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The conclusion of the paper was rather unambiguous in that GDP growth slowed as the level of debt rose. However, if you took the mean, instead of the median, you actually had a negative GDP result when debt to GDP levels reached 90%. RR was careful to point out that the median was a much better statistic and a more conservative interpretation of the data. Unfortunately, many on the conservative right side (both political and media) used the study to promote their views that austerity was crucial, and took the outrageous position that 90% was a kind of Maginot line or fiscal cliff level not to be crossed or the national economy would collapse – pure sensationalism that was never espoused by RR.
The summary below shows how RR’s study is presented across different sample periods and analysis to demonstrate the correlation between growth and debt levels.
The paper, which was not peer reviewed,came under severe scrutiny in April when a UMass grad student Thomas Herndon and two UMass professors, Ash and Pollin, (collectively “HAP”) released a paper2 that found a coding error in the excel spreadsheet provided to them by RR. Instead of averaging across 20 countries they only used 15; after adjusting the data the result was virtually the same. HAP also stated that data from Canada,Australia and New Zealand (all have had relatively high debt and high growth experiences) should have been included. Fair point, but the data was not available at the time of the study. After including this new data,the growth rate improves by about 1% as shown in the table above. Finally, HAP thought that the methodological approach was incorrect - but we can leave that issue for now.
The uproar caused by the HAP paper was embraced by those on the left (both political and media) as a refutation of austerity policies around the world. Again, this too is a nonsensical position. It should be noted though that the left does have better comedic prowess - if you have not seen the Colbert Report's take on the issue you have to watch this video (click here to view now) - extremely funny!
So what have we learned from all of this messy debate?
“There are lies, damn lies and statistics.”3 Since the dawn of statistical analysis, people have used stats to reinforce their claims often with little regard to the appropriateness of their application to an issue. A corollary is “liars figure and figures lie.” One has to be on guard and thoroughly review the statistical analysis before accepting anything in social/economic/political sciences as proof positive. Even then, empirical findings are better thought of as guides and not ‘right’ or ‘wrong.’
Heuristics and biases are everywhere in this debate. As a huge fan of Kahneman’s behavioural economics work, it is not surprising to find many commentators using the mental short cuts; including confirmation bias i.e. using information that conveniently conforms to a predisposed viewpoint. In the RR case, we have to get rid of the idea that the 90% ratio of debt to GDP is of any material consequence because it is not! It is far too complicated an issue to be reduced to one single number but that is exactly what people have done. As Lawrence Summers penned in a recent Op-Ed in the FT; “Even if a threshold existed, why should it be the same in countries with and without their own currency, with very different financial systems, cultures, degrees of opinion....” 4
Correlation does not mean causation. It is safe to say that there is a negative correlation between GDP growth and the level of debt to GDP. But the more important issue is whether high debt levels cause slower growth or whether slow growth cause higher debt levels? The evidence here can support both sides of the argument. Confusing correlation with causation is a classic behavioural bias. It should be noted that RR went out of their way to not imply causation. As a side note, I find it interesting that the Maastricht Treaty of 1992 imposed debt to GDP levels of 60% on each European country - either that was fatally flawed from the outset or the number needs to be revised to reflect the new information.
So what should we make of all this debate?
Clearly the quality of the debate is guttural but then that makes for good media and politics. I do not think it takes a PhD in economics to understand that no government can spend beyond their means forever. Taking the high road, it does seem that programs on both side of the debate should be implemented in an effective and efficient way in order to be pro growth and fiscally responsible. In fact RR wrote on FT Op-Ed on May 1 entitled “Austerity is not the only answer to a debt problem.” 5 On the government spending/pump priming side, programs need to create both employment but also high value infrastructure assets that have long term benefits for economic activity. The CBO notes that the “multiplier” on the 2009 Obama fiscal program was 1 i.e. it was just a transfer of wealth;governments have to do a better job of issuing ‘good’ debt and not wasting taxpayer contributions on ‘pork’. RR also believe that certain ‘non transparent’ forms of financial repression will emerge, such as, governments cramming debt into “domestic pension funds, insurance companies and banks.” 6 Sound familiar? On the structural side, the government needs to put in more programs to encourage investment and innovation. They critically need to reduce the tax on labour not to mention simplifying the tax code itself. I am not holding my breath – it would appear that the politicians will continue to rely on the central banks to “kick the can” a bit farther down the road before the important but difficult decisions are made.
