that we are using to forgive ourselves for failing.

Listen to the interview. My excerpts are just what I wanted to keepsake. My notes covered:

  • motivated reasoning for social acceptance
  • the process of radicalization
  • reactance (or what I call “reflexive contrarianism”)
  • shaming
  • specific approaches that work to unblock discussions
  • “street epistemology”
  • cognitive empathy

If you do nothing else, zoom in on the “reactance “section which I titled this post for — that feeling of “F you I won’t do what you tell me” is ingrained and worth understanding.

If you know the reference, you know RATM. And just in case you’ve never seen it — the video below is a recording of one of their first public concerts. It was filmed in 1991 at Cal State Northridge. It’s a bizarre scene juxtaposing a routine day on a sunny campus quad against the band’s angry energy. An ice cream social with an a cappella group like Chorus against The Chaos would have drawn a crowd faster.

Zach is unfazed. By the end of Bullet In Your Head, the audience starts noticing. If you consider the state of rock just coming out of the 80s (Nevermind was released only 3 months before this performance) and the relative infancy of hip-hop this performance must have been pretty alien.

They would go on to release their debut album a year later and play a side stage at the second Lollapalooza.

They’d play the main stage one year after that.

[Unclassified personal thought: I like watching old concert videos. I’d waste one of my 3 genie wishes to have the power to peer into the present of the audience members I see in these old clips. It’s an escapable thought every time I watch them. Like knowing that skinny, shirtless viper with the long hair slithering to the groove is now bitchin’ about Blackrock makin’ his truck expensive to fill up. Mind you he’s a landlord in Laguna where he bought his first bungalow in 1972. Discovered the town after catching the Dead at the Newport Pop Festival a couple miles down the road a few years before that. A show he hitchhiked to from Indiana while running from the life the ”squares” back home had envisioned for him.

The brightness of youth casts a shadow — the finer rays suggest their own sorrows]

Money Angle

Last Wednesday in Investing With Your Hands On The Wheel, I beat my old drum that trading isn’t really something one does “on the side”. Trading is a business. And I am quite skeptical about the reward per unit of effort for playing Nostradamus in your investing portfolio. I know there are people who disagree with me on this. I’ll happily grant them their track records at face value but wave the plane with zits at them:

via Wikipedia

The quote:

I’m pretty much in the camp of “get a job where you can do this full-time if you really want to”. If you can’t do this but still want to explore strategies, then fence out some capital to play/learn/experiment…

For the rest of your assets stick with some kind of permanent portfolio implementation depending on your risk tolerance. You can follow folks like Corey Hoffstein, NomadicSamuel, Jason Buck, Lily for that stuff. InvestResolve guys too. All these tweet about it too and it’s all quite solid. I recommend this series by the InvestResolve team.

My gut feel is return-stacking/permanent portfolio for long-term DCA is probably the efficient frontier of work/return/risk triple axis.

If you insist on being active, there is a totally acceptable framing too:

But there’s no doubt that many people want to put their hands on the wheel and that has innate personal value (and that’s true whether it’s misguided or not). So in short I think it’s a tree:

  1. DCA permanent portfolio variant if you want autopilot
  2. If you want to put your hands on the wheel what does that efficient frontier of effort/return/risk look like where return also includes some illegible component of DIY satisfaction?

I should probably pull together a new Moontower wiki of permanent portfolio content that I like. It might be an insurance policy against me never writing the Implementation portion of moontowermoney.com

[I have all the material that goes into it collected and sorted but it’s a small book-level project that’s on the back burner]

In the meantime, I’ll dribble out some things that really resonated in this column. Today, I’ll point you more closely to the InvestResolve series I referenced in the above quote.

Adam Butler and his team at InvestResolve did a wonderful 12-episode Masterclass on the topic of portfolio construction.

