On Ben Hunt’s Epsilon Theory Manifesto

From a young age, I’ve always been fascinated by financial markets. My fascination began as curiosity; a desire to understand the daily movements of the S&P and Dow Industrial Average that I read in the newspaper or heard on NPR on my way home from high school.

This desire led me to studying finance as an undergraduate student, where I gained an entree into the theorizing behind the markets’ mysteries: the efficient market hypothesis, modern portfolio theory, and the relationship between risk and return. I supplemented my college coursework with books that poked holes in the arguments and dented the authority of my theory-first finance professors: Lowenstein’s When Genius Failed, Michael Lewis’ Liars Poker, and Taleb’s Black Swan and Fooled by Randomness. These books (especially Taleb), as well as the ongoing financial crisis that served as the backdrop for my initial finance education, led to an ingrained skepticism of markets and the strange mix of rationality and irrationality belying their daily movements

From this early education onwards, markets always seemed to be a human construction more than a mechanical reliability, subject to fashionable trends, human hubris, and a level of inherent enigma that captivated me. I relished the opportunity to accompany the markets as a casual observer: an intellectual exercise of (mostly) intelligent individuals squaring off against one another for an “edge,” with extremely high stakes coloring their emotions and behavior.

A tidy summary of the mystery of investing were recently summed up by Morgan Housel on his Collaborative Fund blog, which gets at what I find so inherently interesting about the practice:

If investing were all about math, mathematicians would be rich. If it were all about history, historians would be rich. If it were all about economics, economists would be rich. If it were all about psychology, psychologists would be rich. In reality it’s a mix of many disciplines, but some of the brightest people specialize in one topic and can’t see the world through another lens.

To me, it seemed like these individuals, with decades of experience under their belts and a full and nuanced understanding of efficient markets and the average return of so-called “active” investors (one thing professional investors aren’t lacking is information), had to be a bit crazy, arrogant, or both to clear-headedly take on such a massive challenge. Further, the key players  operating within “the market” seemed pulled from the pages of classic novels, with their stories of espionage, closely-held tradecraft, economy-shaking speculation, and robber baron behavior. Active investing seemed like a contact sport — as entertaining to watch as football, and potentially as dangerous to play.

I first came across Ben Hunt’s Epsilon Theory blog via Tyler Cowen’s Marginal Revolution, a repository of curiosity and knowledge from the wide-ranging mind of Cowen and his team. The first blog post I read, offering advice to a passive college-aged observer like I was once was, rang immediately true to me, and as with other writers that I quickly fall in love with, I traveled back in time to familiarize myself with his work and broader worldview.

Undergirding Hunt’s observations and analyses, I soon learned, was the Epsilon Theory Manifesto, explaining the origins of the blog’s title and his view of markets.

Hunt believes that the Greek letter “epsilon,” meant to signify error in the modern portfolio theory (return = alpha + beta + epsilon), is a vastly underexplored concept worthy of its own school of study. Whereas countless ink had been spilled on the relevance of beta (i.e., the passive return of the market) and alpha (i.e., unique characteristics of a specific security that made it differ from beta), epsilon is an afterthought. However, Hunt sees that ‘error’ as something that merits an equal amount of study to the other two Greek letters it shares an equation with, and even further can be an opportunity for ‘arbitrage’ – to outwit other market participants via a clearer picture of the environment around you. Every single active investor in the world has a position on their ability to achieve alpha – i.e., returns above a passive investment strategy – but very few offer a position on epsilon.

In Hunt’s interpretation, the “error” underlying the equation are humans themselves, and our strategic decision-making capabilities and shifting behavioral preferences. The discipline of behavior economics has provided an introduction to the human role in markets’ imperfection, but Hunt suggests taking things a step further: using the study of game theory (“a methodology for understanding strategic decision-making within informational constraints”) and informational theory to analyze the oftentimes counterintuitive movements of the markets. Like a game of poker (beloved by investors), movements are made up of “dynamic interactions,” considerations that are far beyond traditional investment indicators or financial ratios.

Following the hypothesis of the efficient market theory, as more and more information has become available over time, the markets theoretically should be closer to perfect, with limited legal ability to gain an informational edge on other market participants. This has led to an environment of “alpha scarcity,” and countless examples of one-time esteemed market “gurus” with multiple years of sub-passive performance, an embarrassing reality for any billion/millionaire who grew rich on their initial rightness and their hubristic belief in themselves to beat the monolithic market.

