On Jim Simons, String Theory, and Quantitative Hedge Funds

Renaissance Technologies founder and mathematics professor Jim Simons is an enigma in quantitative hedge funds.

 

Simons rarely gives interviews. One of the best is an Institutional Investor interview he gave in 2000 (PDF). One insight is that Renaissance makes trades in specific time periods using pattern recognition to model volatility.

 

Simons has done important work in differential geometry and the theoretical physics subdiscipline of string theory. I recently looked at some academic journal articles by Lars Brink (Sweden’s Chalmers University of Technology) and Leonard Susskind (Stanford University) to try and understand how Simons views financial markets.

 

String theory proposes one-dimensional objects called strings as particle-like objects that have quantum states. String theory and cosmology has progressed over the past 35 years to describe this phenomena but still lacks some key insights.

 

How might Simons use string theory to understand financial markets? Two possibilities:

 

(1) The mathematical language of couplings, phase transitions, perturbations, rotational states, and supersymmetries provides a scientific way to describe financial market  data and price time-series. It does so in a different way to fundamental analysis, technical analysis, and behavioural finance: Simons uses string theory to understand the structure of information in financial markets. (Ed Thorp pursued a similar insight with Claude Shannon using probability theory.) String theory-oriented trading may be falsifiable in Karl Popper’s philosophy of science.

 

(2) String theory provides a topological model that can be applied to money flows between mutual funds, hedge funds, and bank trading desks over short periods of time. This might enable Simons’ traders to forecast the likely catalysts for changes in stock prices in the short-term and to trade accordingly. This might involve using string theory to forecast how price trajectories might change if portfolio managers at other funds alter their portfolio weights for a stock. In doing so, Simons is trading in a similar way to SAC’s Steve Cohen (who uses game theory) and D.E. Shaw’s David Shaw but uses different methods of pattern recognition to do so.

 

I have made a list of popular science books and Springer academic monographs to keep an eye on string theory. Simons’ success also illustrates how insights from one knowledge domain (string theory, astrophysics, computational linguistics, and voice recognition) can be transferred to another domain (financial markets trading).

Special Order 937

Special Order 937 from Alien (1979)

Special Order 937 from Alien (1979)

 

In organisational strategic subcultures the decision elite / leadership may have different ranked grand preferences to its followers. Ridley Scott’s film Alien (1979) dramatises this two-level game of principal-agent and moral hazard risks in the revelation that the Weyland-Yutani Corporation’s priority is to retrieve the alien xenomorph for its weapons division, and the USCSS Nostromo crew are considered expendable.

 

The Nostromo crew evoke the MacLeod-Gervais-Rao-Church model of role power dynamics in organisations. Parker (Yaphet Kotto) and Brett (Harry Dean Stanton) are Losers: low-level employees who argue with other crew members about bonuses. The rest of the crew are largely Clueless: Kane (John Hurt) puts the crew at risk when he ventures into a derelict alien spacecraft; navigator Lambert (Veronica Cartwright) is a dedicated worker who becomes emotionally unstable; and captain Dallas (Tom Skerritt) makes bad risk management decisions. Science officer Ash (Ian Holm) is a Sociopath who is aware of Special Order 937 and hides this agenda until Ripley (Sigourney Weaver) discovers it. Ripley transforms from Clueless to possible Sociopath near Alien‘s end and becomes a Sociopath in James Cameron’s sequel Aliens (1986).

 

Special Order 937 is a powerful narrative-like metaphor that has wider applicability. It depicts the potential breakdown or fraying of employer-employee relations in circumstances of disruptive industry change, distressed debt, and organisational restructures. The MacLeod-Gervais-Rao-Church model predicts that Sociopaths will externally transfer the negative risks to Clueless and Loser employees – whilst simultaneously covering this up through selective framing / interpretation of facts, policies, and procedures.

 

Awareness of Special Order 937 gives Clueless employees the opportunity to see the underlying Reality of the organisational strategic culture from the decision elite / leadership’s perspective (and perhaps from a whole-systems viewpoint). This provides some optionality and the potential to become more than Sociopath: a fully sovereign actor who is anti-fragile (Nassim Nicholas Taleb).