  • I took notes on the first 8 episodes. I didn’t take notes for episodes 9-12 as they get into the weeds of quant methods, backtesting, and ensembles. I was more interested in a conceptual primer to risk parity as a portfolio construction method for diversifying across unique edges.
  • The notes include a link to the episode as well as a transcript

💡Most important ideas

  1. A more diverse portfolio has a higher expected risk-adjusted performance over time.
  1. Asset allocation is useful because it maximizes the number of independent bets in the portfolio.
  1. Those bets are independent are sustainable because they’re directly linked to fundamental economic properties.
  1. A risk parity portfolio is the most efficient portfolio if you believe major asset classes are fairly priced (ie their Sharpe or other measures of risk/reward are the same)

🔗InvestResolve Masterclass On Risk Parity (Link)

If you are short on time focus on the first 3:

Money Angle For Masochists

I saw a tweet:

Let’s set aside the obvious “just short bonds” response to a crystal ball that tells you mortgage rates are going to roof. While I’m not sure how volatile the 10-year note/MBS basis is, just shorting bonds would seem like the most direct and reliable trade.

The rest of the crystal ball portfolio underwhelms expectations. Ahh, a recurring parable in the “trading is hard” bible. Like if you knew what a stock’s earnings were going to be would you be able to make money? How do you know what the “whisper” number is or if the market is focused on guidance more than income for this quarter?

It also reminded me of 2 adjacent reads that cut to the heart of “how would you trade if you knew the future but not the path?”

  1. In Financial Hacking, a puzzle is presented:Assuming you could not trade options, how much would you pay to know the closing price of SP500 in one month?

    🧩Excerpts from the discussion

  2. Even God Would Get Fired As An Active Investor (AlphaArchitect)

Alexis reminded me of cringe times from my NYC days. Almost as cringe as referring to probabilities as deltas. As in “I’m 75 delta to meet you for drinks after my work dinner” 🤮

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Also, if you were never cringe about anything you have the heart of a dead fish and you should get that checked out.

@yayalexisgay

it’s not “banking” per se but… I mean, it’s all “banking,” really……. right? 🥴 🎥 edited by @Alex Moudgil #finance #comedy #dating

♬ original sound – Alexis Gay

Investing With Your Hands On The Wheel

Newsflash: This letter’s audience has lots of professional and retail investors. There are also lots of aspiring traders or just people who want to supplement their income with “alpha” from the markets.

So I commonly get asked for advice on trading for oneself. “I have a $250k account I’ve studied A to Z…etc”

Many of the backstories are impressive. Y’all impress me. I got a non-rigorous econ degree that only required 8 core classes. And those catered to my strength — bullshitting on blue-lined pamphlets. I limp into a stellar firm that knows how to teach trading and decision-making just as it’s hiring its largest cohort ever. I’m a product of those I was lucky to be surrounded with. If I was good at anything it was assimilation. More practical than heroic ultimately.

So when a smart, bushy-tailed go-getter asks me about prospects for succeeding as a retail trader I’m torn. Trading is a hard way to make a living even when you’re sitting in the F-16 cockpit of a prop firm. Seems like it should be impossible for retail. On the other hand, I’m not built of the best stuff so who the heck am I to piss on the grit-factories that email me.

I got one of those emails on Monday. Sharing my responses(italics) here:

A few thoughts:

1. This thread from Lily is spot on

2. Listen to this interview with Darrin

Reader: What would your advice be to someone who loves markets and trading more than anything and doesn’t look at this as a chore, but rather a passion? Is it still a fool’s errand to not just DCA into QQQ and SPY and go find another interest?

Me:  99% of people should probably look elsewhere but that’s true of anything that is exceptionally hard. There still will always be the 1% who do not take no for an answer. Nobody can tell you who you are. You ultimately seize who you are. If you fall to the level of your weakest strength, you can still decide if that’s your resolve or something else.  

Reader: I know about all of the time in the market > timing the market, the Buffet bet, all of it – but maybe I am just irrationally stubborn?

Me: If you listened to the Will England interview you can hear him say that a lot of the neutrality guardrails are in place because nobody trusts anyone’s ability to time. Vol traders can’t even time vol and I’m talking about the best vol traders in the world. If this is what you think the edge is nobody is going to buy it. You will need to prove it with your own $. That said, timing is not really the edge most try to have. This interview might be helpful to expand your thoughts on it.

Reader: I guess I have seen some of my mentors trade very, very well, but maybe I am just not able to allocate as much time and attention via a full life elsewhere. Are there any resources you would recommend to explore further ideas? There are people way, way smarter than me that just say DCA into low cost interest ETFs and go take a walk, but is there anything worth anybody’s time when it comes to more active stuff?

