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not fare so well. Indeed only 4 out of 30 funds beat the TSE index of 34.9 % and their average return was 19.1 %, more than 15 points below the Topix.
Over time the hard efficient market line has softened into a Risk Premium (RP) camp. They feel that markets are basically efficient but one can realize extra return by bearing additional risk. They strongly argue that, if returns are above average, the risk must be there somewhere; you simply cannot get higher returns without bearing additional risk they argue. For example, beating the market index S&P500 is possible but not when risk adjusted by the CAPM. They measure risk by Beta, which must be greater than one to receive higher than market returns. That is, the portfolio risk is higher than the market risk. But they allow other risk factors such as small cap and low book to price. But they do not believe in full blown 20-30 factor models such as described in Chapter 25. Fama and his disciples moved here in the 1990s. This camp now dominates the top US academic journals and the jobs in academic finance departments at the best schools in the US and Europe.
The third camp is called Genius (G). These are superior investors who are brilliant or geniuses but you cannot determine in advance who they are. Paul Samuelson has championed this argument. Samuelson feels that these investors do exist but it is useless to try to find them as in the search for them you will find 19 duds for every star. This view is very close to the Merton-Samuelson criticism of the Kelly criterion: that is, even with an advantage, it is possible to lose a lot of your wealth (see Table 2.2). The evidence though is that you can determine them ex ante and to some extent they have persistent superior performance, see Fung et al (2006) and Jagannathan et al (2006). Soros did this in futures trading with superior timing and choice of futures to bet on: this is in the traders are made not born philosophy. This camp will isolate members of other camps such as in (A) or (H).
The fourth camp is as strict in its views as camps (E ) and (RP). This group feels that the efficient market view, which originated in and is perpetuated by the academic world, is hogwash (H). In fact the leading proponent of this view and one with whom it views is hard to argue as he is right at the top of the list of the world's richest persons is Warren Buffett, who wants to give university chairs in efficient markets to further improve his own very successful trading. An early member of this group, the great economist John Maynard Keynes was an academic. We see also that although they may never have heard of the Kelly criterion, this camp does seem to use it implicitly with large bets on favorable investments.
This group feels that by evaluating companies and buying them when their value is greater than their price, you can easily beat the market by taking a long term view. They find these stocks and hold them forever. They find a few such stocks that they understand well and get involved in managing them or they simply buy them and make them subsidiaries with the previous owners running the business. They forget about diversification because they try to buy only winners. They also bet on insurance when the odds are greatly in their favor. They well understand tail risk which they only take at huge advantages to themselves when the bet is small relative to their wealth levels. They are thus great put sellers.
The last group are those who think that markets are beatable (A) through behavioral biases, security market anomalies using computerized superior betting techniques. They construct risk arbitrage situations with positive expectation. They research the strategy well and follow it for long periods of time repeating the advantage many times. They feel that factor models are useful most but not all of the time and show that beta is not one of the most important variables to predict stock prices. They use very focused, disciplined, well researched strategies with superior execution and risk control. Many of them use Kelly or fractional Kelly strategies. All of them extensively use computers. They focus on not losing,
Three great investors: Warren Buffett, Paul Samuelson and Ed Thorp and they rarely have blowouts. Members of (A) include Ed Thorp (Princeton Newport and later funds), Bill Benter (the Hong Kong racing guru), Blair Hull, Harry McPike, Jim Simons (Renaissance hedge fund), Jeff Yass (Susquehanna Group), David Swensen, Nikolai Battoo (a private trader with unique criterion applications) and me. Blowouts occur more in hedge funds that do not focus on not losing and true diversification and over-bet; when a bad scenario hits them, they get wiped out, such as LTCM, Niederhofer, and Amaranth; see Chapters 11-13; and the June 2007 Bear Stearns hedge fund blowout bond blow up; see our forthcoming column in Wilmott that discusses this typical hedge fund blowup and the wider August 2007 sub-prime world wide equity, banking and bond market crisis. My idea of using scenario dependent correlation matrices, see Chapter 21 is very important here.
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