Escape from Freedom; The Glenn McGrath Model of Investment

Escape from Freedom; The Glenn McGrath Model of Investment

In his widely-acclaimed book “Escape from Freedom” (published in 1941) the German philosopher Eric Fromm extolled the virtues of reducing our own options – something that goes against the tenets of basic economics and even militates against common sense. He argued that lack of freedom represented by social or biological determinism made life easier. In this case with limited number of options, life has a well-defined structure with less requirement for decision making, low chances of confusion, enhanced commitment, and even lesser possibility of regret in hindsight.

Burning the Boats

Life in the ancient era was hinged largely on the above framework. There was this incident where a Chinese general called Xiang Ji set his army’s ships on fire on the night preceding an important battle with a formidable enemy – the Qin armies. As his troops watched the boats go up in flames they  realized that their rations also had been burnt down with the ships. From there-on they had only two options left – fighting their way out through the enemy ranks, or perishing in this self-imposed pursuit of glory. Armed with clear focus and absolved of fear, Xiang Ji’s heavily outnumbered army emerged victorious after a protracted set of battles defying heavy odds.

Even in the current era there are many instances where lesser number of options makes life less complicated and improves the average happiness levels. The tenacity and vigor that comes from shutting all doors save one can often lead to unexpectedly positive results.

More Options Better Than Less Options?

However in real world a rational human being (the “econ” in economics parlance) always prefers more options than less. A student is likely to be happier if she has admission offers from the three Indian Institutes of Management (IIM) at Ahmedabad, Bangalore and Kolkata than she is when she has just one offer – only from IIM Ahmedabad, even if the latter is considered to be much better than the other two IIM’s. Here the student gets more satisfaction if she has admission offers from Bangalore and Kolkata also since it adds to her self-esteem even though the latter offers are redundant in the face of the offer from Ahmedabad.

A football club manager wants to have 8-9 defenders in his squad of 25, even if he knows that 2-3 of them will never be used, even if he is convinced that the latter 2-3 defenders are not good enough to be in the first team, even if he knows that other 6-7 defenders are capable to carry through the season assuming the normal injury rates and form reversals. This is a case of over designing which eventually curtails the manager’s ability to rotate strikers as the season progresses. The manager, with his economically rational approach, gets more satisfaction in the knowledge that he has 4-5 additional back-up defenders versus the back up strength of 2-3 players that he may actually need.

Another example – an investment manager feels constrained if all his fund schemes are based on the same investment style. Most investment managers enjoy using discretion especially the one that comes with being in a position to apply various models and styles of money making. In this case the larger number of options add to the feeling of excitement, level of active involvement and sense of being in control which often act as emotional drivers for higher level of satisfaction.

However over-designing, or keeping all options open till end may not necessarily lead to the most desired outcomes.

Same line, same length, same height, same speed – ball after ball, over after over, spell after spell

Cricket lovers fortunate enough to have witnessed the great Australian test cricket teams of the nineties in action, would recall whom does the above description refer to. Glenn McGrath, arguably amongst the best fast bowlers of all times, will always be remembered for his persistent accuracy which led to his spectacular feats on record books and to his domination of the game in the nineties. He rarely tried variation, novelty or deception in his deliveries nor was he a speed merchant. McGrath used to surprise- even the best players of fast bowling- with his irritatingly repetitive but exceptionally accurate bowling spells. Most of his deliveries would be a couple of inches outside the off stump, would be of good length and at a pace of around 130-135 kmph.

McGrath had deliberately curtailed his armory and instead focused on perfecting one kind of delivery. He sent down similar deliveries over long spells and waited for batsmen to commit a mistake. This enabled him to curb his own mistakes as a bowler (as evidenced in his top class bowling averages and economy rates) as well as in reducing the need to make too many split second decisions (regarding what type of ball to deliver) before releasing the ball form his hand. Cutting down on options is what differentiated him – and fetched him spectacular success and provided elegance as a fast bowler – versus some other top class fast bowlers of his generation.

Where do investors stand

Admit it – when the friendly wealth manager suggests instruments like derivatives, commodities, cash equities, real estate, arbitrage fund etc doesn’t it feel like that the best way to go about it is to distribute the corpus amongst all these asset classes and instruments? Similarly, the freedom and the mandate to invest in any geography, in any asset class, and in any portfolio proportion is amongst the most alluring factors for a professional fund manager. Indeed, there are many fund managers who manage more than one fund schemes based on meaningfully different investment styles.

Consistently Strong Returns -Over Long Term- Demand Consistency in Style too

History is replete with examples that suggest that sticking to one style offers better success rates for investors. Warren Buffet (quality, margin of safety, buy and hold) and Charlie Munger (quality, buy and hold), Phil Fisher (quality, buy and hold), Ben Graham ( margin of safety), John Templeton ( contrarian), Peter Lynch (quality, bottom up), George Soros ( global macro, arbitrage), Howard Marks( margin of safety, arbitrage), Jim Simons ( quantitative strategies), Ray Dalio ( Arbitrage) etc are some legendary investors who have led the investment world with consistency and scale of their performances over long periods.

