Investor Bucketing and Believing one’s own BS
Photo by Jessica Johnston on Unsplash
In most cases, narratives are designed to make products easier to sell. The more complicated the product (think structured products that don’t behave in a linear way), the more profitable the sale, but the greater the abstraction needed so that the average man on the street can understand it. Not fully, surely, to be able to grasp the likely asymmetry in risk inherent in the product, but sufficiently to be able to decide of their own volition to take on that risk and affirm that it is something they understand.
So, the narrative comes: “the yield is good”, “it’s a structural story”, or perhaps even “it’s a supercycle”.
But what happens when the salesman starts believing his own sales pitch? What happens when the vendors sell so well that they suspend all skepticism and forget that they were supposed to be the “masters of the universe” who manufactured that narrative in the first place?
Markets are reflexive on the way up. Few remember until it’s too late that they are also reflexive on the way down.
Do you want to be right, or do you want to make money?
This wonderfully succinct line is, no surprise, a crypto twitter special, often dished out by the old-school crypto veterans who survived the previous crypto winter to the ideological and idealistic newbies on the scene.
Put differently, it is a call to pragmatism, to not let idealism and ideology rule over decision making. It is the companion to the other line that says, “I’m in it for the tech”, or what crypto twitter calls “coping” – in this case, coping with the unending decline in a token price for a project “despite the great tech”. To be fair, “cope” also happens when numbers are going up, although that phase of the market is a bit of an ancient memory by now.
On one hand, we had all the narratives around holding through the cycle, and markets always going up – these are narratives that are created to abstract away the complexity of running money through volatile markets (trust us, we know!) and convince non-professional investors to essentially leave their assets with the professionals. But whereas clients can leave their assets with managers, when managers say that they are “leaving it” to the market, that should raise red flags all around.
Investment management, as the name suggests, involves hard work, managing the plethora of moving parts in whatever market the manager is involved in, along with the volatility. It is the responsibility of the manager to do all of the work that they offered to do on behalf of their investors: if a manager tells clients to set it and forget it, it’s only true if the manager never forgets and never takes eyes off the ball.
But when the managers start believing their pitch, that the market always goes up, that THEY can set it and forget it, then one could be staring disaster in the face and still not know it. And if they fail to sell, ending up “hodling” as they advised their clients to do, how will they ever realise the profits that were made?
Profits only ever become real once positions are closed. Making unrealised profits is easy – keeping them and realising them is hard.
It turns out that one could easily end up drinking too much of the same kool-aid that was peddled.
Buckets and flags
While we’re on the subject of kool-aid, there’s a different sort of kool-aid that was also being consumed in copious amounts – that of crypto being the magic solution that takes over the world, the one thing to abandon everything else for because nothing else compares. Crypto = good, everything else = old fashioned, boring and outdated.
At the peak of crypto mania last year, it seemed like no one in crypto could do wrong. Heroes were being made of twitter personalities who had appeared magically out of the ether – they were geniuses of the highest order, the new masters of the metaverse, overturning the old order of centralised finance. They were living the dream: young and beautiful, rich and successful, they were everything that everyone else wanted to be.
We too were feeling the benefits of this newly minted wealth. It was extremely pleasant, and certainly the world of crypto, compared to the equity markets, appeared to be much more revolutionary and dynamic. And to some extent it was true: it was capitalism at its purest. Brutal, unregulated profit seeking behaviour was the order of the day, and everyone was in it for the money, to buy somewhere and sell higher.
No one needed to concern themselves with earnings season, options expiry or conference calls – it was all about discord chats, flooded with news about roadmaps, partnerships, airdrops and freebies. Everyone in crypto was making money, and everyone who wasn’t in crypto looked like a relic en route to the museums.
There were certainly times when we questioned the sensibility of running our main strategy. Sure, the returns were respectable, but why make low-mid teens returns when going all-in to crypto could make mid-teens MULTIPLES of capital? The running humble brag line amongst crypto managers was that while in TradFi, returns were measured in %, in crypto returns are measured in x: 15x, 20x, 25x – no problem at all.
At one point, a number of people advised us to give up our core product and go all-in on crypto. “The old model is dead”, “Equities are boring”, “If you paid as much attention to crypto as you did to stocks, you’d be WAY richer” – this was what we were told, and to be completely honest, it was a very tempting prospect.
Except at the back of our heads was that little voice of sense that said, “remember what happened in EM?”.
For those who don’t already know, in our previous lives prior to founding Three Body Capital, we used to run an Emerging Markets Hedge Fund. The fund was started in 2008, in the wake of the GFC, and for years printed stellar award-winning performance investing in the wonderful world of emerging markets, the same countries in which we have made many friends over the years, who have now opened doors to new networks for us in our current business.
Yet there was one strategic mistake that ultimately caused much consternation when it came to running a business: the label.
Being labelled as an “Emerging Markets” fund was a double-edged sword: when EM was in vogue, the inflows came hard and fast; when it wasn’t, the outflows never stopped. As we’ve written before over the past years, buckets and labels are great for allocators to work with – by constraining what managers can do with their strategies, allocators can more easily make top-down decisions based on a strategic asset allocation. But for managers, it’s easy-come, easy-go, and our experience at our prior fund taught us that being bucketed was never a good thing.
Of course, back at the end of 2021, we didn’t know exactly when the crypto party would end, and admittedly it is only through hindsight that we see this episode of exuberance as the “top”. But in itself, the idea of abandoning a track record in the all-in pursuit of a shiny new thing (mind you, crypto is an infant when it comes to the age of the asset class) rang alarm bells in our heads.
And we’re thankful that it did. What we’ve done in this business when managing money is that we don’t consider ourselves equity investors or crypto investors or macro experts or growth guys or value guys. We look at whatever opportunities are out there; we determine the risk vs reward at any moment in time and we act accordingly. This allows us to do what we do best which is find the bull and bear markets. Our motto is that there is always a bull market somewhere.
Likewise, since no bull market lasts forever, had we gone all in on anything, we would have regretted it.
Reset
And so, we find ourselves here today: stocks are down, bonds are down, crypto is VERY much down.
But we’re not down - in mojo nor in our stock book nor in our crypto book. Thanks to that little voice at the back of our heads, perhaps born of the adversity from years before, we didn’t take an insensible plunge. Nor did we “hold” through the cycle: for better or for worse, we sold what turned out to be the top in crypto, even if selling drew a fair amount of mockery at the time for being light on conviction.
The kool-aid, whatever the flavour, wasn’t drunk.
There is no doubt that the advice given to us was well-meaning, meant to be an exhortation to do what we do well, to take what those who gave the advice believed was the best course of action. But even our most respected and trusted advisors can fall prey to their own kool-aid, and the narratives that are spun out of the market.
The reality is this: markets are tough, there isn’t any easy formula and being flexible to be able to catch any run – wherever those trends may be, up or down – is CRITICAL for long-term survival. Likewise, not losing money and holding on to gains is arguably MORE important than making lots of money – the math can’t be cheated, and -20% followed by +20% isn’t equal to a flat position. It’s down.
We’re here to make money, and it doesn’t matter whether we’re “right” or not according to the narrative of the day. And in the end, only the track record matters. We are 2 years and counting and have a very long way to go.
While we’re on that journey, we’ll be doing our best to avoid the temptation of the inevitable kool-aid peddlers (potentially ourselves included).