NEWSFLASH: Despite the exponential proliferation of “healthy” products being offered to the American public, we are getting fatter at a worrying pace. According to the latest Gallup poll, 28% of the population is obese. That’s an amazing 10% increase since 2008 alone. The Centers for Disease Control estimates that 70% of Americans are either overweight or obese. (By contrast, a mere 1.8% are classified as underweight.) While we tend to associate obesity with diabetes, its effects go much deeper than that. One-third of all cancers are related to it as well. In fact, if you look at the major causes of both death and disability, weight is a key factor in every one of them. One study estimates that absenteeism due to weight related health issues costs the US $153 billion in lost productivity annually. However, that figure doesn’t come close to reflecting the true impact were you to add in medical expenditures, both privately and publicly funded.
The big question is, how is it possible that every food product on the shelves these days is seemingly free of gluten, high fructose corn syrup, saturated fats, preservatives and artificial flavors, while being packed with protein, yet we continue to get bigger and bigger? Interestingly, and ironically, there is actually a positive correlation between eating healthier meals and becoming less healthy. The reason lies not in how our bodies process food, but in how our brains process information. We explore this phenomenon here, because it helps explain how it is that we can be so hyper-focused on diversification as a means for reducing p&l volatility, while p&l volatility is on the rise thanks to diversification. Negative Calorie Foods Researchers at Northwestern University discovered an interesting phenomenon when they asked subjects to estimate the calorie content of a series of unhealthy meals and then again for those same meals, but with a healthy addition. For example, one of the unhealthy meals was a hamburger. The average estimate among self-proclaimed weight-conscious subjects was 734 calories. When the same hamburger was accompanied by three celery sticks, the average estimate provided by the same group dropped to 619. Think about that for a moment. When food was added to the meal, respondents perceived the bigger meal to contain 15.6% fewer calories. The same occurred when a small apple was added to a bacon and cheese waffle sandwich, a small salad without dressing was added to chili with beef, and a celery/carrot side dish was added to a meatball pepperoni cheesesteak.
I know what you’re thinking. These people are fools. How could more food contain less calories? Don’t they realize that a small apple doesn’t contain negative 66 calories? Well, actually, they do. When assessed independently, people properly attribute calories to both the hamburger and the celery sticks. However, we tend to assess things as they are presented to us. That is the nature of framing, and the reason it is so important to understand how it affects our decision making. When shown a hamburger, we bucket it as a vice, whereas the celery sticks are perceived as a virtue. Take a large vice, add a small helping of virtue to it, and voila, you have a smaller vice. When we eat an unhealthy meal and add a healthy option to it, we perceive it to be less unhealthy.
Our brains are fantastic at swapping out one hard-to-answer question for a simpler, yet very different one, often without us even knowing. In this case, our brains erroneously perceive the words “healthy” and “low calorie” as interchangeable. People behave as though healthy foods, such as fruits and vegetables, have benefits that extend to all aspects of a meal, including its effect on weight gain. It is a bias that, like all others, leads to suboptimal decision making, and marketers are both aware, and taking full advantage of it. (See images)
Diversifier’s Paradox Diversification is the name of the game these days. The portfolio manager diversifies her portfolio to reduce p&l volatility. The CIO looks to create a diversified portfolio of portfolio managers for the same reason. Endowments, fund of funds, family offices and other institutional investors seek to build a portfolio of diversified funds, and end investors do the same. Not to mention non-financial companies are diversifying their revenue streams and funding sources to reduce their reliance on a single one.
The concept of diversification is predicated on incorporating holdings that are uncorrelated, or possibly negatively correlated. Simply adding a long in Brent crude to a long in WTI, won’t likely reduce my p&l volatility. If I build a portfolio of longs in Brent versus an equal number of shorts in WTI, it’s possible I could make or lose money, but in order to generate the same returns that are possible on a portfolio comprised of longs in one or the other alone, I’d have to size up the positions, considerably.
Let’s look at the concept of a “market neutral” strategy using long/short equity positions. I believe XYZ Company is undervalued, because their earnings are better than the market’s expectations. When the earnings announcement comes, I believe it will be repriced so that the company’s stock once again trades at a multiple similar to the industry average. In anticipation, I want to get long XYZ’s stock, but by doing so, I will expose myself to a possible adjustment in the industry multiple, general equity market risk and a whole host of other factors separate and distinct from the company’s earnings expectations. So, I identify a stock or group of stocks that represent the same industry, similar revenue streams, dividends, etc and go short them in an appropriate proportion so as to isolate the one aspect of XYZ Company that makes it a compelling long. This leaves me exposed purely to the earnings announcement repricing for which I have high conviction. If the stock market moves down, I am protected with my short. If industry multiples come off, I am protected. Essentially, for everything exogenous to the earnings announcement, I am protected.
