Risk Over Reward

Thinking About Investing

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The Segmented Equity Market

by Alpha and Vega, an Investor and a Trader
April 26th, 2011

In this issue:
1) The Retail Investor
2) Long Equity Managers
3) Fundamental Hedge Funds
4) Short-term Equity Traders
5) Quants

Dear Friends, Colleagues, and Investors,

From the “Invisible Hand” to the “Rational Actor”, the “Electronic Herd”, or
just the monolithic “Market”, we tend to think of asset prices as being driven
by a uniform force. In reality, there are many different types of investors
and traders who push and pull prices in myriad ways. The battle between
these actors creates inefficiencies and profitable opportunities. I’ll discuss
the most important market players and how their actions create distinct
waves in asset prices. A rough estimate of the relative trading volumes:
1) The Retail Investor
The backbone of the stock market is the passive retail investor. Many people
buy stock every year without giving much thought to valuation. Through the
employer’s 401k, pension fund, or by consistent mutual fund purchases, these
investors provide a relatively steady tailwind to the market. When the
economy is doing well and they are optimistic, they invest more. During
severe recessions they may produce net withdrawals. Even when their money
is professionally managed by someone with great discretion, it tends to be
invested in a way that is 100% long the market, and very diversified. When
these investors pour money into the market, the result is an indiscriminate
rally that will lead to the overvaluation of some weak companies that are
simply getting swept along. This causes the market truism, “a rising tide lifts
all boats.” Over a 5+year horizon, their contributions will be influenced by the
public attitude towards stocks and bonds in general. For example, for 20
years after the great depression, the American Public believed that stocks were
inherently risky and unsuitable for most investors. Over a 10+ year horizon,
contributions are also greatly influenced by demographics. As more
Americans near retirement age, net investment into the stock market as a
percentage of income will decrease. It’s also worth noting that passive
investors are still relatively geographically isolated; American investors drive
American stock market prices, and German investors drive German
prices. Over the long term, the valuation of a large country’s stock market is
primarily determined by passive investors.
To take advantage of opportunities created by the passive investor, we want
to identify when they make poor choices. The simplest example is the passive
investor’s exaggerated response to crisis. During a major war, recession, or
natural disaster, public sentiment is likely to become extremely pessimistic. If
the market has already sold off by as much as you think appropriate for the
actual risks, it’s time to prepare for a contrarian trade. Similarly, we know
that a young country with a growing economy will have a tremendous tailwind
from a continuous flow of new earnings into the equity market. In the absence
of a crisis, stock prices are likely to continue to rise regardless of valuation. As
long as valuations are not obviously too high, we can ride the tailwind.

2) Long Equity Managers

These professionals consist of mutual fund managers and some pension and
hedge fund managers. They frequently focus on picking sectors that will
outperform the market and individual companies that will outperform the
sector. These managers usually have a 6 to 18 month investing horizon and
they dominate the market in that time frame. They are driven by “ideas.” For
example, a well respected analyst might put out a research report arguing that
solar energy stocks are dramatically undervalued for various reasons. As this
idea percolates through the market, fund managers overweight solar stocks in
their portfolio. They tend to look for “pure plays”, stocks that are most
directly tied to the investment thesis. They follow the dictum that it’s better to
fail conventionally than to succeed unconventionally, so they avoid “ugly”
stocks, like those of companies embroiled in lawsuits.
It’s relatively easy to take advantage of these investors because their
motivations are so clear. It’s sometimes possible to jump on a popular
investment thesis near the beginning, but at the very least, you can avoid
sectors that have already been pushed to bubble valuations. Because the fund
managers look for “pure plays”, simple stocks are usually overvalued relative
to more complex conglomerates. Conglomerates take more time to analyze
and have less exposure to the trend, but frequently provide better
value. Finally, these investors avoid “ugly” stocks because they don’t want to
have to explain to their investors why they lost money on an obviously bad
company. Ugly companies frequently provide the very best value investments
for this reason. To borrow an example from the bond world, after Enron went
bust in 2004, Seth Klarman of Baupost Group studied the company intensely
and bought up a large portion of its bonds for 15 cents on the dollar. At the
time he believed they were worth about 35 cents on the dollar and they paid
off closer to 50. Most money managers didn’t want to risk losing money
connected to one of the greatest stock scandal stories of all time; they were
afraid to look stupid.

