The Origin of Wealth: Differentiate, Select, Amplify. Repeat.

by: Nemo Incognito

I've just finished reading Eric Beinhocker's The Origin of Wealth (now available in paperback) and it is a remarkable tour de force - I'm not sure whether I like it as much as The Blank Slate, but it isn't far off. It is broadly about "complexity" in economics and covers a multitude of areas: evolutionary biology, cellular automata, non-linear systems etc etc, amongst which there is a lot of overlap.

There are a few observations I gleaned from the chapter on finance which I thought were peculiarly good advice and often ignored in the industry including the following:
  • Ultimately surviving as an investor is what evolutionary biologists would call a "Red Queen" race. On the margin, trading is a zero sum game and the costs of adaptation or entry barriers are relatively low, as a result, what makes you a successful gene is remarkably similar to what makes for a long lasting asset manager: flexibility, the ability to evolve, and having at any one time a few different approaches to feel out the market and then ride the winners. How many funds or even PMs are genuinely capable of enacting a Plan B or C, and, more importantly, when circumstances change, how many would actually do so? There is a reason why one of the attributes that are allegedly common amongst a Paul Tudor-Jones or a Soros is the ability change one's mind quickly.
  • Any given strategy that becomes successful for long enough is doomed to become crowded and cease to be so, often via a sudden collapse in returns. This is a little like cutting one's losses quickly but on a strategic level.
  • Ideas or content driven businesses should be relatively small and flat in their hierarchical structure whereas process driven ones with a large number of interdependent parts need more hierarchy and explicit organization. Hands up who has seen a bloated liquid markets hedge fund with way too much head count where hardly anyone talks to one another which soon is wiped out by massive losses in one part of the business that could have been forseen? Too many examples to mention here.
The macro fund structure makes a lot more sense than most because it broadly gives a smart manager to do the right thing in exchange for liquidity for investors rather than locking them into something very specific like credit, real estate private equity or the like that only makes a whole lot of sense for some of the time.
One thought I did have on the back of this book was to wonder whether big macro trades may in fact be exhausted, at least in the medium term and whether the better bets may be a bit more micro: sector trades, country level trades and more event driven trades. Russell Napier of CLSA is convinced that there's no point trying to fade a major equities correction driven by inflation until it gets to 4%, similarly, given the reflexive nature of monetary stimulus and Ben Bernanke's reappointment it may be the case that any real shocks are going to be heavily dampened by the Fed so long as the public outrage can be kept in check.
Longer run, it’s basically a given that US budgets are going to be in deficit for a while yet, similarly, it appears that at the long end of the yield curve the bids are mostly coming from US banks that are holding excess reserves and riding a steep yield curve to rebuild their equity. The problem with this is that as the financial system improves, it's going to be really hard to keep mortgage rates under control (ie, once JPM feels comfortable making loans etc again they don’t need to hold 30 year bonds up the wazoo so yields go up). This leads to problems as follows:

a. The curve is going to stay steep since as the economy recovers the marginal buyers of the long end disappear, this could adversely affect equity markets and lead to corporations borrowing short more often in turn leading to greater volatility in recessions (ie, refi risk is high when you have to roll a lot of your debt annually).

b. As a response, US bond issuance is going to be much heavier in lower duration (ie, t bills etc). Is it possible that over time this could lead to more severe currency and short rate volatility in the US?

But that, as they say is for the longer run and in the long run we're all dead. The more pertinent story might just be that rather than hunting for elephant moves in FX and the like, investors should be looking for more rabbit sized moves in industries and countries and pack the appropriate firearms.