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Why Systems Investors are Glad David Einhorn Killed it with Green Mountain Coffee

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Often I hear people tell me, "Rules-based trading has no future. Eventually, the computers will compete with each other to the point of no profit". They usually go on to tell me about how smart people like Greenlight Captial founder David Einhorn (and he *is* a smart guy - make no mistake!) pick stocks like GMCR to short, and make a killing. This, they proclaim, is what investing is all about.

Background - David Einhorn mentioned GMCR as a short candidate in mid October, when it was in the mid 80s. He had probably sold it from $100 down to $90. The day after he made his announcement, the stock lost $15. Yesterday is announced what amounts to an admission that the company will have to restate earnings. The stock tanked to $45 in after hours, and now is $41. Nice trade for David.

Why does this matter to an investor who focuses on algorithms and mechanical systems for buying and selling securities? Because the vast majority of the money in the stock market is handled by mutual funds, which have endless rules and strictures as to how they can invest (universe, percentage that can be in cash, etc.). Regardless of whether they are index or active funds, they are both subject to numerous restrictions. The people who run these funds are often bored with the work they do, and look to other investors for inspiration.
Who inspires them? David Einhorn, digging through countless documents to develop his, "investment thesis", or a "quant", quietly testing his/her ideas by writing new lines of computer code? Its not even close. 
Those who believe that their own research and analysis result in better outcomes for the performance of the stock not only want to hear stories, they need to hear these. The whole industry, which may well be built on intellectual sand (time will tell) needs desperately to believe that there are magical stocks out there that either never go down, or only go down when you have sold them short. If you miss these gems, you have not worked hard enough. 

There is $12trn in US mutual funds, and $2trn in US hedge funds. And of these hedge funds, probably less than half would subscribe to any sort of disciplined quantitative strategies. The majority of the money in the market is chasing the strategy that is now the most popular. As a result, this enormous normative exercise of portfolio managers and analysts, prescribing future prices for securities, will not end soon, at least not for the balance or my lifetime. As long as this is the case, algorithm driven investment strategies will have smooth sailing in the markets.

 

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