What Makes This Environment Unique by Stephen Duneier
Thirty five years before Hurricane Sandy hit, the Citigroup Center was erected at 601 Lexington Avenue. It is a masterpiece of modern design and engineering, the result of a collaboration between architect Hugh Stubbins and structural engineer William LeMessurier. The ingeniously engineered structure met all regulatory codes, was approved by all the necessary committees, and construction was overseen by a team of highly regarded experts.
One year after completion, in 1978, a civil engineering student at Princeton by the name of Diane Hartley, called Mr. LeMessurier to ask him a few questions in order to complete a research paper she was working on for an undergraduate class. One question caused him to pull out the old plans and calculate whether the building could withstand hurricane force quartering winds, something he hadn’t considered earlier. According to those calculations, the building would in fact withstand those winds, if it had been constructed exactly as originally drawn up. Turns out, the builder made a few seemingly minor, and not uncommon adjustments in order to save some money. However, because of the unique design of this particular structure, those adjustments were potentially disastrous. According to LeMessurier’s calculations, if hurricane force winds were to hit midtown Manhattan, as they do roughly every 55 years, the 59 story tower would likely have collapsed. The Red Cross estimated that such a collapse could result in a domino effect that would impact up to 156 midtown blocks.
For the next three months, in the middle of hurricane season, under the cover of darkness, and without anyone in the building, or the 156 blocks around it knowing, a construction crew swooped into action each night. By 4 am the welders would stop and clean up crews took over.
Not a single newspaper reported on it. Not one tenant was made aware of the work that had been done right under their noses. Even Diane Hartley, the student likely responsible for saving tens of thousands of lives and billions in damage, was unaware until she saw a BBC special that aired almost twenty years later.
———————————-- In the late 1990’s, the argument that smaller schools produced better results was gaining steam, and powerful adherents. Research, such as that based on test results from the Pennsylvania System of School Assessments, had made a compelling argument in favor of smaller schools. They’d gathered scores from 3rd, 5th, 8th and 11th grade math and reading tests, plus writing scores for 6th, 9th and 11th grade. In analyzing the data provided by 1,662 separate schools, they found that of the 50 top-scoring schools (the top 3%), 6 of them were among the 50 smallest (the smallest 3%). If the size of the school were unrelated to performance, the smallest schools should have represented just 3% of the top 50, but according to the data they actually represented 12% (6 out of 50). That’s an overrepresentation by a factor of four!
The Gates Foundation, one of the leaders in education reform, was sold on the idea. They began pouring money into programs designed to support small schools, nationwide. By 2001, they provided roughly $1.7 billion in grants to education projects and were quickly joined by the upper echelon of not-for-profits, including the Annenberg Foundation, Carnegie Corporation, Harvard’s Change Leadership Group, and the Pew Charitable Trusts. The availability of such large amounts of money to implement a smaller-schools policy yielded a concomitant increase in the pressure to do so, with programs to splinter large schools into smaller ones being proposed and implemented broadly in New York, Los Angeles, Chicago and Seattle.
Lives were uprooted and impacted for years to come. Westlake Terrace High School, a suburban school in Seattle with 1,800 students was broken into 5 smaller schools, enabled by a Gates grant of nearly $1 million. It was just one of many such changes being carried out across the country. School boards were taking action, not based on the underlying data that had created the flows, but on the flow itself. Articles were written about the flows, who was behind it and the action being taken as a result. Politicians jumped on board ideologically, and financially.
Then, in 2005, the Gates Foundation made a stunning announcement. They were moving away from converting large schools into smaller ones. What led them to stop out after leading the charge, and seemingly mid-course? Turns out their initial analysis was severely flawed, and both it and the follow up data made a very strong case that not only were smaller schools not better, they may actually be worse.
The researchers, Gates, Harvard, Pew and the others that had reviewed the data focused on only one side of the results. Had they gone one extra step and looked at the opposite end of the spectrum exclusively, they would have arrived at the exact opposite conclusion. Among the 50 worst performing schools, you will find that 9 of them were among the 50 smallest schools. In others words, there was an overrepresentation by a factor of 6! When a regression was done of all the data, it showed no relationship between results and school size. However, when applied to those of high school students, the regression line showed a significant positive slope. In other words, the larger the high school, the better the scores.