Me: I didn’t up in this biz on my own like say Darrin did. I don’t know how those people do it, I can just listen to their stories. I’m pretty much in the camp of “get a job where you can do this full-time if you really want to”. If you can’t do this but still want to explore strategies, then fence out some capital to play/learn/experiment. For the rest of your assets stick with some kind of permanent portfolio implementation depending on your risk tolerance. You can follow folks like Corey Hoffstein, NomadicSamuel, Jason Buck, Lily for that stuff. InvestResolve guys too. All these tweet about it too and it’s all quite solid. I recommend this series by the InvestResolve team.

In general, my advice, which sounds hard but is probably easier than trying to trade for a living: get a high-paying job. 

All this focus on trying to make your money work for you is totally secondary to the biggest muscle movement — make more money with your skills or with a business. I came to the internet around 2015 to learn about investing because I already had a lot of savings, a house etc. So I was like “now what to do with the money”. Most of my option traders friends have no process or framework for investing. In fact, most of them find it to be a waste of time to give it a lot of thought. I don’t fully agree with them on that, but I was like that myself. Instead, we all focused on — “I want to make so much money that it doesn’t matter if I just stuck it in t-bills”. It’s a pretty jarring answer compared to conventional thinking and it’s not fully right — but there’s truth in the instinct.  When I look at people who have built more wealth in the past decade from investments than income I think — “that looks fragile”.

Everyone wants to feel like they slayed the investing dragon and were great at making their money work for them. Meanwhile, there’s a bunch of folks out there who want to focus on what they’re good at, have hobbies and be f’n happy on the weekends not researching the next investment or managing rental properties. They out there just thinking — I’m gonna go get paid seven figures a year on a W2 working for an elite organization.

I added this later in a tweet and it’s just straight talk if someone is sweating lots of financial success:

Be special enough to get pedigree

Or

Be special enough to not need pedigree

In other words, this reduces quite easily to things that are very hard. Invoking the “Why would it be otherwise” line.

And as far as being methodical about the original question of trying to earn a return on $250k, John has said it well:

One of my favorite writers,

Venkatesh Rao

just published an incisive climate posture post [paywalled]. It has this amazing passage that can be ported from climate contexts to people’s need to trade (bold is mine):

The narrative web of the climate discourse is very hard to map, but one thing is clear: Almost everybody is an NPC in the current situation, and is primarily desperately solving for how not to feel like an NPC. This is an important point. Humans have a strong tendency to confuse a psychologically satisfying amount of agency with a materially effective amount. A broad culture of what we very-online people call cope rules everything around us when it comes to climate. It is a deep-rooted tendency, and an understandable one. Much as we might intellectually desire such laudable goals as the survival of almost everybody through a planetary crisis, our sense of meaningful existence is tied to individual agency. We’d rather stride grim-faced with a gun across a devastated post-apocalyptic landscape, masters of our own fates, than feel helpless within a world that’s largely doing fine and even providing for us.

What. A. Line:

Humans have a strong tendency to confuse a psychologically satisfying amount of agency with a materially effective amount.

Don’t just stand there, do something, right?

But also…

A trader pinged me saying:

There is a false dichotomy between 100% passive and 100% active. I feel like with the right mindset/education/strategies, there are ways to meaningfully add value to one’s portfolio via lower touch strategies and this can be done in addition to one’s day job.

Like in the guys email, one of his first questions was whether it is a fool‘s errand to not just DCA into SPY. I feel like the investment education landscape is so distorted that DCA SPY is the baseline. I would almost argue it should be quite easy to outperform buy and hold, especially on a risk adjusted basis without having to spend hours of screen time.

Ultimately, questions like this are ones without tidy answers.

This is where I shake out on it for now:

My gut feel is return-stacking/permanent portfolio for long-term DCA is probably the efficient frontier of work/return/risk triple axis.

But there’s no doubt that many people want to put their hands on the wheel and that has innate personal value (and that’s true whether it’s misguided or not). So in short I think it’s a tree:

  1. DCA permanent portfolio variant if you want autopilot
  2. If you want to put your hands on the wheel what does that efficient frontier of effort/return/risk look like where return also includes some illegible component of DIY satisfaction?

This is related in a weird way but one of my favorite interviews was with Professor C. Thi Nguyen, author of Games: Agency As Art. It’s a penetrating twist of how art or creation is a form of agency — games allow players to take on different agency roles. To step outside themselves in a low-stakes way.