What I’m Reading: Achieving Happiness

1. Some interesting new research on achieving happiness: “Over the past decade, an abundance of psychology research has shown that experiences bring people more happiness than do possessions.”

 

2. David Thomson’s insights on the film Whiplash: “Genius is actually beyond teaching or example. It doesn’t bother with or heed advice to practice 25 hours a day or suggestions to give up on sex, golf, and other addictions.”

 

3. Norway’s climate change trade with Liberia echoes the Coase theorem on negotiation: “In 1960, the economist Ronald Coase argued that bargaining between parties could, under certain conditions, produce a mutually beneficial and efficient solution to problems like pollution.”

 

4. A bug in video poker made two allies rich; personal enmity and tax problems followed: “Every jackpot, he realized, was being reported to the IRS, and he’d already won enough from the bug to propel him into a higher tax bracket.”

 

5. Fail-Safe‘s insights about Cold War nuclear strategy: “But the crisis’s real cause is the logic of the nuclear system at every level—its institutions, structures, procedures, and rationales. This isn’t a movie about why we should fear machines or the people who control them. It’s about how managerial systems can bring about just the things they’re designed to avert.”

 

6. How to live an anti-fragile way of life: “The general underlying principle here is to play the long game, keep your options open and avoid total failure while trying lots of different things and maintaining an open mind.”

Dissecting Steve A. Cohen’s Edge

One of my discarded PhD chapter outlines was on the hedge fund SAC Capital and the insider trading case involving former SAC trader Matthew J. Martoma and the firms Elan and Wyeth. I had hypothesised that SAC founder Steve A. Cohen had developed a specific organisational strategic subculture. Recently, I read and analysed Cohen’s legal defence. Now, The New Yorker‘s Patrick Radden Keefe has written a lengthy article on SAC, Cohen, Martoma, and the insider case’s legal outcomes. I reflected on how Cohen developed his edge:

 

1. Cohen had ignition experiences early on in his career. Keefe and the PBS Frontline ’To Catch A Trader‘ point to Cohen’s formative trading experiences with the investment bank Gruntal & Company as a likely first encounter with insider trading. Possibly more important to Cohen’s creative psychobiography are his early experiences in learning to perceive fluctuations in stockmarket prices, as told to Jack Schwager. This tape-reading ability has been part of trading education since Jesse Livermore and is echoed in the Market Wizards series interviews that Jack Schwager did with Michael Marcus and Paul Tudor Jones II. Cohen’s early experiences also parallel the role of ignition experiences in the literature on genius and creativity. They also meant that Cohen did not adopt the dominant approaches of fundamental and technical analysis. Instead, he anticipated behavioural finance in looking for catalysts that moved stocks and that led to rational herding and overconfidence behaviours he could trade against.

 

2. Cohen hired a performance psychologist. Keefe mentions but does not name the late Ari Kiev as the performance psychologist who Cohen hired to mentor his traders. Kiev’s books notably The Mental Strategies of Top Traders (Hoboken, NJ: John Wiley & Sons, 2009) draw on his SAC experiences and detail his personal synthesis of elite sports training, game theory, portfolio management, and leadership frameworks. Kiev foreshadowed other performance psychologists such as Brett N. Steenbarger who have worked with hedge funds. In doing so, Kiev and Steenbarger became de facto strategic foresight practitioners, albeit with a different knowledge base to futures studies.

 

3. Cohen created a specific organisational strategic culture. Keefe and PBS Frontline‘s narratives focus on SAC’s competitive culture between rival portfolio managers; the inside discussion of “black edge” as material non-public information; how Cohen ran his trading floor; and how Cohen got the best trading ideas from portfolio managers whilst also insulating himself from their information sources. There are observations here worthy of the third generation literature on strategic culture, and how specific organisations have developed ways to hedge risk and volatility. If Keefe had been familiar with the sociology of finance literature then he might have focused on this more. Now that SAC has transformed into Point 72 Asset Management – to manage Cohen’s estimated $9 billion wealth – we may never really know what went on inside SAC, unless there is further operational disclosure in civil cases, or in trader memoirs.

