Too Much Testosterone Is Bad for Returns

(Bloomberg View) -- Alpha.

Great title, great abstract: Here's "Do Alpha Males Deliver Alpha? Testosterone and Hedge Funds," by Yan Lu and Melvyn Teo.

Using facial width-to-height ratio (fWHR) as a proxy for pubertal testosterone, we show that high-testosterone hedge fund managers significantly underperform low-testosterone hedge fund managers after adjusting for risk. Moreover, high-testosterone managers are more likely to terminate their funds, disclose violations on their Form ADVs, and display greater operational risk. We trace the underperformance to high-testosterone managers' greater preference for lottery-like stocks and reluctance to sell loser stocks. Our results are robust to adjustments for sample selection, marital status, sensation seeking, and manager age, and suggest that investors should eschew masculine hedge fund managers.

You can imagine an alternative causal explanation along the lines of the recent paper about how hedge fund managers who grew up poor outperform those who grew up rich. The explanation there was not that poor people are better investors than rich people, but that "managers born poor face higher entry barriers into asset management, and only the most skilled succeed." Perhaps high-testosterone managers, similarly, have an easier time starting hedge funds and attracting clients -- because they bring firm handshakes and booming voices to their marketing pitches or whatever -- while only the most skilled low-testosterone managers can make a go of it. This is related to Nassim Nicholas Taleb's argument that "Surgeons Should Not Look Like Surgeons": "the one who doesn’t look the part, conditional of having made a (sort of) successful career in his profession, had to have much to overcome in terms of perception."

Lu and Teo hint a little at that explanation here:

Why do hedge fund investors subscribe to high-testosterone hedge funds given their lower alphas and higher operational risks? We leverage on return data from funds of hedge funds (henceforth FoFs) to show that hedge fund investors are themselves selected by testosterone and that investors select into high- versus low-testosterone hedge funds based on their own testosterone levels. In particular, FoFs managed by managers with high fWHR underperform those managed by managers with low fWHR by 5.03% per year (t-statistic = 2.88) after adjusting for co-variation with the Fung and Hsieh (2004) seven factors. Moreover, relative to other FoFs, high-fWHR (low-fWHR) FoFs load most on high-fWHR (low-fWHR) hedge funds. One view is that the aggressive trading style of high-testosterone hedge funds may appeal to high-testosterone investors as it mirrors their own.

The next sentence is also a gem: "The findings in this paper challenge the neoclassical view that manager facial structure should not matter for fund performance." Ehh? I think if you had asked me 24 hours ago, "does manager facial structure matter for fund performance," I would have laughed, but then I would have thought about it and said "sure yeah good-looking managers probably perform worse." If attractiveness makes it easier to raise money for a given level of performance, then that is the relationship you would expect. (That is of course not quite Lu and Teo's result; they make no judgment about attractiveness, only about face width.) Still yes I suppose that on a "neoclassical view" that is a bit out of bounds. If markets were perfectly efficient then hedge-fund-manager looks wouldn't matter. But if markets were perfectly efficient then why would there be hedge funds?

The crypto.

I think most people have figured out by now that "hedge fund" is a term of art referring to a set of legal structures, compensation schemes, and, yes, also investment strategies, and that you don't have to "hedge" to be a "hedge fund." No one complains that concentrated equity activist funds aren't hedge funds. Even so, the notion of "cryptocurrency hedge funds" strikes me as a bit silly; often the way a cryptocurrency hedge fund works is that you give it money and it buys Bitcoins with the money and charges you some fees. It doesn't do activism on the Bitcoins; it certainly doesn't hedge them. You could have bought the Bitcoins yourself! Here's a guy:

Few cryptocurrency funds have established much of a track record, and many private banks have been reluctant to offer them to clients, said Mohammad Hassan, head of hedge-fund research at Eurekahedge Pte. Ltd. in Singapore.

Most cryptocurrency funds use a simple strategy of buying cryptocurrencies and selling them after they appreciate, he said.

“What they’re doing is pure market timing,” he said. “For me, the question is, why would anybody pay 20% fees for this?”

But now some cryptocurrency hedge funds have discovered selling, and even hedging, and a long/short strategy:

“You need to sit down and put a towel on your head and have a think about things,” said Lee Robinson, founder of Monaco-based hedge-fund firm Altana Wealth, whose $45 million cryptocurrency fund returned roughly 1,500% last year.

Mr. Robinson said he became concerned when the time taken for the price of cryptocurrencies to double was halving late last year, a sign the market was overheated.

He said the fund is now positioned to profit from price falls on stocks associated with bitcoin and blockchain technology, and cut back its bet on rising cryptocurrency prices. 

I have to say, "our money keeps doubling twice as fast as it doubled before and it is making us nervous" is a really good problem to have as a hedge-fund manager. Most people running concentrated equity activist funds would kill for a problem like that. I guess that helps answer the question "why would anybody pay 20% fees for this?" Why would anyone pay 20 percent fees for anything else?