The pragmatic view of investing/trading is and should be for profit. But whether partitioning some of that mental and monetary budget to satisfy agency needs might say something about whether you are getting enough of that in other endeavors. Investment as agency?

I’ve been reading Ed Thorp’s autobiography with my 10-year-old (very slowly I might add — between myself and the boys we are simultaneously reading 5 books. Sympathies to Yinh who is surrounded by broken brains). We are about to start the second half of the book where Thorp leaves gambling (after the casinos tried to kill him by jamming his car’s accelerator!) and sets his sights on the world’s greatest casino — Wall Street. But despite being on the Mount Rushmore of investors, Ed left the game content to invest his fortune with other managers, seeing more to life than the day-to-day of this particular game.

An interesting side-note was Ed and Claude Shannon were good friends and accomplices in devising the world’s first wearable computer (which they used to break roulette). Claude was also a wildly successful investor. Both of these men saw investing as an interesting puzzle. Money was a byproduct. They didn’t seem to care too much about money other than its evidence of their hypothesis.

There’s a line in Tomorrow, and Tomorrow, and Tomorrow where celebrated video game designer describes a (less than mentally healthy) scene from his youth:

They were in her car on the way back from a math competition in San Diego, and Sam was giddy with the feeling of being better than everyone else at something that he didn’t care about at all.

I have several option trader friends who are misfits — amongst the smartest traders out there getting paid big bucks at the firms you know. They could care less about investing but find trading fun. This is just a game that pays way too much for what it requires of them. They have all these other nutty interests and would sooner off themselves than read an investing book. Me, I’m just a normie pragmatist. I did it for the money, not because I love the game. In fact, one of these friends has told me he thinks I’m totally f’n weird because I don’t love the trading part, I love the conceptual parts, the building parts — which is the exact opposite of his position.

My ability to pull any useful insight from this is strained. But it’s probably just some cliche — think deeply about what you’re good at and what you want…and the conversation that’s hardest to have with yourself — why do you want it? The answers are always laden with some amount of insecurity, but I think that’s what keeps us alive. And abolishing insecurity probably isn’t a reasonable or even respectable goal. Coming to agreeable terms with it strikes me as more human.

It must be nice to find that thing that’s in-demand that comes really easy to you. I wonder what an emphasis on finding that would look like rather than preaching the grit catechism.

The Pods On Top Of The Food Chain

There are lots of videos online of orca pods feasting on white sharks. What rattles the imagination is how they go straight for the liver. The liver’s bounty is a dense nutrient-rich oil called squalene that can account for up to a third of a shark’s weight.

Hopping over the semantic curiosity that benz and squal just adopt an “ene” to become oil words, I’ll skip straight to ruthless analogy. The pod shops in investing are top of the food chain in asset management. It’s said on the internet, so I know it’s true, that a single shark liver can nourish an orca for a “whole day”. First of all, if that’s supposed to be a jaw-dropping amount of nutrition call me underwhelmed. If a white shark a day keeps the doctor away, I’m left to think Shamu’s cursed appetite has no end — this is an aqua-treadmill of blood without a killswitch.

Which serves the analogy perfectly.

Squalene is alpha. There’s not a ton of it out there and the hunt for it mobilizes the top of the academic food chain. In 2000, I made $50k including signing and year-end bonus my first year out of college. That figure is 8x today for top grads accepting prop shop offers. Talent war.

The trading world’s ruthless focus on squalene — risk-adjusted returns while staying market-neutral to print money in any environment has been adopted by the investing world. And the allocators have noticed. The pods, like the orcas, are eating everyone’s lunch right out of their bellies. And those inflows are arming the war for mature talent too. Giant guarantees to proven managers. The kind of money that can get even the most ambitious manager to re-think starting their own firm.

With that intro, I’ll point you to a podcast:

Patrick O’Shaughnessy interviews Will England (Invest Like The Best)

Will is the CEO/CIO of Walleye’s $5B multi-manager hedge fund. I’m familiar with Walleye because they started in the mid-aughts as an option market maker. Several friends and ex-colleagues have traded for them. But this podcast is about their hedge fund, not the prop biz. It’s the best investing interview I’ve heard this year.

First of all, if you are unfamiliar with the multi-manager or “pod shop” pass-thru hedge fund model then this interview is a great primer. The big 4 managers in the space are Citadel, Balyasny, Millenium and Point 72.

