The Hindu Business Line : Barking at cars

This is a story about a dog that walked itself. "A large German shepherd, this dog lived across from the city park. To get to the park, the dog had to cross a very busy street," begins Joseph G. Nicholas, as `afterword' in his book Market-Neutral Investing, from Bloomberg (www.bloomberg.com).

"To cross the street, the dog found a solution. Each day he would position himself prominently on the corner, face the oncoming traffic, and aggressively bark at the cars driving by. Eventually, they would stop, and the dog, very much in control of his world, would confidently proceed across the street."

The same strategy was used for the return trip too; the dog would bark and cross the street when the traffic stopped.

"But one day on his return home from the park, the cars would not stop for him no matter how loud he barked. The dog became bewildered, no longer in control of his world." Oh, what happened then?

Nicholas explains: "The reality of the situation was that the traffic stopping had nothing to do with the dog's barking and everything to do with the traffic light on the corner. A decision by the city regarding traffic flow had resulted in the removal of the traffic light, leaving the dog stranded."

Let's assume that the dog somehow reached its abode after much difficulty. But what's the insight that the author wants to draw from the anecdote?

"Analysing hedge-fund strategies and making investment decisions involve a high degree of resilience on understanding the true cause-and-effect relationships," says Nicholas. "As I work on such endeavours, I keep this story in mind and try to avoid making the same mistake that the dog made in confusing cause and effect. To do so I need to do more than identify what appears to be cause-and-effect relationships; I need to identify whether there is actually a nexus between the two."

The author cautions investment managers against `over-reliance on past activities and performance, good or bad, as an indicator of suitability to the investor's needs'. Remember: "That a manager or investment approach has generated certain levels of return, or that those returns have certain statistical relationships with those of other asset classes, is not enough to base expectations of future performance."

The underlying factors driving returns may be less evident, watch out! If you don't identify such factors, your evaluation may be `no different than barking at cars'. Moral: "Be careful not to be fooled by appearances. The reality of market-neutral strategies can only be understood by looking beneath the surface."

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