Elsewhere, Securities and Exchange Commission Chairman Jay Clayton and Commodity Futures Trading Commission Chairman J. Christopher Giancarlo are deeply concerned about the crypto, as they explain in an op-ed:

Distributed ledger technology may in fact be the next great disruptive and productivity-enhancing economic development. If history is any guide, DLT is likely to be followed by many more life-changing innovations. But we will not allow it or any other advancement to disrupt our commitment to fair and sound markets.

You have to have some sympathy for them. The cryptocurrency/blockchain/what-have-you boom may be the greatest development in technology since the internet, or not, but it is surely the greatest efflorescence of outright financial fraud since the internet bubble, and that is probably  understating things. It takes 15 minutes to cut and paste a white paper and raise millions of dollars by combining a random noun (bananas, fake news, sexual consent, forgiveness, Buddhism) with the words "on the blockchain." My job is just making fun of all the dubious crypto projects and initial coin offerings and pivots-to-blockchain, and I can't even come close to keeping up with the volume. The SEC's job is to actually stop the frauds, to find evidence that will hold up in court that the latest ICO's promise of thousand-percent returns is misleading. Sure they have more staff than I do, but I still do not envy them. Writing Very Stern Op-Eds is not really a substitute for actually cracking down on all of the fake ICOs and fake blockchain companies, but you can see why the SEC would resort to it. Going after the frauds one by one just looks exhausting; maybe shouting "knock it off everyone!" instead will work.

Elsewhere, Arsenal is pivoting to the blockchain. And Stripe is ending support for Bitcoin payments. And you can't use your Discover card to buy bitcoins. And Ripple owns $81 billion worth of its XRP token that banks don't use. And here is the story of the main data source for cryptocurrency prices, which is of course the Queens apartment where a 31-year-old programmer runs coinmarketcap.com. The dream of cryptocurrency is to disintermediate the legacy trusted intermediaries, and replace them with new trusted intermediaries running websites out of their apartments.

I blame the index funds.

On Tuesday, United Continental Holdings Inc. announced that it will grow capacity at 4 to 6 percent a year until it stops being profitable. I mean it didn't actually say that last part, but that seems to be what Wall Street took away from it; one analyst called the move "snatching defeat from the jaws of victory." United's stock was down 11.4 percent yesterday. Warren Buffett's Berkshire Hathaway Inc., United's biggest shareholder, lost about $252 million on its United stake. 

But Berkshire Hathaway is also the biggest shareholder of Delta Air Lines Inc., and the second-biggest shareholder of Southwest Airlines Co., and the third-biggest shareholder of American Airlines Group Inc., and all of their stocks were down too; Berkshire lost about $476 million on those stakes yesterday. United's decision to expand capacity "could lead other airlines down a similar path, forcing a drop in fares," a movie that airline investors have seen before. "In a business selling a commodity-type product, it's impossible to be a lot smarter than your dumbest competitor," a skeptic once said about the airline industry, and that skeptic was Warren Buffett.

This was not supposed to happen. "The industry has been more disciplined in recent years," and, as regular Money Stuff readers know, there is an intriguing and increasingly influential theory about why that has happened. Warren Buffett is not the only person who is a big shareholder in a bunch of different airlines. Vanguard Group and BlackRock Inc. are both top-five holders of all the big U.S. airlines, which is no surprise because they are giant index-fund managers and the airlines are in stock indexes. Other big investors, both indexed and otherwise, are also cross-owners in multiple airlines. These investors have no interest in one airline adding capacity to take market share away from the other airlines. They don't care who has what market share; they own all of the airlines. They just want them all to be profitable. 

And, the theory goes, corporate managers know this, and respond to it. Somehow. Perhaps the index-fund managers call up the airline CEOs and whisper "hey don't cut fares or add capacity," but this seems unlikely. Perhaps the cues are subtler. Perhaps compensation schemes incentivize managers to grow the pie rather than fight for a share of it. Perhaps the mere absence of shareholder pressure discourages competition, because more concentrated holders would push managers to compete more. Or perhaps the shareholders don't do anything, but the managers simply feel a fiduciary duty to maximize the shareholders' wealth, and they know that the way to do that is to maximize the value of all the airlines. The managers at United don't want to do anything that would reduce the value of Warren Buffett's investment in United; they certainly don't want to do anything that would reduce the value of his investment in United and Delta and American and Southwest. 

But here we are! Presumably United's management has some idea of what it is doing; presumably it thinks adding capacity will be good for its business and will fulfill its fiduciary obligations to its shareholders. It is more of a stretch to assume that  United's management thinks this move will be good for Delta's or American's business. But certainly the result of its announcement was a big one-day drop in the wealth of its shareholders, both as United shareholders and as shareholders in the industry more broadly. If, like a lot of airline investors (like Warren Buffett!), you thought that the airlines had finally solved the problem of overzealous competition and were on a path to sustainable profits, that will disappoint you. But if you thought that airlines were being driven by their institutional shareholders to abandon competition and become a cartel, then I guess this is good news?

