Connecting the Dots: Tidal Flows of Capital
Part 1:
I recently listened to a Capital Allocators podcast which focused on Dmitry Balyasny. While the whole podcast was worth a listen, one comment in particular jumped out at me:
In general, the best environment is when there is a lot of generalist participation in a strategy and there is a lot of money coming into a strategy because then your specialist participants…should be able to do a better job of forecasting where the capital is going to go…the worst environment is when there is no generalist capital and money is flowing out of the strategy…how much room you’re willing to give things…is very dependent on which of those environments you’re in.
Part 2:
I’ve been reading about Market Wizard Monroe Trout and found a New York Times profile on Mr. Trout from October of 1993. The following quote jumped out at me:
But that explosive growth is only an extreme example of this industry's tremendous expansion. While derivatives have been around in one form or another for centuries, investing in funds that trade in derivatives took off only in the 1980's. With roughly $100 million at the start of the decade, these fund managers, known as commodities trading advisers, now speculate with some $14 billion of investors' money, according to Managed Account Reports, an industry publication.
This made me think of a quote from my paper on Michael Marcus:
The theory that the evil government was constantly debasing the currency provided the perfect perspective for trading the inflationary markets of the mid-1970s…The markets were so fertile for trading then that I could make plenty of mistakes and still do well…Everything was going up…Honestly, I think the markets were so good, that by buying and holding you just couldn’t lose. There were a lot of other success stories. Fortunes were being made.
Part 3:
I’m reading Going Infinite Michael Lewis’s book about Sam Bankman-Fried (SBF) and the following comment jumped out at me:
…Jane Street had gone from a few traders with a few million dollars, in 1999, to roughly two hundred traders working with several billion dollars, in 2014. One big reason was ETFs, whose global value had grown from less than $100 billion to $2.2 trillion (on its way to more than $10 trillion in 2022).
Part 4:
As I consider the relatedness of parts 1 - 3 above, I’m reminded of an earlier post I wrote on ideal windows for given strategies. Here is a quote:
Another thing I notice is that the Market Wizards books often come out right after an epic window for the methods used by the subjects of the books and returns decrease for a while after. For example, the original Market Wizards had a lot of trend oriented futures traders and came out after the late 1970s/1980s which was a great window for that style of trading. Or notice Stock Market Wizards came out in 2001 shortly after the epic stock market dot com boom. Or Hedge Fund Market Wizards which came out in 2012 which is close to the top of hedge fund prominence in the last ~30 years.
Part 5 (Conclusion):
When I add everything above up, what seems to be true (and perhaps obvious but it never hurts to remind oneself of the obvious) is that the larger tides dictate a lot of what happens in terms of investment success.
Managed futures traders (one of my favorite areas of study probably due to the rags-to-riches nature of the space) were the stars of the investment business from the late 1970s until the early 90s. Was this skill? I’m sure to some degree it was. But I also notice that there are very few people in that space thriving like in the 1980s despite a lot more knowledge, experience, information, etc. Does competition account for the change? Probably to some degree. But, perhaps to a larger degree, capital inflows account for the lion’s share of investment returns and success for a given discipline - the evidence I’ve seen so far supports this claim.
Now the important questions:
Q: How does one benefit from this?
A: Figure out where the money is going to go. Get there early and leave before the proverbial lights come up.
Q: Is it possible to figure out where the money will go?
A: Maybe. I think that, more often than not, those who benefit from the rising tides don’t actively choose their discipline because they think or know that the tide will rise. Instead, they’re just plying their trade and along comes the tide to propel their ship.
Q: How does one best figure where the money will go?
A: I don’t have a great answer, but I have a few thoughts:
At a high level, I think the best chance one has at figuring out where capital is going involves reading a lot on two things:
First, figure out the idea that has the world in its grip (to use a Vic Niederhoffer concept) and invest accordingly. Right now the world is focused on carbon neutrality and AI as an economic engine. Of course, just because you know what the world is focused on and who benefits doesn’t mean the stocks will behave as expected. For example, Virtu Financial (VIRT) is a market maker that benefits from the growth that benefitted Jane Street (see above). Without looking, I’d assume a healthy return on their stock, but VIRT has significantly underperformed the S&P 500 since their 2015 IPO.
The other idea is to figure out what central banks are doing and align with what they are doing. Central banks have, in theory, unlimited reloads given printing presses so they can, in theory, achieve their goals. That said, Soros famously broke the Bank of England in 1992 and as long-time practitioners know, markets ultimately do whatever they are going to do.
This leads me back to my work on Trading Principles which involves a willingness to cut losses. But the loss cutters don’t typically achieve the largest returns when a given market goes to the moon - the true faith crowd does. Ironically, the truth faith crowd often also hangs on far too long and gives back a lot.
Perhaps, in the end, the best approach to capture a rising tide is simply to pick a discipline that suits your goals/temperament/etc. and keep chugging along hoping the rising tide finds you early and stays for years.
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Great stuff George