Introduction
Most won't have heard of Ed Thorp. In fact, before Greg Zuckerman's excellent book, "The Man Who Solved the Market: How Jim Simons Launched the Quant Revolution", few would have heard of quantitative investing or those working in this space (sometimes known as quants). Thorp was a quant pioneer, and in this blog post, we look back on his many achievements and why these matter to investors.
Blackjack
Thorp believed in only playing gambling games in which he had an edge (the odds being in his favour), and he thought one of these games might be Blackjack. Using powerful (for the day!) IBM 704 mainframe computers, he undertook rigorous analysis and simulations and determined that a relatively straightforward card-counting strategy gave the player a definite edge against the house (casino). A simple strategy was necessary, as putting this to work under pressure on the casino floors without mistakes was crucial for generating real-world profits. In 1961, along with backers Manny Kimmel and Eddie Hand, Thorp travelled to the Nevada casinos and proved the theory worked in practice. He subsequently published a book, "Beat The Dealer", in 1962.
Roulette
In late 1960, Thorp worked with renowned mathematician Claude Shannon to evaluate whether they could also find an edge with Roulette. They created the world's first wearable computer and calculated that their "edge" over the casino, at 44%, was far greater than for Blackjack. Despite this edge, they decided not to pursue this idea further, as the casinos, after Thorp's winning Blackjack exploits, were now aware of him and were making life more difficult.
How difficult became apparent when Thorp visited Las Vegas during Spring Break of 1963 to evaluate whether his card counting methodology would also work with Baccarat. While at the Dunes hotel and casino, he believed his drink had been spiked (twice!), and on the drive home to Las Cruces, he discovered that his car's accelerator pedal had jammed open, requiring some frantic manoeuvring to avoid a crash!
Similarities between gambling and the markets
Thorp realised that gambling and the markets could be analysed using mathematics, statistics and computers. He set out to determine if he could beat the markets using the methods he had learnt with gambling, including money management and obtaining the optimal balance between risk and return. Thorp was initially tempted to believe the academics' claim that any edge in the market is limited, small, temporary and swiftly captured by the best-informed or smartest investors. However, further research identified frequent mispricings between warrants (a warrant is a security that offers the holder the right to buy (or sell) a stock at a fixed price) and the underlying stock. By buying (or selling) the warrant and selling the underlying share (or buying), it was possible to enter into a position theoretically unimpacted by market movements - the elusive investing dream of high returns with low volatility*.
Similar trades could also be undertaken with options, convertible bonds and preferred (or preference) shares, and based on this research and initial trading, Thorp founded Convertible Hedge Associates in 1969 (which became Princeton Newport Partners (PNP)), the world's first market-neutral hedge fund.
*This was proven during the market downturn of 1973-1974. The S&P fell 15.2% in 1973 and 27.1% in 1974, whereas PNP was up 6.5% and 9% over the corresponding periods and never had a losing year during all the time it was in operation. Another example was October 1987, the month of Black Monday. The S&P was down 22%, whereas PNP was broadly flat.
Option Pricing, Bachelier and Black Scholes
To evaluate potential mispricings and determine which trades to place, Thorp used the earlier work of French mathemetician Louis Bachelier and developed an option pricing model that he started using in 1967 that was identical to the one that financial economists Fisher Black and Myron Scholes published in 1973 and later won a Nobel prize for. Thorp observed that it was like "firearms vs bows and arrows" on the trading floor, with his model being far superior to the primitive methods most other market participants used. Thorp continued to stay ahead of economists, academics and other market participants, determining how to accurately price American put options a few years before a formula was published.
The end of PNP and a new start
PNP moved into statistical arbitrage and continued to perform well until it came crashing down in 1987 when it became embroiled in the Michael Milken Drexel Burnham case. All PNP parties were subsequently cleared, but this led to the liquidation of PNP in 1988.
In 1994, Thorp created another partnership, Ridgeline Partners, specialising in Statistical arbitrage, one of PNP's strategies. They wound down the partnership in 2002 as increased competition (more hedge funds implementing the same strategy) in the marketplace led to reduced returns.
Madoff
In 1991. Thorp was hired as an investment adviser by an investment committee to evaluate their current portfolio holdings. One of these holdings was with Bernard Madoff Investments, which claimed to use a split strike strategy to generate regular monthly profits. Thorp found many inconsistencies, including faked trades, and recommended the firm sell their Madoof investments, which they duly did. The fraud eventually came to light in 2008
Influence
Thorp had several interactions with many other investing legends, some of which are detailed below.
Jerry Bamberger: (Considered by many to be the pioneer of Statistical Arbitrage strategies): Created a joint venture between PNP and Bamberger called BOSS partners in 1985. Bamberger elected to retire a millionaire in 1988.
Ken Griffin: (founder of Citadel, a hedge fund with $62bn AUM): Helped Ken launch Citadel in 1990 by sharing PNP documents and becoming an early investor.
David Shaw: (founder of D.E. Shaw, a hedge fund with $60bn AUM). Thorp met with Shaw in 1988 to discuss investing in Shaw's new firm but decided not to proceed as Thorp already had a working Statistical Arbitrage system.
Jim Simons: (founder of Renaissance Technologies, a hedge fund with $130bn AUM): Thorp was planning to meet Simons in 1998 to discuss becoming an investor in their Medallion fund but was disuaded by Simons' chain smoking!
Bill Gross (co-founder of PIMCO, an investment management firm with $2tn AUM): Bill read Thorp's "Beat the Dealer" while recovering from a nasty automobile accident. He subsequently went to Vegas as one of the early card counters, making £10,000, effectively launching his Wall Street career.
Conclusion
Thorp made an enormous impact on the gambling and investing worlds, and investors can take away some valuable lessons:
Many consider the star fund managers they read about in the press to be at the top of the "investing tree". While they are undoubtedly very clever, it's reasonable to assume that people like Thorp are in a different league. If you follow an active management approach, it's worth understanding who your fund managers will compete against.
Thorp used strategies 50 years ago that many would struggle to comprehend today. Considering how much the investing world has changed since then and how much more competitive the market has become, it's worth considering what edge your active fund manager may have.
The market is not efficient, but you have to be extraordinarily talented to exploit these inefficiencies. Furthermore, your strategies must continuously evolve to keep ahead of the competition - see Ridgeline Partners' declining returns in 2002 as one example.
Perhaps most importantly, Thorp realised after PNP closed that what matters in life is how you spend your time, and he made a conscious decision after this to not focus on making the most money (knowing that he had enough money to last the rest of his life). Unfortunately, Thorp's wife Vivian passed away in 2011, but Thorp remains in good shape and was driving a Tesla at age 90!
Next steps
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