The Quant Myth

The mystery surrounding the Quants of Finance has been on the rise. Many universities now offer "Quantitative Finance" as a discipline. Since Finance has always been quantitative, this new discipline can only mean "Super Quantitative Finance" - sort of Finance on steroids (perhaps). Quants come from many walks of life - mathematicians, physicists and even statisticians - able and eager to conquer the world by "predicting" what will happen in the future using mathematics. These rock stars have been pouring over every piece of data to create a Grand Unification Theory of Finance - sort of theory of everything - that (presumably) will make them infinite (or at least all the available) amount of money.

After watching this statistical orgy for over a decade, I felt that it is good to observe the following:

(a) Statistics is not Mathematics. So, Empirical observations and predictions based on them are not theories.

(b) Quants are still distinctly behind in their stated goal of amassing infinite wealth. Apparently sometimes they make money and sometimes they lose money - showing perhaps the "human" in them.

(c) There has not been a single fundamental advancement in finance and economics since Black and Scholes in the 60s. So, the rock stars who flocked to money seem to have created sort of dark ages of finance with no new understanding.

(d) Universities turning to this discipline at the cost of fundamental education may be creating more problems than they are solving.

(e) The financial meltdown is not due to the formulas of Quants (as hypothesized by a great investor) but rather the incompetence of bankers who bought and sold securities as if they were tulips. Most business school students can figure out how to value these "complex securities."

So, it may be unfair to blame the rather harmless Quants for the troubles we have - they are having their own problems.

Measuring talent by compensation

Is the best metric for talent, compensation?  This is the latest claim by those who wants to increase compensation for the "talent," managing bankrupt companies kept on life-support by tax payers. This is a circular argument. If the executives of these firms convince the public, compensation indeed is the best measure of talent, it will be only reasonable to assume that they would want their own compensation increased because they are, indeed, great talent. The only measure for talent is the success of the firm and the value added to the economy and this is (thus far) inversely proportional to short term compensation such as bonuses. If a company is bankrupt, the "talent" that led the company to the hole is not "great," regardless of the compensation bestowed upon them. This is yet another sign that inept leaders of incompetent firms are far from learning anything new.

The nuclear option

Nuclear power - in different pronunciations - has been surfacing with monotonous regularity. It is an elegant technology with no visible pollution and that appears to be attractive to many. However, it does have a draw-back - the spent fuel (nuclear waste) is radioactive and will remain so after production for 10s of thousands of years. The nuclear waste is created both during the preparation of the fuel as well as the use of it. The waste produced by nuclear plants is high level waste and has a long half-life. With the current crop of plants worldwide, this waste is increasing at over 10,000 tonnes per year. Consensus is that storage of the waste deep in earth is the best way to contain it. However, storing something hazardous for many 10s of thousands of years is not that easy - especially because humans have not yet shown great abilities to contain harmful materials for long periods of time. Also, geological storage is always susceptible to unpredictable shocks and other calamities.

To make the nuclear option viable for power generation, a system that is able to remove the waste from the earth is needed. This can only be done by sending such waste to outside the solar system. Current technology to send objects to space, largely based on fossil-fuel burning rockets, will not be adequate to accomplish the task of transporting spent fuel because of high cost and unreliability. A new technology needs to be developed for this as it is possible that humans are going to find many objects to get rid of in the future (not just spent fuel). So the development of the nuclear option has to be tightly coupled with the space program with a focus on low cost and reliable interstellar transportation of non-human objects. The nuclear power generation, as currently practiced, is a bit like national debt - we are just shifting the problem to the next generation.

Blue sky strategies

Strategists talk only about the next horizon - what will happen decades into the future and how to succeed then. Anything less is considered to be tactical or operational - something most strategists will not be caught engaging in. Most strategists avoid all contacts with operations for the fear of being tainted by such tactical notions as manufacturing, products and profitability. This is indeed a special breed of people who have (attempted) to shape companies to win through well crafted strategies as the world unfolds in a prescribed fashion in the future. An aircraft manufacturer recently slashed its forecasts for aircraft demand for the next 20 years to $3.2 trillion. I am sure both internal and external strategists poured over data to determine exactly what will happen to aircraft demand in the next two decades. Strategies will then be created as to how to win in that market - with more detailed forecasts around how the size, shape and capabilities of airplanes will change. However, will humans be packed into aluminum tubes like sardines to go places in 20 years?

It is the same process followed by automakers, investment banks and pharmaceutical companies (with the aid of external strategists, of-course). Those adept at creating long term strategies may occasionally want to look back (and stoop low and pretend to be mere humans for a few minutes) and ask if what they predicted last 20 years in fact unfolded exactly as thought. Are the strategies created then helping companies today "to win?" Did many of their clients go bankrupt before the 20 years came to an end? If so, does this tell them something about the effects of  long term pontification and associated intellectualization? Those who cannot win today with commonplace tactics are unlikely to win 20 years from now with blue skies strategies, regardless of the size of the brains who concocted them.

