Sunil K Pai, CFA
On Black Holes and Stock Prices
Updated: Oct 5, 2020
What do current forms of "active" equity management, roach motels, and a black hole all have in common? That's right: everything goes in, nothing comes out.
Recently, I was explaining the ARBi optimization process (internally with our institutional partner) and why it is distinctly different from other systematic, "machine learning", "artificial intelligence" processes. Using black holes as an analogy, I suggested we think it through like this:
1) Why do black holes form and exist?
2) How do we identify and locate black holes?
3) What happens inside a black hole?
At this point in science, we can reasonably answer questions 1 and 2. But, question 3 is the real kicker because one cannot reasonably get data to support a factual answer so science infers one based on what is observed outside and around the black hole.
Now, if we take our cosmic hat off, and substitute stock valuation in place of black hole we can get a general context for why most active management is at great risk of wasting time and your money on a generally futile activity.
A liquid, developed stock market is a black hole by nature. Sucks in all kinds of information and there is no reliable, statistically sound mechanism to know how that information will drive stock price movement. And, the bigger it gets, the more efficient it becomes. But, we know the stock market is doing its job because it has stock prices that show up via an exchange-regulated auction process from which we infer that the process is working and the stock market actually exists (just like a blackhole). A rather symbiotic-like relationship.
So, here is the rub. If prices are naturally occurring (as a result of a generally fair auction process) and confirm that the stock market is functioning, why would the majority of active managers try to argue they are smarter and stronger than the stock market/black hole by entering it? Just as any object or energy will lose when caught by a black hole, any attempt to argue with the prices surrounding the stock market is largely a mathematical act of futility.
Leaving us thinking, is this not the reason why so much of "active management" today has sub-performed a simple price-based index?
So, here are some dead giveaways of those investment managers that want to play inside the black hole:
Fundamental stock analysis
Macro/micro economic analysis
Using stop gain/loss limits
Using individual profits/losses for trading decisions
Rank ordering a list of stocks and picking the bottom or the top performers based on some preset rules
Preset rules that define a return stream (aka factors, "smart" beta)
Admittedly, most of those who practice the above will take issue with me, but let's not forget that without them doing what they do, those on the outside of the black hole may not have a price offered that can be used to their advantage (read: alpha). So, from our perspective, keep doing the above and more of it, please!
To wit: even mega Blackrock gave up on this idea a couple years ago by firing all of its human-based active managers and now relies largely on quantitative investment products of dubious value but of course Blackrock saves plenty on payroll costs. Separately, the "Aladdin" system that Blackrock touted as the source of great alpha-driving investment information is now being sold to anyone outside of Blackrock. With Aladdin at your side, you should have no problems navigating headlong into that black hole (tongue firmly implanted in cheek).
Let's face it being a price giver (those that enter the black hole) is far sexier than being a price taker (like passive and our ARBi) but from an investor's standpoint, one has to decide which has the higher likelihood of meeting your return/risk objectives and placing your chips accordingly. If you can't resist the notion of entering black holes, then movies like The Black Hole of 1979 and Interstellar from 2014 are the only way to enjoy a black hole, not with your hard-earned investment dollars. The majority of investment managers are playing science fiction games with your money, not their own.
Moral of this cosmic story: pick investment strategies that utilize price and infer an investment decision (buy/sell), avoid those that suggest that they have figured out how to move in and out of a black hole.
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