3) Fundamental Hedge Funds

The next economic actor at bat is the hedge fund that trades equities with a 1
month to 1 year time frame. Various hedge funds focus on long-short equity
portfolios, predicting and trading around earnings announcements, medium-
term technical analysis, and business cycle investing. The key feature of these
funds is the timeframe, because they vary greatly in methodology and
psychology. They are generally pretty efficient and rational in their investing
process, but occasionally they fail spectacularly in ways that can be exploited.
In October of 2008, shares of the car maker Volkswagen soared 286%,
making it briefly the largest company in the world. Many hedge funds had
sold Volkswagen shares short because the company seemed generally weak
and its stock overvalued. It was widely known that Porsche owned over 40%
of Volkswagen shares, but Porsche had vehemently claimed they had no
interest in acquiring more. Suddenly Porsche revealed they had secretly
gained control of about 75% of Volkswagen, which meant that some
shortsellers would be unable to find shares to cover their shorts. There was a
stampede for the exits and as shortseller after shortseller bought back the
stock, the price rose to the stratosphere. At that point, even hedge fund
managers who wanted to remain short could not, because they were margin
called and forced to buy Volkswagen shares. While equity hedge funds with a
medium-term outlook are generally rational, extraordinary events can force
them to create wildly mispriced valuations that we can trade against.

4) Short-term Equity Traders

Over a 1 minute to 1 month time frame, we have short-term equity
traders. These traders are responsible for creating what we think of as the
“efficient market.” They trade equities immediately after public
announcements, natural disasters, economic releases, and even weather
updates. When rumors float that a large hedge fund is getting margin called,
these equity traders will fly like vultures over its corpse and take advantage of
the resulting mispricing. Short-term equity traders try to anticipate the
actions of the longer term equity managers and hop on “idea” trends at the
very start. They ride the ebb and flow of bigger players’ orders.
These traders don’t frequently make “mistakes” that we can exploit as
investors, but we have the advantage of a longer time frame. While they are
rational at what they do, their disinterest in holding positions longer term
means they leave a lot of money on the table. For example, after a subtle but
strongly bullish announcement from a company, these traders will
immediately buy a company’s stock, but if the stock price stalls, they may sell
the stock out in an hour or a day. We can buy the stock from them and enjoy
the gains over the next few months or years.

5) Quants
The last player in the equity game are “black box” hedges funds or “quants",
and they represent about 70% of the trading volume. These traders program
computer algorithms to trade in a time frame measured in microseconds to
minutes. They immediately exploit simple arbitrages and use complex models
to try to predict the actions of other market participants and jump ahead of
them. For example, a computer program will notice that every 5 seconds,
there is a purchase of 1000 shares of Microsoft stock. The program will
purchase 10,000 shares and then sell the shares to the original purchaser
every 5 seconds at a higher price. The quants make many basic
mistakes. They overweight simple historical data and frequently fail to
consider changing circumstances. For example, their programmers will
estimate the impact of a good GDP number on stocks by looking at the impact
of GDP reports over the last 10 years. However, they will likely fail to consider
more subtle variables like current valuation levels, market sentiment, open
stock option interest etc. Every once in a while, quants make eggregious, even
comical errors. For example, during the “flash crash” of May 6th, 2010,
quants sold the stocks of several large companies at $0.01.
It’s difficult to exploit quants unless you have access to similar
technology. Even when the quants make eggregious mistakes, they are
generally protected by the exchanges; the NYSE cancelled the trades in which
the quants sold stock at $0.01. We can at least be mindful of their market
impact. While quants are frequently thought of as “liquidity providers” in that
they are constantly making markets and trade great volume, they become
“liquidity takers” when the market is strongly trending. This means that a
market with a high volume of quant trading is much more likely to experience
a “flash crash.”

Your "monolithic" trader,

Vega

Risk over Reward: A conversation about intelligent investing – we discuss the nature of
risk and uncertainty, macroeconomics, security valuation, and how to think about
markets and invest profitably - http://www.riskoverreward.com/

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