 

4. Cohen was pro anti-fragile. Keefe tells an anecdote about how Cohen would ask job applicants: “Tell me some of the riskiest things you’ve ever done in your life.” Keefe segues from this into an anecdote about insider trader Richard Lee. But there are several other possible ways to interpret Cohen’s question and why he would pose it to SAC job applicants. Cohen may have wanted to assess how the job applicant conceptualised risk; how they made decisions; and what specific decisions they made when faced by risk. As Kiev identified these are crucial aspects to successful trading. The anecdote also suggests to me that Cohen was pro anti-fragile: options trader and philosopher Nassim Nicholas Taleb’s term for phenomena that become stronger due to volatility exposure. Being pro anti-fragile – and taking considered risks – was in part how Cohen turned an initial $US25 million in the early 1990s into his fortune – as a possible successful example also of the Kelly Criterion risk management strategy.

 

5. Cohen factored in transaction and execution costs. Keefe alludes in passing to how SAC used dark pools – private exchanges that hedge funds use to trade their positions – in order to exit Martoma’s Elan and Wyeth trades. Kiev’s game theoretic reasoning about catalysts and other market participants provided one rationale that was influential in SAC’s organisational strategic subculture. Awareness of transaction and execution costs – and their impact on a trade’s profitability – provide another rationale. In one of the few public statements by SAC staff, Neil Chriss emphasised the importance of considering transaction and execution costs in his introduction to Robert Kissell and Morton Glantz’s book Optimal Trading Strategies (New York: AMACOM, 2003), pp. viii – x. Chriss suggested there was “an efficient frontier of trading strategies . . . Each strategy has a certain transaction cost and a certain risk” (emphasis original) (p. x). He then stated: “no institutional manager can afford not to understand transaction costs” (emphasis original) (p. x). In doing so Cohen anticipated the impact that dark pools, and algorithmic / high frequency trading have had on contemporary market microstructure.

 

There is thus far more to Cohen’s hedge fund success with SAC Capital – his sustained edge over two decades – than what the Martoma insider trading case has revealed to-date. Keefe’s New Yorker profile reveals aspects – but more trading knowledge is needed to piece together Cohen’s secrets from public information sources.

Rekindling Aletheia Studies

Earlier this year I moved a 20-year book collection into storage. Part of the collection was a shelf of Fourth Way literature I acquired in my early twenties when I explored the Gurdjieff Work. At one point, I had most of the Arkana reissues of memoirs by George Gurdjieff’s followers. In 1995, I began reading John Godolphin Bennett’s studies in La Trobe University’s Borchardt library, whilst researching an article on King Crimson and Robert Fripp for Perth’s REVelation Magazine.

 

These encounters led to a chain of events over a six or seven year period: first to Melbourne’s Theosophical Society library and their Bennett collection on Systematics and Subud; later to a Work Group run by Brian and Nina Earl; then to more personal self-work and discussions with others; then to dossiers for the Disinformation website on Gurdjieff and Bennett; and finally in 2001 to an undergraduate essay on Gurdjieff and peace studies in which I tried to synthesise all that I had learnt. In 2002, I started Masters studies in the Strategic Foresight program at Swinburne University which was deeply influenced by the Club of Rome’s Limits to Growth simulation, which Gurdjieff and Bennett had anticipated.

 

The thread running through these experiences was the Greek word Aletheia: an ‘embodied’ presence of Self from Self-Remembering practices.

 

At the time, Bennett’s books were either dusty hardbacks in a rarely visited part of a university library or Bennett Books paperback reissues. Now, you can get many of them on Amazon.com’s Kindle platform. The first volume of Bennett’s Dramatic Universe study has been reissued; along with monographs on Hazard and other topics. Other books I had put into storage – such as psychologist Claudio Naranjo’s Character and Neurosis: An Integrative View on the Enneagram of the Sarmoung – are also on the Kindle platform.

 

Two decades later I am starting to have a better grasp of Bennett’s synthesis of ecological thinking, cross-cultural encounters, and strategic intelligence. I’ve had experiences with Naranjo’s influences in psycho-dynamic and existential therapy. It feels like revisiting an earlier part of life – with more informed insights – and the portability of modern computer and smartphone technology. I’m also seeing how – living under different life conditions and with different influences – I might develop a personal synthesis like Bennett and Naranjo did.

