A Bitcoin primer

Dressel 150 x 150Ryan Dressel, Investment Analyst

There is a famous scene in Seinfeld, where outspoken character George Costanza pitches a TV studio executive “a show about nothing.” When pressed to elaborate, he simply re-iterates “nothing!… that’s the show!” I jokingly refer to this scene when people ask about Bitcoin, and if it’s a good investment. The parallels to “nothing” are plentiful: Bitcoin is not tangible, it is hard to find, nobody is responsible for its success or failure, and the buyers and sellers in the marketplace are untraceable ghosts. If the above is true, how can one explain Bitcoin’s meteoric rise in price and press coverage?! The price of one Bitcoin has risen from approximately $1,000 to $13,600 over the past year. The number of searches for Bitcoin on Google has exploded by 4,200% since July.

What is Bitcoin and why are people so interested in it?

Bitcoin is one of many digital currencies that have gained popularity since 2009. It has no value by itself; it only has value because an ever-growing community of Bitcoin adopters have agreed to trade goods and services in exchange for a higher amount of the digital currency, to which the community has trusted each other to do the same. This basic concept is no different than the use of fiat currencies such as the US dollar or the British pound. But that’s where the similarities end.

Today’s fiat currencies are managed by central banks around the world. The US dollar is regulated by the Federal Reserve, the Yen is regulated by the Bank of Japan, and the Pound Sterling is regulated by the Bank of England, to name a few. Conversely, Bitcoin is autonomously managed within an open source network of computers known as “blockchain.” Think of blockchain as a community of referees that allow two parties to make an exchange. The rules that the referees use to enforce an exchange can be reviewed by anyone that is part of a network. Every transaction prior to the one being made must be reviewed before it can take place, hence the term “blockchain,” which is intended to make the network more secure with each transaction.

To visualize the application of blockchain, think about a transaction at a farmer’s market. If you use a dollar to buy a vegetable, the farmer puts his faith in you to truthfully hand over a dollar that can be used to buy other goods & services and assumes it is not fake and that you won’t just steal his vegetable. On the other end of the transaction, you put your faith in the farmer that his product has all the properties of a vegetable as advertised, and does not contain defects such as poisonous pesticides. Additionally, nobody but you and the farmer knew that transaction occurred and nobody reviewed the accuracy of the exchange except you and the farmer.

Conversely, a digitalized farmer’s market transaction using blockchain would be reviewed by every computer that is part of a network (consisting of digital farmers and digital vegetable buyers). The predefined rules of the blockchain are also reviewed to ensure that all qualifications are met by both parties before one item is exchanged for another. If any criteria are not met, the exchange will not occur. After all criteria have been met, each party is rewarded their contractual obligation. This technology can be used to exchange Bitcoin, as well as a seemingly infinite amount of applications involving two or more parties i.e. physical property exchange or even corporate mergers.

blockchain 2Graphic Source: Thomson Reuters

Why adopters love blockchain

The primary benefit of blockchain technology is that it breaks down the barriers of trust, allowing any two parties to transact directly with each other without the need for a third-party to broker a deal. This creates transparency that we simply do not have today. Our third-party brokers take many forms, ranging from banks to cashiers, to Facebook, to Lawyers. These intermediaries act as agents of two or more parties, but you cannot see every message, transaction, or exchange that happens within them. Blockchain provides complete transparency for all to see.

In the example of the farmer’s market exchange, the dollar that was used to buy a vegetable is an example of a central repository holding information. The dollar had a state-sponsored (US government) serial number on it that is part of a taxable transaction. In the case of Bitcoin, no third-party owns the record, there is no third-party manipulating the data or supply of a good or currency. Cryptocurrencies rely on this benefit and offer additional benefits such as the ability to make transfers without geographic limitation, the finality of settlement, lower transaction costs compared to other forms of payment, and the ability to publicly verify transactions.

Today’s fiat currencies are also underpinned by central banks, tax systems, judicial systems, militaries, and any number of other connections to a governing body. The freedom from these agencies is very enticing to Bitcoin users. In areas outside of the developed world, this technology could be life changing due to corrupt governments manipulating currencies or transactions.