———————————-- In 1980, a five-man night crew working for Texaco was drilling a test hole on Lake Peigneur near New Iberia, Louisiana. Although the first 1,227 feet down had gone off without a hitch, when they reached 1,228 feet below the surface the drilling rig began to tilt. Suspecting that the rig was collapsing, they abandoned it and headed for the shore, about 300 yards away. Very quickly, the water began to turn until it formed a massive whirlpool. “It was as if someone had pulled the stopper out of a giant bathtub.”
The crater which formed at the drilling site grew to sixty yards in diameter, sucking in 1.5 billion gallons of water, the drilling platform, a second rig, a tugboat, eleven barges and their loading dock, 70 acres of Jefferson Island along with its botanical gardens, greenhouses, a house trailer, trucks, tractors, trees and a parking lot.
It turns out, Texaco was drilling on the edge of a salt dome which was home to a huge Diamond Crystal Salt Mine. They knew it was somewhere in the vicinity, they just didn’t know exactly where. Even after consulting with the US Army Corps of Engineers and Diamond Crystal itself, Texaco managed to wipe out a three story tall salt mine with 80 foot high ceilings and tunnels as wide as four-lane highways, not to mention 50 people working some 1,500 feet below the surface at the time. The Delcambre Canal that connected the lake to the Gulf of Mexico went down by 3.5 feet and began flowing in reverse.
———————————-- In 2001, a baby died at the Juliana Children’s Hospital in The Hague. In response, deaths under similar circumstances over the previous twelve months were investigated, with a particular focus on those cases where the same pediatric nurse, Lucia de Berk, had also been responsible for the patient’s care and medication delivery. Nine incidents that hadn’t attracted attention previously were now considered “medically suspicious”. She was arrested and convicted for the murder of four patients and the attempted murder of three others. The verdict relied on testimony provided by statistical expert, Hank Elffers, who reported that the chance that her presence was mere coincidence was 1 in 342 million. When combined with the limited forensic evidence that showed traces of toxic substances found in two of the exhumed bodies, Lucia de Berk was convicted and sentenced to life in prison.
The case was eerily similar to Sally Clarks’ from just two years earlier in England. Clark was convicted for the murder of her two babies, two years apart, after each had died in their crib while in her sole care. Her conviction hinged on the testimony of renowned pediatrician, Dr. Roy Meadow who argued that the probability of both babies dying under similar circumstances was 1 in 73 million. While a statistician had prepared written evidence that undermined the flawed statistical evidence provided by Meadow, the lawyers and judge argued that “it was not rocket science, so a statistical expert was not needed.” Two appeals later, Clark was freed after it was understood that the statistics presented in the original case had indeed misled the jury to a wrongful conviction.
Clark’s case and many others have exposed a cognitive bias which leads to a recurrent mistake in legal cases now known as Prosecutor’s Fallacy (see Seeds 15-24 for details). The bias is so difficult to detect that at almost the exact moment Clark was being released to international fanfare, Lucia de Berk was being convicted based on the very same mistake. While de Berk was freed in 2010, thousands of people remain in prison or have been put to death, having been convicted on the back of the very same flawed statistical arguments and little else.
———————————-- In 1990, Marilyn vos Savant published a version of the Monty Hall problem in her Parade Magazine column. While the math is unassailable, the magazine still received more than 10,000 letters including “close to 1,000 signed by PhD’s, many on letterheads of mathematics and science departments,” declaring that her solution was wrong. As a result of the firestorm it caused, Parade published four additional columns on the subject, not to mention a cover story in the New York Times. (She wasn’t wrong.)
———————————-- In 1997, after discovering an arbitrage opportunity in the US Dollar versus Brazilian Real option market, I asked my boss on how much I could do the trade. His response was unequivocal. “There’s no such thing as an arbitrage in FX. The markets are too efficient.” To his credit, he heard me out and even though market size at the time was just $5 million, he allowed me to put on the trade in $200 million per side. (It was a true arbitrage.)
———————————-- In 1998, while being interviewed by a whole team of derivative traders at one of the most prestigious investment banks, I was asked to provide the details for a recent trade that had worked out well. I described an arbitrage opportunity in US Dollar versus Saudi Riyal options that I had just unwound. Collectively, they chuckled. In no uncertain terms, they explained to me that you can’t build a career that relies on finding opportunities like that. “The markets are just too efficient these days.” (They were wrong.)