Exploring Dual Momentum Strategies

Dual Momentum Investing

Gary Antonacci‘s forthcoming book Dual Momentum Investing: An Innovative Strategy for Higher Returns with Lower Risk (New York: McGraw-Hill, 2014) is currently Amazon.com’s top-ranked book for “momentum investing”. Antonacci’s 2013 paper ‘Risk Premia Harvesting Through Dual Momentum’ (PDF) contains a preview – including a great opening discussion of why the momentum anomaly exists in the stockmarket and why behavioural finance factors are likely to be involved.

 

Antonacci distinguishes between two types of mometum strategies: (1) cross-sectional / relative momentum — used in long-short and index tracking strategies, and in the Relative Strength Indicator in ‘chartist’ technical analysis; and (2) absolute momentum – a time series phenomena where an asset’s prior price helps to determine its current price – used in trend-following.

 

Antonacci’s dual mometum framework combines both types of momentum to extract alpha from volatile asset classes. He uses a modular approach to portfolio construction. Treasury bills provide an initial hurdle rate for relative momentum, with a 12 month lookback period. Antonacci then uses absolute return increase the basis point return, whilst decreasing the portfolio’s volatility and maximum drawdown. He has tested the dual momentum strategy in fixed income, equity, and real estate REIT asset classes, and with other market factors such as credit risk and economic volatility.

 

The paper’s final paragraph summarises Antonacci’s dual momentum strategy:

 

The combination of relative and absolute momentum makes diversification more efficient by selectively utilizing assets only when both their relative and absolute momentum are positive, and these assets are more likely to appreciate. A dual momentum approach bears market risk when it makes the most sense, i.e., when there is positive absolute, as well as relative, momentum. Module-based dual momentum, serving as a strong alpha overlay, can help capture risk premia from volatile assets, while at the same time, defensively adapting to regime change. [emphasis added]

 

Dual momentum investing is thus an alpha extracting strategy that combines two different forms of momentum to diversify the portfolio, and to lower volatility. The two different forms of momentum identify a set of market assets that are highly probable to appreciate in value in the near-term, particularly in periods of economic volatility.

 

I suggest that momentum investors adapt to these market changes by possibly buying from distressed debt value investors near market lows that show signs of recent asset appreciation – and through identifying herding and overshoot conditions – selling to trend-following, news effect, and late-coming retail investors or mutual / pension fund managers. Thus, an understanding of game theoretic reasoning – as argued by the late trading psychologist Ari Kiev whilst at the hedge fund SAC – and population ecology models applied to market microstructure – might be helpful to momentum investors.

What I’m Reading: Momentum Investing & Hedge Fund Strategies

This week I did some research program planning on hedge funds as strategic subcultures. Some recent material:

 

1. AQR Capital Management focuses on the momentum anomaly as an investment strategy (PDF).

 

2. The investor information for Goldman Sachs Asset Management LP contains some useful information (PDF).

 

3. AQR’s Cliff Asness and index fund pioneer Jack Bogle have a great discussion on active / passive management and pension fund investing.

 

4. BlackRock’s guide to Absolute Return investment strategies (PDF).

 

5. Nassim Nicholas Taleb talks with James Altucher about anti-fragility and uncertainty.

 

6. Slate’s John Swansburg dissects the American myth of the self-made man.

 

7. Wagner Award 2014 submissions to the National Association of Active Index Managers.

 

8. Trend-follower Michael Covel asks: Does momentum investing work?

 

9. Patrick O’Shaughnessy on two ways to improve the momentum strategy.

Picks & Pans

The Organized Mind: Thinking Straight in the Age of Information Overload by Daniel J. Levitin (New York: Dutton / Penguin Group, 2014) (TS-1). Levitin is the James McGill Professor of Psychology and Behavioral Neuroscience at McGill University and is dean of the College of Arts and Humanities at the Minerva School at KGI. The Organized Mind synthesises the latest research on attention, memory and neuroscience to offer extensive tips on how to organise your life. An appendix discusses how to use Bayesian probability models for problem-solving. Levitin’s book is a guide to cultivating Dianoia in contemporary life.

