16 September 2019

'We have a deep understanding of bias and statistics'

David Harding talks to the Australian Financial Review about Winton’s source of competitive advantage.

The Trend Follower Trying to Avoid the Crowd by Jonathan Shapiro, Senior Reporter, Financial Review

David Harding arrived in London seeking a fortune from financial markets in the early 1980s, when the government’s stockbrokers still wore top hats. But in the rough-and-tumble pits of the futures exchange where the captivated maths genius began his path to hedge fund fame and fortune, “they sure as hell weren’t wearing top hats”.

“It was completely normal to go out and drink several beers at lunch time or champagne at 10.30 in the morning,” Harding recalled last week.

Spike, as he was nicknamed, didn’t hit the bar but spent his time programming computers, calculating and drawing charts.

“[Drawing charts is] a pretty tedious thing to do but it does force you into very close contemplation. You get to look very closely at things every day and think about them,” he says.

It was this close contemplation that awakened him to trends and unlocking the profits that could be made from them.

How Harding and his friends formed AHL (Adam, Harding and Lueck) which later split into three of the world's largest trend-following hedge funds is well known in industry circles.

Harding’s Winton Capital is among the largest and manages about $30 billion of capital for investors, including individual Australians.

He has faced a career-long battle to convince investors that trend-following is a reliable source of long-term returns.

But as more capital has embraced the trend-following factor, he’s become increasingly wary of its powers.

“It’s not a physical science yet a lot of scientists who go into markets make that mistake."

“That a lot of people have decided it’s a permanent feature is a negative thing for how exploitable that feature will be. You are not going to make as much money out of it,” he explains from Winton’s small Sydney office.

Harding joked that the headlines will say that he’s given up on trend-following, but he insists that is not the case.

Rather, he says, the firm has diversified into new trading strategies that combine both technical and fundamental features.

“We made a business decision 18 months ago but we have been going that way for many years,” the 58-year old says.

“We constantly think about what is our source of competitive advantage and it’s mainly developing trading strategies."

“We have a high level of understanding of bias and a high level of understanding of statistics, and a deep understanding of bias and statistics.”

Shake Out

The interview came just as the momentum crash occurred, when a swift reversal in bond prices that trend-following strategies had latched on to caused a violent shake-out, leading to losses for many strategies.

While the firm would not comment on the momentum shock, it is understood Winton’s strategies have given back some of their monthly gains, while its other non trend-following strategies have advanced.

The momentum shock will no doubt resurrect the debate about the role of quantitative investment processes, and the dangers they create for each other. Harding has built his firm on investing via a quantitative process. But he says scientists and mathematicians will continue to misunderstand markets.

“It’s not a physical science yet a lot of scientists who go into markets make that mistake. They believe they can discover things about the market which are sort of like the laws of the universe."

“And they trip themselves up because they overdo the parallel with physical reality."

“That doesn’t mean there’s not a lot of useful things you can do with statistics and maths when studying financial markets, because there are a lot of numbers in

But he says that if someone is trying to explain a large market move as something that has only ever happened once in the lifetime of the universe, it’s not “your reasoning that’s good. Your model is wrong”.

“It's good to have a view but it's also good to be aware that you might be wrong."

He remains a steadfast critic of the efficient market hypothesis taught extensively to budding finance professionals. It assumes that all known information is factored into the price of traded securities.

“The idea of market efficiency is that, in an almost supernatural way, they know everything there is to be known and they perfectly discount the future.”

Perplexing and somewhat paradoxical

Harding says he can buy this argument for a security like a 10-year bond, or a stock that pays out a dividend.

“But what about a Jean-Michel Basquiat artwork? There is no income so it cannot have a fair value. Therefore it cannot be efficient. There is no concept of efficiency.”

This, however, is a world where trillions of dollars of fixed income assets will never produce income.

And billions of dollars is being ascribed to private venture-backed companies with an unclear path to profitability.

The value of new economy companies, he says, remains “perplexing and somewhat paradoxical”.

“I have to wrestle with that paradox. I am not a creature of the new economy.”

But he says he’s been wrong on so many things that he should have a high degree of humility.

“It’s good to have a view but it’s also good to be aware that you might be wrong. There might be things going on that we won’t know about for many years to come.”

What he is convinced about is that there is room for firms like Winton to manage ever more assets if they can achieve the returns that justify the fees they charge.

“The big picture is everyone is living longer and the world is getting richer. And many more people are going into pension schemes.”

The amount of money managed has increased by tens of trillions of dollars, he says.

But it is also a world where technology is driving deflation. The brokerage on a futures trade from the days when a young Harding first arrived on the futures floor has gone down by 99.5 per cent.

“Those are big trends changing the structure of firms – they are making the big firms bigger and cheaper.”

But he says there is more room for specialist players and compares hedge funds to luxury brands.

He knows, however, there will be increased competition and cost pressure. “You wish your competitors didn’t exist but you know the world would be a worse-off place. Any competition keeps us all honest.

“You just fight for your levels of fees and if you are not justifying what your investors are paying you, they disinvest and it dies. That is competition.”

Reprinted with permission from Financial Review.

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