When I worked on Wall Street, it was the golden age of hedge funds. They were on the bleeding edge of finance in the mid-2000s, swashbuckling market pirates who did all kinds of exotic stuff to earn alpha for their investors.

There were about 4,000 of them at the time. There are much fewer today, and fees have come down considerably, as there has been a lot of competition and a lot of consolidation. But the thinking at the time was that the operator of a hedge fund was practically omniscient, with a massive advantage over slow money mutual funds.

That turned out not to be true.

I had the opportunity to meet dozens of hedge fund managers in the early 2000s. Some of them were impressive, but many of them had a primitive understanding of markets and risk management. Capitalism being what it is, the good ones are still around, and the bad ones disappeared.

But I have a firm belief that there are very few strategies in the markets that are repeatable. Over time, most of that edge will get arbitraged away. I will return to this in a moment.

Repeatable vs. Investing Fads

Repeatable means a way to make money in the market that persists over time. By “over time,” I mean over decades.

For a long time, people thought value investing was a repeatable strategy. That has turned into a graveyard over the last 10 years. What hedge fund manager Jim Simons was doing looked repeatable for a long time… then he ran into trouble.

There have been some investing fads that have come and gone over the years, like the short volatility strategy. None of it worked over an extended time. I think about this a lot. The first thing I would want to learn about a hedge fund before I invested in it was whether the strategy was repeatable. Because when a strategy stops working, it can be catastrophic.

Most equity long-short investors are some variation of value investors. Buy the cheap stocks, short the expensive ones. Equity long-short has had a tough go over the last few years, especially when GameStop blew up. Fundamental investing works most of the time, but there are periods, like 2019–2021, where things just don’t make any sense. Convertible arbitrage worked in the ’90s and 2000s, and then it got hard. Macro had a long period of underperformance until last year. And so on.

Sentiment

The only strategy that is repeatable over years, decades, and centuries is sentiment. Sentiment always works. Every once in a while, I’ll hear from someone that sentiment is no longer working—and then it does.

The problem is that starting a hedge fund based on a sentiment-based strategy is… impossible. Investors like magic money machines. People like to hear that a hedge fund has a quantitative black box that spits out what stocks to buy and sell, then they are much more willing to hand over their money.

We trust computers, and we trust systems—but we don’t trust judgment. And the idea that a money manager can use judgment to determine what stocks to buy or sell based on sentiment just does not compute. Nobody would invest in such a hedge fund. The interesting thing is that there have been some attempts to systematize sentiment and trade off it, and those systems have worked, but they are typically high-frequency and aren’t as good at catching big turning points in the major asset classes.

Some hedge funds do some sentiment investing already. Everyone knows that if most people are bullish, you should be bearish, and vice versa. The challenge is partly identifying extremes in sentiment because to identify extremes in sentiment, you must be completely emotionally detached and free of bias. It’s not easy to do, meaning there is manager skill involved, which nobody wants to hear.

Arbitraged Away

Let’s pretend for a second that sentiment strategies actually caught on—then things would get really complicated. At some point, you would have more capital chasing the reversion of trends rather than the actual trend. Of course, sentiment trading would work in that instance, too—but you’d be dealing with second-order effects.

It is a general rule that newsletter writers should not manage money. Typically, people who are good with ideas are not so good with execution and risk management. And I think that might apply to me as well.

But I have long wanted to test this thesis: if it is possible to manage money completely based on sentiment (and I’m not talking about a systematic strategy). I might think about doing it someday. It’s the last mountain I really have left to climb.

Better start doing push-ups on my lunch break.

Jared Dillian

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