(Note: Another example of investors ‘seeking alpha’ was highlighted in this week’s New York Times via a profile of Farnam Street’s Shane Parrish, who pitches “reading, reflection and lifelong learning” as the antidote to the attack on the active investor: “These days, if you are not getting better you are falling behind. Reading is a way to consume people’s experiences, to learn something timeless and then apply it to your life.”)

According to the Manifesto, Epsilon Street represents Hunt’s attempt to analyze the markets through the lens of game theory, by studying “narrative” and “common knowledge,” two concepts that seemingly color the day-to-day political newscycle than the financial markets. However, as Hunt presciently explains, narrative is far from truth (it just has to sound truthful), and is normally driven by our human appetite for “news,” even in its absence. The competing narratives of Trump’s impact on global trade, and the ongoing EU/Brexit spat, and the various competing interests (oftentimes without “skin in the game”) inserting their views into the global conversation, serve as ongoing examples of the power of narrative, and its divergence from the “truth.” Per Hunt, the ability to “identify narratives, measure their strength, assess their likely impact” through an analysis of narrative through the lens of game and information theory is an underexploited and worthy of examination.

Similarly, the concept of common knowledge, known as “what everyone knows that everyone knows,” adds a further, postmodern wrinkle to narrative. Common knowledge, or the “second order” consensus (“the consensus view of the consensus view”), represents a war of competing narratives to reach a consensus, and the second order effect of how those competing consensus arrive at a universally held view. The battle for common knowledge is a battle of loudly promoting one’s view and one’s ability to conquer competing views to reach ubiquity, either by virtue of the loudness with which one shouts, or the ability to compound-grow these beliefs onto others. Confusing, but actually incredibly insightful.

An example of the impact of narrative and common knowledge pertain to the recent rollercoaster ride associated with Tesla’s ($TSLA) stock. For the past few years, short sellers, who seek to profit from poor performance of a stock, have sought to create a narrative around Tesla’s inevitable decline, associated with production shortfalls and a perceived inability to ever meet demand for vehicles in a cost-effective way. Meanwhile, Tesla products continue to wow both consumers and automotive reviewers, coloring their view of Tesla’s ability to dominate the market in the future, driving up its stock price. In both cases, the truth is not the underlying driver of their ongoing attempts at creating common knowledge – their behavior is guided by their financial and human incentive to be right. Even more recently, comments made by Elon Musk, who has every right to be incensed by the economically-counterproductive efforts of short sellers, have sent the stock plummeting among questions of his fitness as a leader, and Tesla’s future as a result. In all of these cases, the actual value of Tesla is far from point – it’s very quickly turned into a battle of competing narratives in an attempt to reach a common consensus.

Amid all of this news, a fascinating but incredibly rare volte-face was recently published by a Tesla short seller, which shared the underlying assumptions behind their initial dour view of Tesla, followed by information that rebuts these initial hypothesis and has now led them to reverse their decision. The fact that this type of reversal is so rare gets at the heart of Hunt’s thesis – that a better understanding of how we shape narratives to reach common knowledge is a fundamental tool worthy of study.

Per their summary page:

The story has become too compelling to ignore.

As much as you can’t believe you are reading this, we can’t believe we are writing this!

The most challenging part of being a short seller is to constantly check your thesis to make sure nothing has changed. You must let all predispositions and prejudices disappear and stay focused on only the facts. It is in that spirit and with a great deal of analysis and due diligence that we can say for the first time, Citron is long Tesla as the Model 3 is a proven hit and many of the TSLA warning signs have proven not to be significant.

It has been almost 5 years since Citron published the following line: “By the time this product is even approaching market, there will be multiple other 200-mile range plug-ins that have been out for years.”

Rumors of the Tesla killers have been as constant and unfounded as Bob Lutz’s call for Tesla’s bankruptcy.

While the media has been focused on Elon Musk’s eccentric, outlandish and at times offensive behavior, it has failed to notice the legitimate disruption of the auto industry that is currently being DOMINATED by Tesla.

What has changed?? Plain and simple — Tesla is destroying the competition.

A new narrative? Maybe. There inlies the challenge of the markets, and the reason that so many are drawn to its magic and mystery as a hobby, career and/or vocation.

One thought on “On Ben Hunt’s Epsilon Theory Manifesto

  1. wordy, incomprehensible. Many truths identified, with no sensible, meaningful conclusion. Sophomoric. Sorry. Maybe I am too thick to unearth the valuable nugget. I confess to my inadequacies. William J. Hirsch, 1st Lt. Neville crew, 717th Squadron, 449th Bomb Group, 15th AAF, Grottaglie, Italy. t ,


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