While they have different styles and philosophies for investment, one factor that separates these names from the “also rans” is that they stick to their styles, philosophies and principles with extreme diligence. Even as their styles have evolved over time they have never spread themselves thin by chasing too many ways of money making. Keeping down the number of fundamental options in terms of styles and philosophies at a minimal level has helped many of these super investors reduce the number of decisions they take thus shrinking the odds of mistakes, stay within their circle of competence, avoid procrastination, and remain focused.

There are Always Exceptions, But Not Many

Of course, Phil Fisher’s saying that “There are exceptions to every rule; though not many” is apt here too. There are some investors who have delivered good returns even with a medley of investment styles in action. However, such investors are much less in number as compared to the prophets of consistency named above.

Alignment of Philosophies of Life and Investments

Perhaps among the most important drivers of an investors’ performance over long term is if her investment style is aligned with her philosophy and perspectives on life in general. If one has done enough introspection then one will be clear on one’s basic value system, principles and philosophy of life. There can-not be a multitude of value systems and philosophies that a person can hold and follow in life. Accordingly, the investment style too must have some core, non-negotiable factors which are aligned with the person’s perspectives on life, and which if practiced with diligence over time can fetch healthy rewards. It is very important for an investor not to try to be someone who she is not.

Lessons From a Crash

It was the year 1987 AD. Berlin wall still stood tall in all its sadistic glory. Developed world was using computers of 386 vintage as a force multiplier in many fields. Back in India a new car called Maruti had recently been launched to challenge the duopoly of Ambassador and Premier Padmini.This was also the period when a certain Diego Maradona was setting football grounds on fire with his brilliant individual skills.
For the US stock markets,1987 was turning out to be another spectacular year. By August the benchmark Dow Jones Industrial Average (DJIA) index had registered about 40% gains for the year. In fact the five year bull run since 1982 had catapulted the DJIA 3 x.US economy too was dashing ahead having registered five straight years of expansion.
The tragic developments that were to follow – particular in October – would leave more than a hole on market psyche. Many large financial institutions received a big jolt, some smaller ones faded into oblivion, a large number of investors lost sizeable amounts in the markets, and many a promising career was cut short after this event, dubbed as the black Monday.
Unfortunately the financial world moved on post the 1987 crash without taking the lessons properly. Not surprisingly some avoidable though extreme disruptions, with some similarity to that of 1987, have been hitting the markets with remarkable regularity. Lessons from 1987 could have cushioned the impact of events like ASEAN crisis (1997), the LTCM disaster (1997), Tech boom and bust (1997-2002) and global financial crisis (2007-2009) – if not prevented them altogether. For the 1987 disaster the culprit was the same, eternal one – unfettered greed that throws caution to the winds. However this was the first time when the folly of greed was riding the dragon of derivative instruments. The latter inflicted the main damage once lust for easy money had blindsided market participants.

The Learnings First

Why did the markets fall precipitously on 19th October, 1987 ? To say gravity, won’t be an oversimplification.The markets had risen too high too fast and hence they were ripe for a rout.
The lessons for market participants (especially equity investors), financial institutions and regulators were quite clear if one analyses the events of that fateful period of October’87 –
1. If some profit seems too good to be true then chances are quite high it is so. It is important for investors to steadfastly refuse invitations for free lunches in markets.
2. At any point in time, inability to justify a course correction for markets in future does not guarantee continued momentum, or even status quo. For example, if market frenzy takes a stock to price/earning multiple of 45x – say, substantially ahead of historical and peer group valuations – then the stock is best avoided even if one cannot pinpoint even a single reason for potential correction.
3. Even simple looking derivatives should be handled with care. People with less than perfect, understanding of and, experience in these instruments should treat derivatives as nothing but weapons of mass destruction
4. There is another and deeper issue with derivatives. Superficially the outcomes and methods look as simple as they seem compelling. Thus slowly people get sucked into the cauldron lured in by specter of easy profits. After some time the application of a particular derivative instrument becomes so widespread that contagion risks grow exponentially and uncontrollably. Now one seemingly innocuous mistake by an untrained hand is what it takes to bring down the entire edifice. Even people who understand and are experienced in these instruments find themselves helpless once the genie has been set free.
5. Quantitative models, even if they are mathematically rigorous and practically simple, are unable to capture emotions and hence can become irrelevant precisely when they are needed the most.
6. A quantitative strategy based on assumptions on correlation – among certain assets – derived from intricate data from past can often fall flat on its face when markets turn irrational. These correlations can in no time swing from a sizeable negative value to a meaningful positive one. An asset supposed to hedge another one may end up doubling the exposure in reality thus piling in the misery.

Anatomy of a stock market crash

On Monday, October 19th, 1987, DJIA nosedived by 22% – the biggest ever single day fall. The index remained extremely volatile for the week though it closed the week above Monday’s closing.

