Not all black boxes survive a crash

One of the simpler lessons of the recent stock market and credit bubbles is this: if you don’t want to be ripped off by a dubious but doubtless plausible fund manager, manage your money yourself.

At the opposite end of the spectrum to this sane approach—to self-manage—is what is called black-box investing. This is where you delegate all decisions over your money to an individual or a computer program. Not only are you in the dark about the strategy that this individual or algorithm intends to employ, but you are told that it would actually be harmful to your interests to find out. That is because if you knew, so might the competition. And if rivals knew they would swiftly arbitrage away the returns. It was at this end of the spectrum that Bernie Madoff lay in wait with his unexplained “split-strike” investment method, which produced its steady stream of high returns. No one knew how it worked or could replicate his results. But the returns? Well, who could argue with those?

We now know that Madoff was a crook on a grand scale. But his path was greatly smoothed by a culture that encouraged people to hand over their money without any real idea what was going to be done with it. This credulousness didn’t just infect the “dumb” retail investors but the professionals too. After all, Nicola Horlick, a self-promoting fund manager, handed lots of money to Madoff, as did Man Group, ironically one of the City’s oldest and most successful black-box fund managers. At root, these highly paid professionals of today were little different from the investors who punted on the famous South Sea bubble company, whose prospectus stated that it was established “to carry on an undertaking of great advantage but no one to know what it is.”

But unlike the banks, which remain entrenched, if crippled, incumbents, black-box investing may have had its day—for a while at least. There’s no danger of any moral hazard at least because the taxpayer isn’t going to bail out anyone who punted and lost on a black-box scheme. Madoff, of course, has gone to jail. But even honest firms like Man have suffered. Its share price has fallen by 65 per cent over the past year even though its funds have outperformed the stock market. Perhaps it should think about opening that black box.

Jonathan Ford is commentary editor of Reuters

This piece is also published in the April edition of Prospect, available from 26th March 2009.