1 NBER Working Paper Series, “Growth in aTime of Debt”, Working Paper 15639, Carmen M. Reinhart, Kenneth S. Rogoff, January 2010 www.nber.orp/papers/w15639
2 PERI University of Massachusetts Amherst,“Does High Public Debt Consistently Stiffle Economic Growth? A Critique of Reinhart and Rogoff”, Thomas Herndon, Michael Ash, Robert Pollin, April 15,2013, Working Paper Number 322
3 Quote attributed to Mark Twain
4 “The buck does not stop with Reinhart and Rogoff”, Financial Times, Lawrence Summers, May 5, 2013
5“Austerity is not the only answer to a debt problem”, Financial Times op-ed, Carmen Reinhart and Ken Rogoff, May 1, 2013
Good morning everyone. Thank you Karen for the kind introduction. It is a real pleasure to help kick off your annual alternatives conference for a second year. In terms of setting the tone for this conference that brings so many different managers and investors together, I thought about tying in one of my favourite economists and authors to provide an entertaining and interesting way for people to frame the day. I am referring to 2002 Nobel Laureate Dr.Daniel Kahneman, author of the bestselling book “Thinking, Fast & Slow.”1
For those of you who are not familiar with Kahneman or this book, let me give you a brief introduction.
Kahneman and the late Amos Tversky postulated that the human mind can be divided into two systems; System 1 and System 2. System 1 handles your automatic,rapid and intuitive mental activity while System 2 handles challenging and effortful mental activities. In our daily lives, our System 1 is generally the “go to” for much of our decision-making efforts. However, those decisions that require more consideration and thought are also often handled by System 1 as well. Why? Because our System 2 is naturally lazy –it takes too much effort. System 1 follows the WYSIATI principle – “What You See Is All There Is” allowing us to simplify and move on. Kahneman wants us to be aware of the biases created by this so that we will be on guard to minimize the potential negative consequences. His book outlines ways to force System 2 into action – to learn these you will have to read the book!
Fast thinking, or System 1, involves two types of intuitive thought – the ‘expert’ and the ‘heuristic’. You will likely know the expert from work done by Malcolm Gladwell and the celebrated 10,000 hour rule to master certain activities – like the chess master who has studied and committed to memory every great match in history. I am more interested in the heuristic. A heuristic is a shortcut used when we are faced with a difficult question – in its place we simply answer an easier question; i.e. we substitute rather than concentrate or think hard for the “real answer.” We do this naturally;we are not the Vulcans assumed in much of classical economic and Rational Expectations theory. This has been the triumph of behavioural economics. So for example, the question “How successful will this hedge fund manager be in 5years?” is replaced with the easier “How successful has this hedge fund manager been in the past 6 months?” WYSIATI –you only see the short term track record.
As you can imagine, there are all kinds of ways that we make decision making easier in our daily lives through the introduction of heuristics that create cognitive biases and illusions. Applying a few of these to the investment industry in general can be helpful to both mangers and investors.
The Availability heuristic refers to the general condition that people are biased by information that is easy to recall. In the hedge fund world, which has had its share of high profile frauds, investors are likely to recall many negative headlines and draw conclusions that do not correspond with statistical reality– the consequence is they decide not to invest in alternatives. The media and most political and regulatory bodies are impacted by this bias. It is not a surprise that exhaustive regulations are typically introduced following a crisis – not before one. As others have pointed out, this heuristic could also be applied to the reality that most investors select managers based on recent performance.