 

Young Money: Inside the Hidden World of Wall Street’s Post-Crash Recruits by Kevin Roose (New York: Grand Central Publishing, 2014) (TS-3). Roose spent three years shadowing eight new recruits to United States investment banks – like Goldman Sachs and Bank of America Merrill Lynch – during the aftermath of the 2007-09 global financial crisis. Young Money reveals the rite of passage strategies that Wall Street firms use on their new hires – and the negative life impacts that can occur in winner-takes-all competitive dynamics. Some of Roose’s interviewees manage to reintegrate with their employer investment banks – and some do not. The selection pressures Roose depicts and identifies also function in Silicon Valley entrepreneurship start-ups. Roose’s narrative captures some experiential life challenges that can occur in other life contexts.

 

Vivid Awareness: The Mind Instructions of Khenpo Gangshar by Khenchen Thrangu (Boston, MA: Shambhala, 2011). (TS-3). Khenpo Gangshar was a meditation Teacher who influenced Chogyam Trungpa and others who brought Tibetan Buddhism to the West. Vivid Awareness details Gangshar’s oral instructions in 1957 to the author on how to train the mind and emotions – using analytic meditation – and how to attain the Dharma in contemporary circumstances.  The book also captures how a meditation Teacher adapts his insights with the foreknowledge that socio-political upheavals and other Shocks will affect the Transmission of his Teaching. Thus, this book can also be studied as a manual to achieving the Remanifestation of a Teaching in difficult life circumstances. The specific techniques of analytic meditation taught in this book will be most helpful to the interested practitioner who wants to gain greater control over their mind and emotions.

Wealth Secrets of Financial Elites

How do financial elites gain effortful power? What are their wealth management secrets?

 

Chrystia Freeland’s book Plutocrats: The Rise of the New Global Super-Rich (New York: Penguin Group, 2012) suggests three factors:

 

1. Anti-fragility or positive growth from the interaction of volatility and time. Freeland focuses on forces like entrepreneurship, globalisation, technology and political change. The “anti-fragility premia” is perhaps best discussed in Nassim Nicholas Taleb’s options trading and philosophy work.

 

2. Capital Accumulation as inter-generational wealth creation. Pick a famous dynastic family like the Carnegies or the Rothschilds. Capital Accumulation can be expressed as the positive growth of wealth over time expressed as a Present Value to Future Value cashflow. This process can also be considered in terms of the financial decisions that we make over our lifespan: decisions today set-up the potential favourable conditions for tomorrow. Warren Buffett’s official biographer came up with a memorable image to describe this process: The Snowball.

 

3. Rent-Seeking: Rent-seeking is control of financial / real assets that allow for Capital Accumulation to occur (as an extraction premia). Gordon Gekko exemplifies this in the Oliver Stone film Wall Street. Rent-seeking may be done via entity structures (such as a pass-through vehicle like a limited liability partnership) and through wealth management strategies (such as funds management and legal tax minimisation).

 

Freeland and others suggest that Superstars are able to use these three factors to gain cumulative career and financial advantages.

 

This leads to the following equation for elites: rent-seeking control of PV and FV cashflows + anti-fragility + volatility (where the first two are stronger than volatility, which in the case of events like the 2007-09 global financial crisis, can still lead to significant drawdowns).

 

An example from my own life: the 1998-2008 period of work with The Disinformation Company Ltd (now TDC Entertainment):

 

1. Pick an anti-fragile trend – such as pre-millennialist conspiracy theories in the mid-late 1990s and a web portal platform during the 1995-2000 dotcom speculative bubble.

 

2. Set-up a structure for capital accumulation: TDC as a Delaware-registered company that engaged in book, television, DVD, web, and conference projects and that built an audience.

 

3. Rent-seeking over time via the free cash-flows from the project portfolio.

 

You can find and understand examples from your own life.

Pink Floyd’s The Endless River

Pink Floyd’s new, mostly instrumental album The Endless River is due out 10th November. It’s a tribute to late keyboardist Rick Wright developed from The Division Bell sessions in 1994. I remember as a student journalist in 1994 the joy that La Trobe University’s Rabelais editors all felt when EMI provided a review copy of The Division Bell (whose ‘High Hopes’ featured ‘The Endless River’ as a song lyric). A lot has happened in 20 years between studio albums . . .