When we conduct regular due diligence on managers, and especially when we’re getting to know a manager for the first time, we like to get a sense of how their system operates. Depending on the manager, we might get a litany of details, or a terse summary from a manager who prefers to keep the details private.
We sometimes refer to this as the “secret sauce,” the part of the manager’s method that remains an in-house secret. Like chef carefully guarding their recipe (or a space-bound billionaire hiding the technology behind the ascent), it’s not hard to imagine why some managers adopt such a secretive posture.
As it turns out, recent academic research has come out to reinforce this idea. Past performance is not necessarily indicative of future results, but if that past performance is published in an academic journal, it just might be responsible for diminishing future results. Via CNN Money:
Professors David McLean (MIT) and Jeffrey Pontiff (Boston College) set out to learn what happens after academic papers on new trading strategies are published, and found that the strategies quickly lose efficacy.
“Our results suggest that when academics publish a paper about a new strategy, investors learn from the paper and begin to trade on that strategy,” McLean explains. “This trading impacts prices, bringing them more in line with fundamental values. This in turn makes the strategy less profitable, so it appears that academic research destroys stock return predictability.”
This research focused on stock-picking strategies, but this is exactly the fear that drives managers to keep secrets. Imagine a scenario in which other manager out there knew that your CTA was going to initiate a long position in crude oil if the 50-day moving average crossed above the 200-day moving average. Other traders could take this into account, bidding the price up to get your system to initiate a position, then selling on the bump that your allocation caused.
For the biggest traders, this can be a serious risk, and it’s part of why JP Morgan’s “London Whale” suffered losses as deep as he did – other traders found out about the position and made unloading the portfolio much more expensive for JP Morgan. (Incidentally, high-frequency traders are often accused of similar practices, except they “sniff out” standing orders through trial-and-error rather than foreknowledge).
It may be frustrating from time to time to encounter a tight-lipped manager, but in a world where one traders’ losses are another traders’ gains, the “secret sauce” can be the difference between a winning strategy and a played-out theory.