Will’s language, tone, and thinking will be deeply familiar to folks who have done tours of duty at prop trading and option firms. My take on this interview is “damn, that was honest”. Will is in Minnesota but shoots as straight as a Chicago pit trader. Heck, he addressed the alignment issues with the “back book” — I’ve talked to pod traders about this idea before and couldn’t believe he broached the topic in this call). His voice was like a lullaby from my younger years.

Patrick asks the right questions. Everything from the knowledge to the story is worth an hour of your time. It confirmed a lot of what I thought I knew and taught me even more.

A few thoughts of my own

Will says 25% of their business is still options trading but a significant chunk is now fundamental equity. The PMs are trying to earn a 3% spread between longs and shorts after stripping away beta and factor tilts. Just like other pod shops, these guys are farming pure alpha or “idio” (for idiosyncratic) and levering it to get to about a 30% return which the investor hopes to see half of after implicit/explicit fees.

It has always struck me that this is the natural progression of active management. A barbell where you pay up for pure alpha and get your beta for free.

The closet beta active management world is a melting ice cube. But the incentives and stickiness of legacy relationships both from allocators and story-telling managers will try to keep the freezer door closed as long as possible.

But I can’t say I know where the equilibrium will shake out. If you have pure alpha, you can choose your investors either by fees or by preference. You have all the bargaining power. But I’m not sure what the capacity of alpha even is. Will didn’t mince words about the competitiveness. He thinks the number of PMs that possess both the chops and psychological profile to play this game is on the order of a thousand people maybe. The pods are flush with cash and signing talent with big upfront deals like athletes. (He admit the model could be in a period of froth at the moment). Will’s belief in market efficiency sounds like “efficiently efficient”. Yes, there are 10 Sharpe strategies. They are also low-capacity. Any strategy with an obnoxiously high Sharpes is basically arbitrage counting down to extinction. But that new species pop up and then disappear is a general truism. A never-ending game of whack-a-mole.

[Aside: Anyone reading Moontower for a long time knows I don’t wade into the market-efficiency debates because they sound like academic masturbation. I have my own version which rhymes with what Will talks about — The “No Easy Trades” Principle. When I encounter someone who disagrees with this I hear one of these possible confessions:

  1. “I got rich on a highly concentrated risky bet and have never considered what the outcomes would be if I re-ran my life 100x”
  2. “I have no idea what I’m talking about”

I was out with a friend recently who ran a high-volume options trading business for 25 years. We talked about how nearly every time they would “exploit” some weird rev/con financing opportunity they found a way to get f’d by the borrow market. He could rattle off example after example of interesting set-ups and yet the outcomes were consistent. You’re literally paying to discover new failure modes but the way each setup arrives you feel like you can see why the opportunities are real.

Almost every time I did a trade and felt good about it afterward, I was in the pre-glow of a bad beat. The trades that feel scary are the ones that pay. And this makes sense — the price is compensation for doing what nobody wants to do. The job-to-be-done is finding a way to manage the risk until everyone who is transacting to satisfy their greed or pain is filled. The removal of that pressure is what begins to turn the trade in your favor.

Trading profitably is painful. It must be or there is no reason to be paid for it. what’s worse — just because you feel pain, doesn’t mean you will make money. The pain is the cherry on top of doing everything right. You can have pain even if you do things wrong and it will be in vain. The difference is when you do things wrong, you feel good about it in the interim because you don’t get how this works. And that fleeting satisfaction is what keeps you from learning.

I’m sorry but trading profitably means being constantly paranoid and finding a way to live with that. I suspect a subtle aspect of what makes the pods so smart is they have codified and automated the risk management in a way that guarantees the PM’s paranoia.

This is an aside because I think you need a lot of reps to grok what I’m saying and honestly most people will just go on pointing to things that don’t make sense and breathlessly exclaim “See the market is inefficient”. You don’t have a right to say that unless you tweet it from your yacht purchased with lots of receipts.

Strategically, in a game where the skill level is extremely high and evenly matched, then variance will drive a lot of the separation. So the counterintuitive response for someone dead-set on being rich but knows they are overmatched is to take a giant, high-variance bet and hope this was the lifetime it panned out.]

Sorry, back to the body.