One could also look at the Representative heuristic in which a mental shortcut is taken when making judgments about the probability of an uncertain event. This heuristic was made famous in Michael Lewis’s “Moneyball” when Billy Beane decided to ignore his scout’s advice on ranking player’s physical attributes first to focus on their past statistics and how they might fit into the Oakland A’s ball club.2
In the hedge fund world, the Tiger Cubs come to mind as an example– plenty of cubs with amazing resumes and tutelage failed when they left out on their own. While Julian Robertson may be a tremendous investor it does not necessarily follow that his protégés will be. Here, the start-up managers all looked like no brainers, but we know the base rate of success for hedge fund start-ups is more akin to that of the restaurant industry – this is the sin of representativeness. Examples also abound in the experiences of investors. For example, many investors invested in fraudulent funds like the Petters, Norshield or Portus because a major institutional investor had allocated capital. The stereotype of a well-respected anchor institutional investor often causes investors to neglect the base rate of success and become overconfident in their allocation.
The other bias worth mentioning is the hindsight biases. Kahneman notes a “puzzling limitation of our mind: our excessive confidence in what we believe we know, and our apparent inability to acknowledge the full extent of our ignorance and the uncertainty of the world we live in…Overconfidence is fed by the illusory certainty of hindsight.”3 We confuse correlation with causation. We have an “unlimited ability to ignore our ignorance.” Hindsight bias is particularly difficult for investors because it confuses the quality of the decision-making process of a manager by only using the outcome as proof.4 For example, we allocated to a manager that had a merger arb. position that went against him – he closed the position (at a loss) and gave his reasons, all of which made sense at the time. Another manager did not close out the same trade and claimed with certainty that the deal would close; he even added to it. I can tell you we allocated to the former manager. The other one went out of business. You need to dig into the manager’s rationale to determine luck versus skill. Which brings up my last set of thoughts –distinguishing luck from skill in the investment business.
Kahneman describes his favourite equation as follows:
success = talent + luck
great success = a little more talent+ a lot of luck
Clearly, we all want great success and we want to invest with managers who will be a great success. In the investment industry talent may be seen as the equivalent of alpha, and luck could be considered beta. So I can now have the following set of equations for our industry:
return = alpha + beta
great return = a bit more alpha + a lot of beta
In terms of beta, I am referring to a broad based definition of “luck.” For example, you may be a manager trading credit – if so, it is highly likely you have produced better returns and raised more capital than say a long/short equity manager since the2008 crisis. Today, many investors will tell you that the credit trade is largely played out and that they are now rotating to long/short equity – why? They expect returns to be better there as correlations have been falling and equities appear relatively “cheap” in the capital structure. As a credit manager, you may have a lot of talent and thus keep your allocation even if the beta is against you; if not,the capital will flow elsewhere.
As managers then, your job is to prove (with more than just performance data) that you have a repeatable and sustainable investment process. As Michael Mauboussin notes, “where luck is rampant we must think of skill in terms of process, because the results don’t provide clear feedback.”5 You must also prove your funds are scalable from an investment and operational standpoint. But back to that concept of “a lot of beta,” or luck. Kahneman would suggest that this luck will eventually “regress to the mean,”i.e. the hot streak will eventually end. Examples that might fit this view are Bill Miller or John Paulson.
Bill Gross penned a really interesting recent monthly entitled “A Man in the Mirror,” where he tries to determine what constitutes a great investor.6 He believes that managers should be judged on their ability to adapt to different epochs,not cycles – with an epoch being 40-50 years. WOW. This seems a bit too long to wait for most of the folks in this room but he does bring up the possibility that perhaps we are on the cusp of an epochal change. He notes that, himself included, all the great investors have been nurtured within an epoch of credit expansion in which they all played the carry trade, sold vol., took on credit risk, etc. – but what if that all changes now? If this is indeed the case, then I would argue that alternative strategies are potentially much better equipped – maybe the next epoch will be the rise of alternative funds? Stay tuned!
So my advice to managers here today is to demonstrate your edge and show that it is repeatable for the next 40 years – OK how about 5years! For investors, put aside your stereotypes and use your System 2 to find the gems from those presenting today.
Enjoy the conference and I hope someone really enjoys the beautiful wine to be drawn at the end of the day – it will really help your System 1!
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