Buyer beware

History has shown that innovation and competition are great for markets and consumers. If credit cards weren’t accepted, we’d still be using paper and coins to make purchases. Prior to paper and coins, different societies used items such as beaver pelts or stone carvings as currency. Without currency, one would have had to travel great distances to make physical exchanges with their personal items of value.   Despite the innovative allure of Bitcoin, it is important to recognize its shortcomings as well.

To date, no cryptocurrencies have been registered with the SEC, whose stated mission is to protect investors, maintain fair, orderly, and efficient markets, and to facilitate capital formation. As such, no licenses are required to sell Bitcoin, which makes the cryptocurrency market subject to volatile market manipulation and scams such as scalping, “pump and dump,” and other types of fraudulent schemes.[1]

Cryptocurrencies such as Bitcoin are not backed by any government body, and thus are not regulated and could be subject to illicit transactions. Buyers and sellers remain anonymous, which holds nobody liable if a transaction fails on either side (Kim Jong Un has even been linked to the marketplace[2]). The ability to exchange Bitcoin for traditional currency is subject to change at any time, without notice. Cryptocurrency networks are also subject to malware and hacking.

Even though the number of exchange platforms is emerging, it is still not very easy to trade Bitcoins for goods and services. Bitcoin and other cryptocurrencies are also extremely volatile, which displaces one of the most important features of fiat currency: a stable store of value. How can buyers and sellers expect to make a transaction if the exchange rate of Bitcoin changes substantially every 2 minutes?

Despite the innovative advances in blockchain, it is important to remember that the technology is in its infancy. Both improvements and loopholes are being added every day. Bitcoin shares features of a currency, commodity, or a security, but is nothing more than a figment of our human imagination. One might say it’s a show about nothing!

[1] https://www.sec.gov/news/public-statement/statement-clayton-2017-12-11
[2] http://money.cnn.com/2017/12/12/technology/north-korea-bitcoin-hoard/index.html


Thank You, Veterans

beaman 150 x 150Noreen D. BeamanChief Executive Officer

Tomorrow, we recognize those who have sacrificed careers, time with loved ones, and even their lives to serve our country. Please take a moment out of your busy Saturday to attend a Veterans Day event in your area, or simply say thank you to those who are currently serving or have served in the military.

On this Veterans Day, we say thank you to the veterans in our Brinker Capital family: Chuck Widger, Tom Daley, Jimmy Dever, Jay O’Brien, Jim O’Hara, Jeff Raupp, and Bill Talbot.

For additional ways to give back to Veterans, click here.

Brinker Capital, Inc., a Registered Investment Advisor

A tale of two billboards

O'Hara 150x150Jim O’Hara, CISM, CISSP, CEH, Information Security Officer

Imagine a plush community of beautiful, sprawling estates where each property is protected by a high-end security system.  Now imagine two enormous billboards along the nearby interstate.  Once per month, the first billboard displays a list of newly discovered flaws in the community’s security systems.  The second describes methods to repair the same flaws.  Which billboard would be more closely watched?  Who would be watching it?

By now it’s common knowledge that the Equifax breach was a direct result of the company’s failure to properly maintain a webserver.  What’s less talked about is the fact that the exploited Apache Struts flaw had been published and rated “Critical” by security authorities well in advance of the breach.  Even less discussed is Equifax’s admission to knowing of the vulnerability at the time of breach, but not applying the associated patch, which had been available for months.

Software patching is essentially the 2-billboard scenario described above:

Billboard #1:  The Common Vulnerabilities and Exposures (CVEs) database.  Maintained by the Cyber Security FFRDC, and funded by the Department of Homeland Security, the CVEs database is an ever-updated list of all known software vulnerabilities.

Billboard #2:  A collection of patches and other mitigating controls issued by software providers and security authorities, designed to mitigate the vulnerabilities listed on Billboard #1.