———————————-- In 2004, a salesperson introduced me to Forward Volatility Agreements (FVA). The conversation began like so many others. “Smart money is…” In this case, the smart money was snapping up FVA’s in the US Dollar versus Mexican Peso. After educating myself on the ins and outs of the instrument over the next two days, I asked whether they would provide liquidity for FVA’s in other currencies, specifically Turkish Lira and Brazilian Real. To my surprise, the answer was, “yes, but we’d rather buy than sell them.” I say “surprise”, because I couldn't think of a single reason anyone would want to buy them. It’s an odd feeling to be so certain when the rest of the world appears so confident in the opposite belief. So, before pulling the trigger, I met with the heads of exotic option trading at the five biggest liquidity providers. I peppered them with questions to find the hole in my argument. I couldn’t, so I informed them that I would be putting on this trade with everyone who was willing and in as much as they would allow. Not a single one of them flinched. I was equal parts excited and terrified. (It was perhaps the single best trade of my career.)
What's Your Point?
Not a week goes by that I don’t find myself debating the claim that this environment is particularly challenging. Truth is, I feel like I’ve been having this conversation since I started in the business two months before Black Monday in 1987. In my opinion, the current environment is no more challenging for generating alpha than it has been at any other time in history. What makes it unique, however, is that it is now far more difficult to generate beta and have it masquerade as alpha. Let me repeat that for emphasis. What makes the current environment so challenging, is that you can no longer deliver beta, including levered beta, and pretend it’s alpha.
The tide has gone out and the pretenders have been exposed. Truth is, it’s always been difficult to generate true alpha. To deliver uncorrelated returns consistently over time, to possess a competitive edge and stand out from the crowd is just as difficult in our industry as it is in any other. However, for so long, almost anyone with capital could make money. In fact, I’ve worked for two CIO’s who have earned phenomenal reputations and amassed great wealth while proudly proclaiming, without any compunction, that they’d never had an original thought in their lives. Can you imagine that being so handsomely rewarded, and applauded, in any other industry? The reason I shared the stories above as a collection of thoughts is to make the point that mistakes are made, opportunities exist, even when highly intelligent, well educated, extremely successful individuals and collectives are involved. While you may believe it isn’t possible to have a competitive edge in this industry, because all opportunities are almost immediately capitalized on and erased, you’d be wrong. In any industry where human beings are involved, opportunity and inefficiency exists. The question is, are you willing to do the work to expose it, and do you have the courage of your conviction to act upon it, even when everyone else believes otherwise?
“It's not that I'm so smart, it's just that I stay with problems longer.” - Albert Einstein
As Einstein says, it’s not about being smarter than everyone else, it’s about being willing to invite cognitive strain when our natural predilection is to avoid it. It’s about questioning long held beliefs among industry participants that, in reality, are little more than old wive’s tales. Are you willing to acknowledge that asset allocators have overwhelmingly underperformed the universe of funds available to them, and as a group, asset managers have consistently underperformed the markets in which they invest? Will you take it one step further then, to acknowledge that many of the most deeply held beliefs about how to manage money and select managers have room for improvement? Are you willing to look yourself in the mirror, remove all those asterisks next to your track record, and begin asking some tough questions about your own process?
Rather than blaming the environment, the managers in your portfolio, the myopic investors, irrational policy makers and liquidity dampening regulators, in order to consistently generate significant returns, to stand out from the crowd, you need to make fewer mistakes, be more patient, think critically, creatively, and most of all, independently.
Are you up for the challenge?
"Navigating these challenging markets requires a consistent and sound decision making process. Bija is a thought leader in this area."
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 60,000 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.
Bija Advisors LLC In publishing research, Bija Advisors LLC is not soliciting any action based upon it. Bija Advisors LLC’s publications contain material based upon publicly available information, obtained from sources that we consider reliable. However, Bija Advisors LLC does not represent that it is accurate and it should not be relied on as such. Opinions expressed are current opinions as of the date appearing on Bija Advisors LLC’s publications only. All forecasts and statements about the future, even if presented as fact, should be treated as judgments, and neither Bija Advisors LLC nor its partners can be held responsible for any failure of those judgments to prove accurate. It should be assumed that, from time to time, Bija Advisors LLC and its partners will hold investments in securities and other positions, in equity, bond, currency and commodities markets, from which they will benefit if the forecasts and judgments about the future presented in this document do prove to be accurate. Bija Advisors LLC is not liable for any loss or damage resulting from the use of its product.
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