If you grew up in the 1980s, the acronym ‘ACTG’ is bound to evoke fond memories of the then newly launched Maruti 800 (bonus points if you spelt it as ‘Air Conditioned, Tinted Glass‘). And, unless you took evolutionary biology in grad school, it is less likely that you expanded it to ‘Adenine, Cytosine, Thymine and Guanine’—the four types of bases found in a DNA molecule. Back in the eighties, neither tinted glasses on cars were banned, nor had the human genome been mapped. In this letter, we take lessons from human genetics and viral mutations to hypothesize why a constant, fixed principle-based investment framework (including passive investing) is likely to fail over the long term.
The Human Genome Project was launched in 1990; it mapped and sequenced the entire human genome (c22,300 genes) for the first time (by 2003). If that doesn’t sound like a lot, consider this—the human body contains c100tn cells with a nucleus; the latter houses two complete sets of the human genome (one from each parent)—close to 3.1bn base pairs! The whole thing was printed in 2012, which if read at the rate of one word per second for eight hours a day, would require 100 years to complete, and yet it fits inside a nucleus of a tiny cell that can easily rest on the head of a pin.
Now, the gene can photocopy (replication) as well as read (translation) itself. But when it replicates, mistakes are made—a letter or paragraph is missed out or gets inserted at the wrong place. This is mutation—human beings accumulate about 100 mutations a generation.
Viral mutation: Viruses, on the other hand, mutate much faster. Just because they technically aren’t a living thing (they need a host to reproduce), doesn’t mean they are spared evolutionary pressures. While on the one hand they must evade the human immune system fighting them off, on the other they must make sure that the host survives long enough for them to reproduce. Take the case of HIV that causes AIDS. It can produce billions of copies of itself each day, while commonly committing errors, which creates mutations in its genetic code (their large population and short 52-hour lifecycle certainly helps).
Often, the human immune system fails to eradicate the virus and cure isn’t available (current status in HIV). In that case, drugs are administered that block their replication by inhibiting key viral enzymes. The drug will initially reduce the viral load for the patient, but the virus will randomly mutate. Now, we have a virus with resistance mutation which will reproduce despite the presence of drugs, and the entire new population will be drug resistant. When HIV started evolving around the drug, virologists started treating it through highly active antiretroviral therapy (HAART), where a cocktail of drugs was administered at the same time, which brought the virus under reasonable control.
Evolving investment framework: Over a long enough timeframe, the principles of asset management are like a mutating gene structure. If generating alpha is the virus we are after, any strategy that aims to capture it will work initially, until the goal post is shifted to something else, and a new strategy is required to tackle it. This essentially implies that a fixed rule-based theory to generate alpha (for example, just buying higher RoE companies at whatever the valuation or buying just the leaders in their respective fields) will have a limited shelf life in finding success.
And, given how well these strategies have worked over the past few years, the reverse may currently appear unfathomable. But history is littered with examples of such failed strategies, that had worked for a bit and haven’t since. For example, from c1928 until c1958, the preferred strategy was to use the spread between earning and bond yield as an investment consideration. Earnings yield on stocks generally exceeded the yield on long-term US government bonds, usually by a substantial margin, and when they narrowed, one switched. Since 1958, however, that relationship has completely broken down and this strategy would have underperformed for the past six decades.
Then came the 1990s. Long-Term Capital Management (LTCM) generated massive assets by arbitraging bond yields. Historically, bond yields had always behaved in a certain manner and LTCM’s complex models had generated stupendous results year after year; so much so, that they had to refuse incremental capital and had, in fact, returned capital even to investors that didn’t ask for it. At its peak, they managed over USD126bn in assets with just USD4.6bn in equity (rest was leverage). The equity got wiped off in the Russian Financial Crisis and the fund had to be bailed out by the Federal Reserve. On the board of LTCM were two Nobel laureates—Myron Scholes and Robert Merton. Acclaimed financial journalist Roger Lowenstein describes the crisis beautifully in his book, When genius failed.
Lately, Renaissance Technologies (or RenTec) is one of the most successful quant-based funds, founded in 1982 by James Simons, an award-winning mathematician and former Cold War code breaker. RenTec’s flagship Medallion Fund has returned 66% CAGR over 30-years from 1998 to 2018, totalling trading gains of over USD100bn (yes, those figures are correct!). In his book about Jim The man who solved the market, Gregory Zuckerman made an interesting observation, “we’re right 50.75% of the time. But we’re 100% right 50.75% of the time. You can make billions that way.” At RenTec, while quant-based models make decisions and trades, the models themselves are continuously evolving based on the feedback loop from the 150 researchers and programmers who work at the fund.
We would like to end this with the belief that when everything else is evolving, why shouldn’t your investment strategy. Investment strategies that are stuck on one fixed paradigm will stop working; the only question before us is, not if, but when? For us, there is no such thing as ‘one strategy to beat the markets all the time!’