Wednesday, December 4, 2013

The Last Word On Asness' Alpha, Buffet's Beta and The Failure of Commodity Quants (and how to turn hyperlinks into footnotes)

I was informed that the theses that took me three five posts to present was wrapped up by Matt Levine in one little package two days prior to my attempts.
And he does it better, backwards and in heels.
Plus, to get the alliteration in the headline I had to mix up the alpha and the beta.

From Bloomberg:

You Can Invest Just Like Warren Buffett, If You're a Quant Hedge Fund
The Internet has paid a lot of attention today to this National Bureau of Economic Research working paper called "Buffett's Alpha,"1 whose principal conclusions are:

1. You could build a robot that replicates Warren Buffett's stock-picking performance.

2. The ingredients of that robot are (1) 1.6x leverage, which is what Buffett runs at Berkshire Hathaway Inc.,2 and (2) a statistical factor-weighting investment approach that overweights what the authors call "high-quality" (growing, high-payout, profitable) companies with low betas.

3. AQR Capital Management LLC, the quantitative hedge fund that employs the paper's authors, can build such a robot with trivial ease, really by just pushing a button, it's no problem, watch, they will do it for you.
So that is interesting, I guess, if you like robots. It is also great advertising for AQR obviously, though they'd need to go match Buffett for the next 40 years before anyone would entirely believe in their robot-building skills. Actually it was initially somewhat puzzling to me that the venue for this is an academic paper written by three AQR affiliates, rather than a flashy launch of the AQR Buffett Replicator fund, but you can probably figure out why that is.3 Anyway, they seem to regard the Buffett-replicating exercise as trivial; it vindicates some of the quantitative signals that they like, but for them the point is not replicating Buffett but rather picking the signals that offer the best risk-adjusted returns.

So why write about Buffett at all? You'd sort of think that the goal of the research done at quantitative hedge funds is to find things that make money and then go do those things, and generally you'd be right in thinking that. (Sometimes it doesn't work.)

But there is another, subtler goal, which is to fit those things into a narrative about the world that is comprehensible by humans.4 "My computer told me to buy these 800 stocks and sell those 700 stocks, and historically my computer has been right 63.4 percent of the time" is a terrible story. Computers crash and go haywire and try to murder their creators. Statistical anomalies vanish. Signals work until they don't. Markets mean revert. Correlation without causation is suspect. Building a computer program to grind out gains in the markets using a complex of factor weightings sounds like the sort of over-complicated, short-term, zero-sum, high-frequency, incomprehensible financial engineering that landed us in various messes and that is not particularly in public favor these days....MORE
My secret weapon to take on Mr. Levine's footnote fetish? The Arc90 Labs hyperlink converter!
Unfortunately at the moment it only works on the reader's side of the conversation, the method for doing it from the writer's side is still to come. Still, quite cool.

Buffett's Alpha or How To Generate Better Risk Adjusted Returns Than Anyone Else in the Biz (BRK)
AQR’s Asness on ‘Smart Beta’: ‘Call a Bet a Bet’
UPDATED--The Economist On How the Commodity Quants Lost It
Warren Buffet: The King of Leveraged Low Beta (BRK.B) 
How to Make Big Money in Small Markets: Commodities