The primary shortcoming of this system is the vulnerability information on Billboard #1 is almost always newer than the remediation information on Billboard #2.  While most software providers strive to release patches concurrently with the publication of the corresponding CVE, this is not always possible.  This occasionally creates a period of time when hackers can use the CVE data to attack vulnerable systems.  In fact, Verizon’s 2015 Data Breach Investigation Report found that half of published CVEs are used to successfully compromise some systems within two weeks.  Hackers are keeping a close eye on the CVE database, and working quickly to weaponize new information it provides.  So, for users and IT departments, it’s an unwinnable race, right?  Not so fast.

The tale of two billboards

The same Verizon study also found that 99.9% of system compromises occurred more than a year after the associated CVEs and corresponding patches were made public.  So, while the hackers may be fast, there is plenty of blame left for the victims –  99.9%, in fact.  Going back to our community of beautiful, sprawling estates, this suggests that even if home owners are bothering to read Billboard #2, many are not acting on the information it contains.  Equifax.

The key to keeping systems protected is a strong patch management program.  Responsible organizations put in place policies, procedures and systems necessary to ensure vulnerabilities are quickly identified and thoroughly mitigated.  Despite a strong patch management process, however, it remains possible that an attacker may find and exploit a vulnerability not yet listed in the CVEs database.  This is known as a “Zero Day” attack.  In order to mitigate Zero Day attacks, organizations must utilize a layered defense-in-depth strategy, which would include implementation of controls such as malware detection software, next generation firewalls, intrusion detection/prevention systems (IDPS), and data loss protection (DLP) technologies.

What can individual advisors and clients do?

 1. Ensure your operating system and software are configured to update automatically.  Waiting for an update to install can be frustrating, but it’s nothing compared to the sinking feeling you’ll experience if your system is compromised.  As a bonus, you’ll no longer see those annoying reminders in the task bar.

2. Consider installing malware detection software on your computer.  This would be in addition to any anti-virus solutions already installed.  There are many free and low-cost malware detection and eradication options available.  Research the tool before installing to ensure it is legitimate and properly supported.

3. Encrypt critical and sensitive data.  Password protecting spreadsheets, Word documents, and PDFs containing sensitive data will greatly reduce the impact of a Zero Day attack on your computer.  The attack may compromise your system, but it won’t be able to decrypt your protected files.  This could spare you many uncomfortable phone calls.

The views expressed are those of Brinker Capital and are not intended as investment advice or recommendation. For informational purposes only. Brinker Capital, Inc., a Registered Investment Advisor.

What we can learn from Hurricanes Harvey, Irma

Dressel 150 x 150Ryan Dressel, Investment Analyst

Over the past few weeks, Hurricanes Harvey & Irma grabbed our collective attention as we watched the fury of mother nature unfold in Texas and Florida. While images of the damage can be jaw dropping, what’s more amazing is the strength of communities coming together to assist those affected. In today’s digital age, acts of heroism, generosity, and courage were on display via social media for the world to see. Examples included neighbors forming a human chain through floodwaters to help a woman in labor make it to a fire department truck; drones that located stranded families on roof-tops; a Delta Airlines pilot who flew into the violent, outer bands of Irma to pick up one last group of passengers desperate to flee the island of Puerto Rico; and Houston Texans star J.J. Watt, who single-handedly generated $30 million in aid (and counting).

The financial impacts of the two storms will no doubt be meaningful. Fortune estimates the loss could be as high as $180 billion for Harvey[1], while estimates for Irma range from $30 to $60 billion. This includes damages to property, infrastructure, crops, natural resources, small businesses, transportation, and unemployment. Political hurdles stand in the way, but the United States has the resources to rebuild.

As an investor, these events remind us that storms can be unpredictable, no different than financial markets. Government officials have many tools at their disposal to handle the unexpected, such as communications, shelters, curfews, utility companies on standby, rescue vehicles, and storm monitoring to name a few. Money managers and fiduciaries also have tools, such as asset allocation, diversification, performance analysis, or monitoring financial conditions including interest rates, liquidity, political risks, valuations, and corporate growth rates among many more.

The emotional mindset of an investor is no different than that of anyone awaiting a hurricane. Prepare for the worst, hope for the best, and expect to be surprised. Or, as Benjamin Franklin said, “by failing to prepare, you are preparing to fail.”