The solid trailing performance over preceding five years had layered a lot of froth over the markets and was also converting investors into reckless risk takers. On October 14th, and 16th the index had fallen by 4% each. Interestingly, news flow leading into the disaster was not too conspicuous even in hindsight. Some examples –
* Surprisingly high trade deficit
* 30 year bond yield rose above 10 percent level for the first time in two years
* US treasury secretary warned that the US might stop providing support for the dollar
* Legislation was coming up in the congress to tax greenmail

However, a chart showing an eerie similarity between 1987 and 1929 crash had been doing the rounds since early 1987 which had prompted some prescient (and/or lucky) traders to go short on the market.

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For the majority though the developments came as an avalanche from which some took a long time to recover.

The Mindset and The Protagonists

While psychological seeds for this disaster were sowed by widespread greed for easy money, by poor memory of market trends prior to 1982, and by an uncontrollable urge not to be left behind peers, there were three sets of protagonists in the mayhem around the black Monday. The three protagonists had one thing in common – they all were based on sophisticated strategies that seemed simple, elegant and practical. The three protagonists were –
1.       Risk arbitrageurs: Risk arbitrage (arb) desks at various financial institutions were thriving on betting on who would take over whom in the takeover boom of those days.The weapons for takeovers were high yield bonds which provided capital for a raider to make a run on the target company.
2.       Portfolio insurance buyers: Portfolio insurance is effectively a dynamic hedging strategy designed to prevent a stock portfolio dipping below a predetermined floor. As the portfolio value rises hedges are reduced. Hedge is increased as portfolio value declines and as that latter slips below the floor the portfolio is fully hedged. Thus the instrument looked like a remarkably simple way to enjoy best of both the worlds – participate in the upside if portfolio is moving up and limit your downside if the markets are tripping. The strategy was based on the now famous Black-Scholes equation for option pricing.
3. Cash – future arbitrageurs

The snowball …..

On October 14th, the Street realized that there was a bill in the congress that intended to tax greenmail. This would dim the prospects for many takeover in the works. As a result risk arb firms started a broad liquidation which in turn weakened the markets.
The drop in the market was felt by portfolio insurance hedgers who were forced into their own programmed selling which continued through 16th October, Friday.

…..Gathers Momentum….

Over the weekend – after running their models on Friday closing prices – many more portfolio insurers got ready to make adjustments to their positions to increase their hedges by liquidating stocks. It still seemed business as usual at portfolio insurance desks as models appeared to be in control and nothing had gone beyond the script.
However mutual fund clients of these portfolio insurers were panicking and giving sell orders. Redemptions on Friday and on weekend meant that a commensurate amount of their equity positions had to be sold.
On Monday, 19th October even before the markets opened portfolio insurers had sold S&P futures worth 500 m, about 30% of public volumes. Futures prices dropped precipitously – and stock markets had not even opened.
Now, as the chasm grew between cash and future prices, cash- futures arb teams waded in to gain from this widening gap. With market yet to open on Monday – 19th October, cash price was being assumed at Friday closing and as futures had dipped pre-market there was a seemingly big opportunity for cash – future arbs. However risk of gap down opening of stock markets that had somehow been overlooked, was to play out soon- and, painfully.
Here in futures market the cash – futures arb traders were the other side of portfolio insurance hedgers .These traders in turn were depending on stock market for their other side of the trade. Effectively the cash-futures arb traders were taking the market impact from the futures and transmitting it back to individual stocks on NYSE. In this normal link up between cash and futures markets the weak link was the difference between the time frames to transact in the stock markets, and in future markets. The latter was much more quicker. Further, liquidity in cash market was much lesser than in futures market. This proved to be calamitous that day for traders who had been lured in by the siren song of cash versus futures arbitrage.

…..Finally turning into an avalanche

Finally when the cash market opened it was at a breath taking discount to Friday closing. Due to this gap down opening of stocks, sell orders started building up and potential buyers, even the long term players, panicked effectively closing a liquidity tap that could have provided succor to markets. Thus stock prices started falling sharply prompting portfolio insurers to throw more sell orders into the futures markets. Dipping futures, in turn, pulled down the stock prices too.
The cascade in stock prices wreaked havoc on cash – futures arbitrage traders ( gap down opening of stocks turned their arbitrage opportunity on its head), who started limping to the sidelines thus depriving the markets of another source of liquidity. Meanwhile the portfolio insurers continued their selling spree even as liquidity was drying up. The result was that the DJIA saw the worst ever single day decline of 22%.

Shrug off  – the post script

The disaster with its genesis in unbridled greed, herd mentality, inability to raise even basic questions, and unrestricted application of derivative instruments by untrained hands – should not have come as a surprise. What was remarkable was the resilience post the disaster. The index retraced the losses in less than 18 months in a sense paving the way for the next disaster in mid -nineties.