In short, I don’t consider what these pods are doing to be investing. They are trading but on a medium time horizon. It’s called “fundamental equity” but let’s say the holding periods are under 2 years and probably more like 1 (if someone knows the stats please share) then this isn’t about “realized” fundamentals. This is about anticipating change in sentiment around expected fundamentals. This feels like a game of nearer-term info, flows, positioning, and game theory. A re-rating game. A game that was much more similar to what I did (although it sounds more complex than vol trading which has more to do with flows and is yet even smaller capacity) than what I imagine value investors do.

My thoughts on value investing are mixed. And I’m being liberal with the word “value”, recognizing that cookie-cutter implementations of “value” are the equivalent of accounting fails (like not updating the meta-principles to handle object-level changes in importance to things like goodwill or brand equity). I assume there are value managers who can spot high-multiple value names because they have a “g” column in their Pandas dataframe (just kidding — I meant in their spreadsheet — we are still talking about value investors here). The problem with these managers and their “long-term” theses is they want you to buy the brand name vitamin instead of the generic and when you ask for the quarterly bloodwork to see if it’s making a difference they say you won’t see the benefits until you retire. The blood results are just “noise” they’ll tell you.

On the other hand, if the manager’s signal reliably swamped the noise then they wouldn’t give that away. They’d try to get pod shop fees. Market efficiency is fractal — there’s a market for the assets and for the labor that moves the assets. I’ve alluded to this before in The Paradox of Provable Alpha and Will’s interview made me think it’s only going to be a more relevant paradox going forward.

Learn more:

🧵BEAT THE PODS: A 7-POINT RECIPE FOR SINGLE MANAGERS (Brett Caughran)

This is a long but good thread by @FundamentEdge

This pairs well with Ted Seides’ interview with Jason Daniel and Porter Collins, 2 of the investors made famous in The Big Short from their work with Steve Eisman:

🎙️Big Shorts and Big Longs (Capital Allocators)

These guys had a stint at Citadel where they learned the intricacies of the pod model. It didn’t resonate with them and for reasons that confirm my own interpretation — pods are more like traders than long-term investors. They had 2 big insights:

  1. The pod model is so prevalent (and it is smart) that if you don’t understand the dynamics they impose on the market, you’re playing with one eye closed. They have respect for the model (and how Citadel implemented it) even if it’s not their game.
  2. They realized the model left some forms of edge behind because of its nature. They could make picking that up part of their own niche. This is touched upon in Caughran’s thread above.

🔗Multi-Manager/Pod/Hedge Fund 101 (7 min read)

Byrne Hobart’s primer from his evergreen Capital Gains Substack

Moontower #197

Just one link before we hop into investing topics.

For his 100th essay in his series “We’re Gonna Get Those Bastards”, Jared Dillian tackles the question:

How do you live a happy life?

It’s short and sweet.

Money Angle

Top of the Food Chain

There are lots of videos online of orca pods feasting on white sharks. What rattles the imagination is how they go straight for the liver. The liver’s bounty is a dense nutrient-rich oil called squalene that can account for up to a third of a shark’s weight.

Hopping over the semantic curiosity that benz and squal just adopt an “ene” to become oil words, I’ll skip straight to ruthless analogy. The pod shops in investing are top of the food chain in asset management. It’s said on the internet, so I know it’s true, that a single shark liver can nourish an orca for a “whole day”. First of all, if that’s supposed to be a jaw-dropping amount of nutrition call me underwhelmed. If a white shark a day keeps the doctor away, I’m left to think Shamu’s cursed appetite has no end — this is an aqua-treadmill of blood without a killswitch.

Which serves the analogy perfectly.

Squalene is alpha. There’s not a ton of it out there and the hunt for it mobilizes the top of the academic food chain. In 2000, I made $50k including signing and year-end bonus my first year out of college. That figure is 8x today for top grads accepting prop shop offers. Talent war.

The trading world’s ruthless focus on squalene — risk-adjusted returns while staying market-neutral to print money in any environment has been adopted by the investing world. And the allocators have noticed. The pods, like the orcas, are eating everyone’s lunch right out of their bellies. And those inflows are arming the war for mature talent too. Giant guarantees to proven managers. The kind of money that can get even the most ambitious manager to re-think starting their own firm.

