choose your own adventure: quarterback or piggyback

i've been starting to read the financial press again. you would think that with everything going on over the last month or two, i would've been voraciously consuming all manner of financial news. not the case. a combination of being surrounded by day-to-day short-termism and my already low tolerance for balderdash being passed off as 'financial analysis' led me to eschew nearly everything in the mainstream press since the end of the summer [ed: that said, there have been very good pieces in the WSJ and the FT and kudos to many of the finance blogs who have been breaking stories way before anyone else].

as part of my creeping back into the fray, i read one of James Surowiecki's columns in The New Yorker. in all the years i've been reading his stuff, i have yet to tire of it. i may not always agree with his conclusions, but he is generally very good at communicating the academic argument that underpins an idea in a way that rarely treads into lowest common denominator territory.

his latest article highlights the idea that agents and institutions in the market that are supposed to act as buffers to market trends (rating agencies, Wall Street analysts, and hedge funds) are more pro-cyclical than counter. that is, instead of stemming the tide, these institutions have exacerbated the slide.

i completely agree with him, though i think that this has been the case for a lot longer than just this year. remind me of the last time a ratings agency actually early-warned about a company's impending capitulation into trouble. i say this as someone who worked very briefly for a ratings agency. trust me when i say "good luck with that". ditto for Wall Street analysts.

and that's my biggest complaint. it is well-understood that these two groups don't generally do a very good job at predicting a company's ability to survive. like, at all. and yet, what is one of the standard factors built into many a hedge fund's black-box model? that's right - upgrade/downgrade by an analyst or ratings agency. and i say this as someone who worked briefly at an investment consultant covering hedge funds who, in any given week, saw 7/10 funds putting on the same trade based on their "proprietary in-house fundamental and technical models". right.

but it's not like non-hedge fund investors do any better. mutual funds, pension funds, endowments, private wealth managers. they all rely on these outside opinions in forming their investment decisions. and i get it. i do. it's not possible to comb through every company's 10-K and run the numbers yourself. and frankly, even if you could, we're not all experts in the particulars of oil and gas exploration companies, but we do know that allocating some segment of a portfolio to commodities can act as an inflation hedge in the long-term. so what's a portfolio manager to do?

here's a suggestion: stop outsourcing your due diligence. someone (individual, university, foundation) is paying you to render an opinion. use other people's work as an informational input, but out of respect for the profession and out of duty to your client, filter that information with your own judgment. check if it passes the smell test. question it. and if you still agree after that, or if you disagree but you see a way to arbitrage an informational inefficiency in the market, then by all means, go ahead with your trade. good investors do this. this is what true investing is all about.

but if you don't do that - if you trust external agents to do your job entirely - then i am not sorry when your fund is down 30% this month or if you end up with a bunch of ABCP that's been downgraded 10 notches in a month or if your mandate is about to be suspended.

nullum gratuitum prandium, people. the only thing that outsourcing your due diligence does is increase the likelihood that you'll get stuck with the cheque.

(cross-posted from tumblr)