The views expressed are those of Brinker Capital and are not intended as investment advice or recommendation. For informational purposes only. Brinker Capital, Inc., a Registered Investment Advisor.

[1] http://fortune.com/2017/09/03/hurricane-harvey-damages-cost/

September 11, 2001: A day to remember

beaman 150 x 150Noreen D. Beaman, Chief Executive Officer

As today marks the 16th anniversary of the September 11 terrorist attacks, we remember those who lost their lives and honor those still fighting for our freedom. We grieve, empathize, and reflect on the day’s events that forever changed our country. From the pain of this unspeakable tragedy, American’s came together to build a stronger, more resilient community.

Since then, we continue to come together in times of adversity. Whether it be Hurricane Katrina, Super Storm Sandy or most recently, Hurricanes Harvey and Irma, the people of this country always can be counted on to reach out and help those in need.

In response to Hurricane Harvey’s destruction, Brinker Capital employees generously donated to the Houston Food Bank, which provided 36,960 meals to help those affected by Hurricane Harvey. Additionally, Brinker Capital will be taking new donations to help those who have been displaced by Hurricane Irma in the coming days.

On behalf of the Brinker Capital family, our thoughts are with the everyday heroes who have helped make our nation stronger today.

Investment Insights Podcast: Forgotten fundamentals

Holland_Podcast_150x126Tim Holland, CFA, Senior Vice President, Global Investment Strategist

On this week’s podcast (recorded September 1, 2017), Tim discusses how recent current events are not fundamental to the market’s long-term performance.

Quick hits:

  • In the first half of 2017, the S&P 500 delivered year over year earnings growth of 12%, driven by double digit gains in both the first and second quarter.
  • The robust earnings performance of the S&P 500 is important for several reasons.
  • The underlying economic and market fundamentals are what matter most over the long term, and for the time being the news on both fronts is much more good than bad.

For Tim’s full insights, click here to listen to the audio recording.

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The views expressed are those of Brinker Capital and are not intended as investment advice or recommendation. For informational purposes only. Holdings are subject to change. Brinker Capital, Inc., a Registered Investment Advisor.

Investing in Game of Thrones

Williams 150 X 150Dan Williams, CFA, CFPInvestment Analyst

Nothing else could make me, and many others, actually look forward to Sunday night like Game of Thrones. Of course I felt a need to draw some wisdom to the investment world from this show if for no other reason than I get to relieve my separation anxiety from the many months until the show comes back for its final season. Thankfully this season lends itself easily to the task.

For those unfamiliar with the show let me sum it up as briefly as possible (warning vague spoilers). There exists a continent called Westeros that is divided into numerous houses/kingdoms that swore fealty to the House that sits on the Iron Throne. In the recent past, there was a rebellion that disposed of the longstanding ruling House Targaryen and drove the surviving member(s) of the house off the continent into hiding. The show opens with a member of House Baratheon sitting on the throne. Well, that king gets killed “by accident on a hunting trip.” His best mate, who is head of House Stark, becomes involved in investigating the situation in the capital city and gets beheaded. House Lannister slides onto the throne by a member of the house being conveniently married to the former king. This whole situation causes much trouble as House Stark wants revenge, House Targaryen and Baratheon want to take back the throne, and the rest of the Houses see opportunity to reposition themselves. A bunch of people kill some other people by various methods. Some body parts get cut-off. Some dragons show up. Some people come back from the dead by unnatural methods. Really a classic story. So that is it.

Wait! I forgot! Up north there are reports of a huge frozen undead army being formed that threatens to sweep down and kill everyone. This threat is summed up as “Winter is coming.” No biggie, right? Oops!

GOT.Winter is Coming
The parallel that can be drawn to the investment world is that while people are chasing and comparing themselves to each other’s performance and asset class benchmarks, they take the eye off the primary goal – survival. The Houses all want more castles and the glory to sit up on the Iron Throne while John Snow, one of the show’s main protagonists who has been positioned up north for the majority of the show, said this season “If we don’t put aside our enmities and band together, we will die. And then it doesn’t matter whose skeleton sits on the Iron Throne.”