Outcome.

Outcome Health is a startup that installed screens in doctors' offices and then sold ad space on those screens. Well, not quite. Outcome Health is a startup that sold ad space on those screens, and then installed the screens? I think? In any case it sold ad space on more screens than it had installed, and got in trouble for that, and is now being sued by investors including Goldman Sachs Group Inc. and Alphabet Inc. But there is an explanation: It sold ads on screens that it hadn't installed, in order to raise the money to install the screens.

Ms. Agarwal in a 2012 interview at a tech event that can be viewed online described how Outcome solved the problem, saying Mr. Shah “negotiated upfront payments” on advertising deals “to have money in the bank and actually go and do these installations and deliver 200 screens, deliver 500 screens, 2,000 screens, that’s how we kept growing.” In a 2016 interview also available online, Mr. Shah described the strategy as bringing “from the future what we need to fuel the future in the present, which is a concept we’ve recycled.”

The risk of that strategy, which Mr. Shah described in both the 2012 and 2016 interviews, was that Outcome needed to execute with “military” precision. “It required you to sell an idea to both” doctors and advertisers, he said in 2016, “and then you couldn’t mistime it, because you know, that would be fraud, right? If you sell something that doesn’t exist.

“It’s like jumping through one train to the other train and making it out and it’s hard right? We’re not the only ones to do it, there are other chicken-and-egg businesses. But to build a chicken-and-egg business that’s capital intensive without any capital is actually pretty hard. I’m not sure it’s been done.”

Well but you're not exactly doing it without any capital. It's just that you're raising the capital from customers rather from investors. Those customers perhaps don't get the same disclosures as equity investors would get, and they certainly don't get equity-like upside for taking on the risk of funding your business. But if you can convince your customers to fund you by pre-paying for ads, instead of by selling dilutive equity, why wouldn't you?

Obviously here I am really thinking about initial coin offerings, which are also often pitched as essentially pre-sales of products to potential users of those products. (Though, somehow, with vastly-higher-than-equity-like returns?) Outcome just missed the zeitgeist; if it had funded its business by pre-selling a token that could be used to buy ads on its screens, no one would have complained and everyone involved would be a billionaire now.

How are the Fyre Festival people doing?

Guess what, if you are on an email list of people who got scammed, you are going to be presented with a lot more opportunities to get scammed:

A private dinner with LeBron James and the Cleveland Cavaliers. Front-row tickets to the Victoria’s Secret Fashion Show. A seat at the invitation-only, $30,000-a-plate Met Gala. The offers sound almost too good to be true — and the people on the Fyre Festival email list receiving them should know.

It is not clear whether the offers actually are legit -- they are being made by a secretive 20-year-old marketer whose patter ("a couple hip-hop managers and their artists, top artists that have all combined and taken their connections and kind of all came together to see what they could do") is remarkably similar to that of the original Fyre Festival -- but there are no better targets for them than the people who paid thousands of dollars for nonexistent private villas at a music festival in the Bahamas that never happened.

People are worried that people aren't worried enough.

Here is Donald MacKenzie in the London Review of Books on the ... VIX:

Maybe investors in the US simply aren’t frightened. That would be worrying for different reasons. It reminds me of the widespread feeling, in the run-up to the global banking crisis, that markets were enjoying a durable ‘great moderation’, free of boom and bust, bubbles and crashes. The time for the rest of us to get scared is precisely when market participants aren’t.

That is a little too pat. October 2008, or October 1929 for that matter, were actually perfectly reasonable times for everyone to be scared. And conversely, the time for market participants to get scared is precisely when market participants aren't. This is why every investor professes to be a contrarian. If you're managing money, you want to sell before everyone else does! Just not too long before everyone else does. 

Things happen.

How Hedge Funds (Secretly) Get Their Way in Washington. Billionaire Steven Cohen ramps up GOP donations amid hedge fund comeback. What the KPMG Conspiracy Case Revealed About Its Audits. GE's Surprise $15 Billion Shortfall Was 14 Years in the Making. Teamsters Tell UPS: No Drones or Driverless Trucks. A Shortage of Trucks Is Forcing Companies to Cut Shipments or Pay Up. "Kimberly-Clark says they're using their tax cut savings to pay for layoffs." Outspoken World Bank chief economist Paul Romer exits. Stanford Business School Seeks Review of Financial-Aid Policies. As More Companies Demand Arbitration Agreements, Sexual Harassment Claims Fizzle. Presidents Club to close after revelations of sexual harassment at all-male dinner. Charity-Dinner Harassment Leaves Guests Scrambling to Explain. Scaramucci Considers Return to SkyBridge, Scraps Vegas SALT Conference in 2018. East Village Bar Bans Customers Who Say ‘Literally.’ 

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This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.

To contact the author of this story: Matt Levine at mlevine51@bloomberg.net.

To contact the editor responsible for this story: James Greiff at jgreiff@bloomberg.net.

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