With that intro, I’ll point you to a podcast:

Patrick O’Shaughnessy interviews Will England (Invest Like The Best)

Will is the CEO/CIO of Walleye’s $5B multi-manager hedge fund. I’m familiar with Walleye because they started in the mid-aughts as an option market maker. Several friends and ex-colleagues have traded for them. But this podcast is about their hedge fund, not the prop biz. It’s the best investing interview I’ve heard this year.

First of all, if you are unfamiliar with the multi-manager or “pod shop” pass-thru hedge fund model then this interview is a great primer. The big 4 managers in the space are Citadel, Balyasny, Millenium and Point 72.

Will’s language, tone, and thinking will be deeply familiar to folks who have done tours of duty at prop trading and option firms. My take on this interview is “damn, that was honest”. Will is in Minnesota but shoots as straight as a Chicago pit trader. Heck, he addressed the alignment issues with the “back book” — I’ve talked to pod traders about this idea before and couldn’t believe he broached the topic in this call). His voice was like a lullaby from my younger years.

Patrick asks the right questions. Everything from the knowledge to the story is worth an hour of your time. It confirmed a lot of what I thought I knew and taught me even more.

A few thoughts of my own

Will says 25% of their business is still options trading but a significant chunk is now fundamental equity. The PMs are trying to earn a 3% spread between longs and shorts after stripping away beta and factor tilts. Just like other pod shops, these guys are farming pure alpha or “idio” (for idiosyncratic) and levering it to get to about a 30% return which the investor hopes to see half of after implicit/explicit fees.

It has always struck me that this is the natural progression of active management. A barbell where you pay up for pure alpha and get your beta for free.

The closet beta active management world is a melting ice cube. But the incentives and stickiness of legacy relationships both from allocators and story-telling managers will try to keep the freezer door closed as long as possible.

But I can’t say I know where the equilibrium will shake out. If you have pure alpha, you can choose your investors either by fees or by preference. You have all the bargaining power. But I’m not sure what the capacity of alpha even is. Will didn’t mince words about the competitiveness. He thinks the number of PMs that possess both the chops and psychological profile to play this game is on the order of a thousand people maybe. The pods are flush with cash and signing talent with big upfront deals like athletes. (He admit the model could be in a period of froth at the moment). Will’s belief in market efficiency sounds like “efficiently efficient”. Yes, there are 10 Sharpe strategies. They are also low-capacity. Any strategy with an obnoxiously high Sharpes is basically arbitrage counting down to extinction. But that new species pop up and then disappear is a general truism. A never-ending game of whack-a-mole.

[Aside: Anyone reading Moontower for a long time knows I don’t wade into the market-efficiency debates because they sound like academic masturbation. I have my own version which rhymes with what Will talks about — The “No Easy Trades” Principle. When I encounter someone who disagrees with this I hear one of these possible confessions:

  1. “I got rich on a highly concentrated risky bet and have never considered what the outcomes would be if I re-ran my life 100x”
  2. “I have no idea what I’m talking about”

I was out with a friend recently who ran a high-volume options trading business for 25 years. We talked about how nearly every time they would “exploit” some weird rev/con financing opportunity they found a way to get f’d by the borrow market. He could rattle off example after example of interesting set-ups and yet the outcomes were consistent. You’re literally paying to discover new failure modes but the way each setup arrives you feel like you can see why the opportunities are real.

Almost every time I did a trade and felt good about it afterward, I was in the pre-glow of a bad beat. The trades that feel scary are the ones that pay. And this makes sense — the price is compensation for doing what nobody wants to do. The job-to-be-done is finding a way to manage the risk until everyone who is transacting to satisfy their greed or pain is filled. The removal of that pressure is what begins to turn the trade in your favor.

Trading profitably is painful. It must be or there is no reason to be paid for it. what’s worse — just because you feel pain, doesn’t mean you will make money. The pain is the cherry on top of doing everything right. You can have pain even if you do things wrong and it will be in vain. The difference is when you do things wrong, you feel good about it in the interim because you don’t get how this works. And that fleeting satisfaction is what keeps you from learning.

I’m sorry but trading profitably means being constantly paranoid and finding a way to live with that. I suspect a subtle aspect of what makes the pods so smart is they have codified and automated the risk management in a way that guarantees the PM’s paranoia.

This is an aside because I think you need a lot of reps to grok what I’m saying and honestly most people will just go on pointing to things that don’t make sense and breathlessly exclaim “See the market is inefficient”. You don’t have a right to say that unless you tweet it from your yacht purchased with lots of receipts.