While we are not necessarily battling our neighbors – like the houses of Westeros – for bragging rights of investment returns, it is still the wrong struggle to have. The great threat to the north is our inability to meet our goals due to poor investment planning. We can go off track by spending too much or saving too little. We can take on too much or too little risk or invest in the wrong account types. We can be operating tax inefficient. We can fail to insure against the unlikely but devastating potential life events. Planning with an advisor should be focused on setting a path that provides the best likelihood for success against this enemy of insufficient assets for our goals rather than the bragging rights of a few year of investment returns.

During this season, attempts were made by John Snow to refocus the warring houses to the real threat of the north. This threat has been lurking for all seven seasons of the show and the big question is – is it too late for them? Similarly, the challenge of investment goal planning is easiest when taken on as early as possible or before winter comes. The adviser’s role is similar of that to John Snow’s, get their clients to start to properly prepare as early as possible for the threats that matter.

The views expressed are those of Brinker Capital and are not intended as investment advice or recommendation. For informational purposes only. Brinker Capital, Inc., a Registered Investment Advisor.

August 2017 market and economic outlook

Lowman_150x150pxLeigh LowmanInvestment Manager

After a strong first half to the year, positive economic growth continued into July.  Risk assets were up across the board and volatility was notably muted. Second quarter earnings came in strong with both revenue and earnings surprises accelerating from already strong levels, helped by a weaker US dollar and depressed oil prices. On the political front, the Senate’s failure to pass a healthcare bill cast a shadow on the “Trump trade”, bringing forth concerns on whether meaningful tax and regulatory reform can be accomplished. However, this failure may serve as a catalyst for other pro-growth initiatives, such as tax reform, to be pushed through in the near future.  Overall economic data leans positive and we expect markets will continue to trend upward over the near term.

The S&P 500 was up 2.1% in July and reached a record high mid-month, stemming from many large corporations reporting stronger than expected second quarter earnings. All sectors posted positive returns with the largest outperformers being telecom (+6.4%) and technology (+4.3%). Large cap stocks outperformed mid cap and small cap stocks and lead year to date.  Growth outperformed value and leads by a large margin year to date.

market outlook

Developed international equities outperformed domestic equities, returning 2.9% for the month.  Improving fundamentals and increased investor sentiment in both the Eurozone and Japan helped spur continued positive economic growth.  Both regions remain heavily reliant on central bank stimulus programs and speculation has begun on whether the European Central Bank or Bank of Japan will begin easing in the near future. Emerging markets rallied, gaining 6.0% for July, with all BRIC countries posting positive returns.  Brazil was up over 11%, stemming from initial failed corruption allegations of the country’s president, Michel Temer.

Likewise India and China posted strong returns, fueled by strong economic growth and evidence of reform.

Fixed income markets were quiet during the month.  The July Fed meeting was relatively uneventful with an expected announcement of no changes to interest rates. The Bloomberg Barclays US Aggregate Index returned 0.4% with all fixed income sectors posting positive returns. The 10 Year Treasury yield ended at 2.3%, relatively unchanged from the beginning of the month.  High yield spreads contracted an additional 12 basis points. Municipals were up 0.8%, outperforming taxable counterparts.

We remain positive on risk assets over the intermediate-term, although we acknowledge we are in the later innings of the bull market and the second half of the business cycle. While this cycle has been longer in duration compared to history, the recovery we have experienced has been muted. While our macro outlook is biased in favor of the positives and recession is not our base case, especially considering the potential of reflationary policies from the new administration, the risks must not be ignored.

We find a number of factors supportive of the economy and markets over the near term.

Reflationary fiscal policies: Despite a rocky start, we still expect fiscal policy expansion out of the Trump Administration, potentially including some combination of tax cuts, repatriation of foreign sourced profits, increased infrastructure and defense spending, and a more benign regulatory environment.

Global growth improving: U.S. economic growth remains moderate and there is evidence growth outside of the U.S., in both developed and emerging markets, is improving. Earnings growth has improved across markets as well.