This protection is important, for even if I am correct in my expectation that XYZ positively surprises, should the industry multiple drop in the meantime, I would expect to make nothing or possibly lose money if I had only the XYZ long in my portfolio. Now, since I have hedged (a form of diversification), I have reduced my risk, perhaps significantly. Therefore, I can size up the position significantly as well. Think about what that does for the risk / reward profile on the underlying view. Very little exposure to extraneous factors, and when the earnings positively surprise, I generate a much greater return for the portfolio. It’s a perfectly rational, compelling story, and a concept that is very appealing to our intuition.
Now, let’s take a step back. I have increased the position significantly, not just on XYZ Company, but have also gone short an equivalently large amount of the stock in a company or group of companies for which I have no strong opinion. Somehow, I believe this to be less risky than a significantly smaller position in XYZ alone, but is it? On paper, perhaps it is. I’ll run an analysis, or more likely, my firm with generate a factor by which I can determine the appropriate size for the hedge, whereby my risk will remain unchanged. Maybe the factor is beta or something more sophisticated, but in the end it’s based on a historical correlation. It might be the last 3 months, 6 months, or 2 years, and for conducting a stress test, perhaps it will examine the exposure during particularly violent moments for markets. Without asking too many questions about the limitations of the analysis, I’ll establish the position, both the long in XYZ and the appropriate short against it. Now, it’s just a matter of waiting for the earnings announcement.
“The multimanager funds succeeded because they are more diversified. The largest ones invest across many strategies, meaning that there’s a greater chance of having positions that are making money.” Bloomberg Briefs (emphasis is mine)
What I’ve just described, sounds so simple, thoughtful and stress free. It’s the story told by countless fund managers to even more investors, year in and year out. When it is told by a fund on a roll, it takes on an air of certainty. Just read Bloomberg Briefs’ annual analysis of hedge fund returns for 2015 and you’ll see what I mean.
The reality is, correlations themselves have been increasingly volatile, so the “correct” notional for the hedge hasn’t been so easy to determine. That in itself has led to far more volatile returns for “market neutral” managers. Perhaps more devastating for many of them has been the timing of the moves between one side of a trade and the hedge on the other. When the side you have no opinion on moves 5%, 10%, even 30% in a day, in the wrong direction, yet your long doesn’t match it, are you willing to hang on for a few days in order for the hedge to retrace or your long to catch up? It’s very unlikely. And that is exactly what has been wreaking havoc among many market neutral energy traders. Rather than having a relatively simple and small long equity position in the stock of a company we believe in, with clearly defined goals, both on the upside and downside, we add complexity and size, believing that we are somehow reducing the risk. It is a myth. Of course, when it works in your favor, it’s not seen as luck, but rather as genius. And that is how you have market neutral funds topping the charts, and seeing huge inflows, while others are closing shop at an astounding pace. A paradox indeed.
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Global Macro Portfolio Manager New York, NY Hedge Fund AuM $10 Billion
For nearly thirty years, Stephen Duneier has applied cognitive science to investment and business management. The result has been the turnaround of numerous institutional trading businesses, career best returns for experienced portfolio managers who have adopted his methods, the development of a $1.25 billion dollar hedge fund and 20.3% average annualized returns as a global macro portfolio manager.
Mr. Duneier teaches graduate courses on Decision Analysis in the College of Engineering, as well as Behavioral Investing, at the University of California. His new book, AlphaBrain, is due to be published in early 2017 (Wiley & Sons).
Through Bija Advisors' coaching, workshops and publications, he helps the world's most successful and experienced investment managers improve performance by applying proven, proprietary decision-making methods to their own processes.
Stephen Duneier was formerly Global Head of Currency Option Trading at Bank of America, Managing Director in charge of Emerging Markets at AIG International and founding partner of award winning hedge funds, Grant Capital Partners and Bija Capital Management. As a speaker, Stephen has delivered informative and inspirational talks to audiences around the world for more than 20 years on topics including global macro economic themes, how cognitive science can improve performance and the keys to living a more deliberate life. Each is delivered via highly entertaining stories that inevitably lead to further conversation, and ultimately, better results.
His artwork has been featured in international publications and on television programs around the world, is represented by the renowned gallery, Sullivan Goss and earned him more than 50,000 followers across social media. As Commissioner of the League of Professional Educators, Duneier is using cognitive science to alter the landscape of American K-12 education. He received his master's degree in finance and economics from New York University's Stern School of Business.
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