Strategically, in a game where the skill level is extremely high and evenly matched, then variance will drive a lot of the separation. So the counterintuitive response for someone dead-set on being rich but knows they are overmatched is to take a giant, high-variance bet and hope this was the lifetime it panned out.]

Sorry, back to the body.

In short, I don’t consider what these pods are doing to be investing. They are trading but on a medium time horizon. It’s called “fundamental equity” but let’s say the holding periods are under 2 years and probably more like 1 (if someone knows the stats please share) then this isn’t about “realized” fundamentals. This is about anticipating change in sentiment around expected fundamentals. This feels like a game of nearer-term info, flows, positioning, and game theory. A re-rating game. A game that was much more similar to what I did (although it sounds more complex than vol trading which has more to do with flows and is yet even smaller capacity) than what I imagine value investors do.

My thoughts on value investing are mixed. And I’m being liberal with the word “value”, recognizing that cookie-cutter implementations of “value” are the equivalent of accounting fails (like not updating the meta-principles to handle object-level changes in importance to things like goodwill or brand equity). I assume there are value managers who can spot high-multiple value names because they have a “g” column in their Pandas dataframe (just kidding — I meant in their spreadsheet — we are still talking about value investors here). The problem with these managers and their “long-term” theses is they want you to buy the brand name vitamin instead of the generic and when you ask for the quarterly bloodwork to see if it’s making a difference they say you won’t see the benefits until you retire. The blood results are just “noise” they’ll tell you.

On the other hand, if the manager’s signal reliably swamped the noise then they wouldn’t give that away. They’d try to get pod shop fees. Market efficiency is fractal — there’s a market for the assets and for the labor that moves the assets. I’ve alluded to this before in The Paradox of Provable Alpha and Will’s interview made me think it’s only going to be a more relevant paradox going forward.

Learn more:

🧵BEAT THE PODS: A 7-POINT RECIPE FOR SINGLE MANAGERS (Brett Caughran)

This is a long but good thread by @FundamentEdge

This pairs well with Ted Seides’ interview with Jason Daniel and Porter Collins, 2 of the investors made famous in The Big Short from their work with Steve Eisman:

🎙️Big Shorts and Big Longs (Capital Allocators)

These guys had a stint at Citadel where they learned the intricacies of the pod model. It didn’t resonate with them and for reasons that confirm my own interpretation — pods are more like traders than long-term investors. They had 2 big insights:

  1. The pod model is so prevalent (and it is smart) that if you don’t understand the dynamics they impose on the market, you’re playing with one eye closed. They have respect for the model (and how Citadel implemented it) even if it’s not their game.
  2. They realized the model left some forms of edge behind because of its nature. They could make picking that up part of their own niche. This is touched upon in Caughran’s thread above.

 

🔗Multi-Manager/Pod/Hedge Fund 101 (7 min read)

Byrne Hobart’s primer from his evergreen Capital Gains Substack

 

Money Angle For Masochists

I published a big post this week. Big enough that it warranted a map. You will get technical knowledge, some trading bits, and ideas that are worth assimilating into how you think about investing. In fact, you’ll even see opportunities that arise because of the different lenses investors and traders bring to markets.

The map:

Outline of the Risk Neutral Probability Lessons (Moontower)

And if you want to jump right in:

Understanding Risk-Neutral Probability (Moontower)

The post was the culmination of connecting lots of dots. I started thinking about it after watching a short YouTube clip on my flight to Vietnam back in March. I hope you enjoy it. I’m biased but think the points are underappreciated (or at least that’s how I justify the 30-40 hours I put into it).

A nice affirmation

I hadn’t looked at my website analytics in a while (it’s a bit more annoying to do so since a lot of the posts I wrote this year are these longer technical ones that I host on Notion).

When I logged in for a gander I found that several trading and brokerage firms are linking my material through their internal wikis or intranets. When I write these posts, I often see them as a useful aide for a senior trader who doesn’t feel like explaining some concept to a trainee. “Ahh, there’s some stoner blog called Moontower that wrote about this, just search for it on there”.

Anyway, it’s a nice affirmation. I probably won’t be thrilled when the LLMs are quoting me but ya know, it’s America — corporations are people, computers are people. Maybe only people aren’t people.