How much is it worth?

It is perplexing to observe that we have a large number of experts, willing and able to calculate the value of a marketed security - such as a stock or a bond but very few are venturing into the valuation of assets that do not have a market. A market is a place where a large number of buyers and sellers come to transact in a stock, as in a stock market. Most investment banks, analysts and countless other financial experts and advisors are able and willing to determine the precise value of securities that have markets. However, in the world of private assets - such as private equity and venture capital, not many are willing to conduct a valuation. The best in the business say it is a waste of time and they will buy or sell something based on a "mere gut feeling." When there is no market or if markets are thin or illiquid, there is no point trying to determine a price, they say. Same logic led the investment banks and hedge funds "not to value," the illiquid assets they transacted in.

This is difficult to understand. When the price is observable in the market, a tremendous amount of effort is expended to precisely "predict a better price." When prices are not observable, no efforts are expended in valuation. It is more logical to assume that the effort expended in valuation is a waste when markets are present, as the value of the security is the the price at which the last transaction occurred, provided no new information arrived between the last transaction and the present. It is equally true that more efforts have to be expended in valuation when markets are not present, regardless of the size of the "gut" of the decision-maker.

It appears that most are "comfortable" to create a "delta" from an observed price but not many are adventurous enough to put a number on something when no "base price" exists. This may be due to the "risk aversion" of the evaluators or perhaps a game played with no impact on the end results. In the public markets, buy-side analysts and intermediaries convince those who transact whether a security is a "buy" or a "sell" by determining a "delta" from the base price (current market price), for it is the fact that the transaction occurred (and not whether it was a good or a bad transaction) that keeps the bills paid for the intermediaries. In the private markets, private equity and venture capital intermediaries convince the capital providers that no valuation is needed, for it is the perception that only a selected few could determine the best investments that keeps the bills paid for the intermediaries.

The efficiency loss, due to both the pricing of securities that already have a price in public markets and the non-pricing of securities that do not have a price in private markets, is significant for the economy. The current intermediaries in both public and private markets should look for other ways of contributing to society and close shop.

A manufacturing renaissance in the US

Conventional wisdom appears to be that manufacturing will continue to shift to less developed countries, while developed countries focus on services. The premise behind this idea is that the value added in services is higher than manufacturing and developed countries will migrate toward them. Historical data seem to support this idea as low value added manufacturing shifted to China and low value added services shifted to India. However, this trend may not continue long and an era of manufacturing renaissance in the US may be close at hand..

There are three primary reasons that manufacturing will shift back to the US in the future.

(a) The flow of low-value added manufacturing to countries such as China was driven by cost differentials aided by an artificial currency. This will normalize soon and that will make the current Low Cost Country (LCC), much more expensive.

(b) Manufacturing in the US has been dominated by extremely inefficient companies ran by incompetent managers in certain industries. As these companies go bankrupt or transition into more efficient manufacturing units, the inefficiency overhead currently plaguing the manufacturing sector will lessen.

(c) Current labor laws and long held and antiquated labor contracts have kept a lid on the technology content of manufactured products in the US. The fear of loss of jobs and the inability to change production methods due to rigid contracts have kept companies behind the technology curve for many decades. Again, as companies who have such impediments give way to innovative manufacturing organizations, the productivity will rise rapidly.

Thus, contemporary companies attempting to reduce tactical costs by rushing into the LCCs may want to take these long term trends into their decisions. The necessary condition for this to happen, however, is less government involvement in the manufacturing sector through bail-outs and subsidies.

Experienced vs the young & the restless

Conventional wisdom is that experience matters. Those who have run large companies for a long time apparently are better qualified to run companies compared to the fresh graduates. Those who have been in industry X for a long time, is "disqualified" to run a company in industry Y. For executives, recruiters and board members, this is an unassailable truth.  The memories of the young entrepreneurs running companies that garnered no revenues but obtained 100s of Millions of $ in capital investment during the tech bubble, are fresh in our minds. But, conveniently we forget that the people who funded these companies were the "experienced" titans of the venture industry. We also seem to not care that it is the "experienced" who ran large companies to the ground in the financial bubble. Recently, a venerable investment bank seeking a new executive apparently found only 6 people in the entire world, "qualified" to run the company. This is because the company is just "too complex" and "too difficult" to manage and it will take the powers of the super-skilled (the same who recently bankrupted their own companies) to run it. The fact that a company is too complex demonstrates the ineptitude of those who was running it before. If a Nobel prize is instituted for complexity, I am sure these super-skilled executives will qualify for it. Engineering complexity into companies, however, it not a skill - it is the lack of it. Running complex companies for a long time (and ultimately failing them) is not a qualification, it is the ultimate disqualification. It is not experience we need to dig out of the morass, just the opposite.