Business confidence has increased: Measures like CEO Confidence and NFIB Small Business Optimism have improved since the election. This typically leads to additional project spending and hiring, which should boost growth.

However, risks facing the economy and markets remain, including:

Administration unknowns: While the upcoming administration’s policies are still being viewed favorably by investors, uncertainties remain. The market may be too optimistic that all of the pro-growth policies anticipated will come to fruition. The Administration has quickly shifted from healthcare to tax reform legislation. We are unsure how Trump’s trade policies will develop, and there is the possibility for geopolitical missteps.

Risk of policy mistake: While global growth has improved, it is important that central banks do not move to tighten too early. The Federal Reserve has begun to normalize monetary policy, but has room to be patient given muted levels of inflation. The tone of the ECB has begun to shift slightly more hawkish.

The technical backdrop of the market is favorable, credit conditions are supportive, and we have seen acceleration in economic growth. So far Trump’s policies are being seen as pro-growth, and investor confidence is elevated. The onset of new policies under the Trump administration and actions of central banks may lead to higher volatility, but our view on risk assets remains positive over the intermediate term. Higher volatility can lead to attractive pockets of opportunity we can take advantage of as active managers.

Brinker Capital Market Barometer

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Source: Brinker Capital. Views expressed are for informational purposes only. Holdings subject to change. Not all asset classes referenced in this material may be represented in your portfolio. Indices are unmanaged and an investor cannot invest directly in an index. All investments involve risk including loss of principal. Fixed income investments are subject to interest rate and credit risk. Foreign securities involve additional risks, including foreign currency changes, political risks, foreign taxes, and different methods of accounting and financial reporting. S&P 500: An index consisting of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. The S&P 500 is designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large-cap universe. Companies included in the Index are selected by the S&P Index Committee, a team of analysts and economists at Standard & Poor’s. Bloomberg Barclays U.S. Aggregate: A market capitalization-weighted index, maintained by Bloomberg Barclays, and is often used to represent investment grade bonds being traded in United States. Brinker Capital Inc. and Santander Investment Services are independent entities and neither is the agent of the other.


A battle of wits with the market

Williams 150 X 150Dan Williams, CFA, CFP, Investment Analyst

One of the greatest temptations of investing is trying to increase investment performance by continuously buying stocks right before they go up and selling stocks right before they go down. As a theoretical matter “timing the market” seems simple as in retrospect the overreactions or ignorance of the markets are clear. Yet, in practice, the task is regarded mostly as a fool’s errand as the timing always seems to be off.

The extremes of market movements relative to economic reality is not a new observation. In his 1949 book, “The Intelligent Investor,” Benjamin Graham asked readers to imagine themselves as a partner in a business with a fellow named “Mr. Market.” On a daily basis, Graham’s Mr. Market becomes wildly optimistic or pessimistic about the business’ value, therefore, is always trying to sell out or buy you out. Graham notes that an investor finds himself in that very position when he owns a listed common stock. The problem is that we are not separate from Mr. Market. Rather, we all contribute a little of ourselves to create this Mr. Market and what he feels, we collectively feel. When he is panicking and wants to sell, so do we. When he is euphoric about market prospects and wants to buy, so do we.

Additionally, Mr. Market is smart most of the time as he knows just about everything we collectively know, and given available information is approximately right about most stocks most the time. This is the oversimplified basis for the Efficient Market Hypothesis (EMH) that states that the market incorporates all relevant information efficiently and accurately into market prices. So what is to be done?

Timing the market

As always, I find a movie to reference. This time I am drawn to a scene in “The Princess Bride” where our protagonist, Westley, sits down to play a game of wits with the mastermind bandit, Vizzini. In the scene, two glass of wine are poured, Westley poisons one glass of wine, but mixes up which is which and places both glasses on a table. Vizzini then gets to pick which glass to drink from and Westley is compelled to drink the other. Vizzini, after thinking and overthinking all of the factors to consider and even switching the placement of the glasses on the table while Westley is distracted, takes a drink from one of the glasses and drops dead. We then find that Westley had actually poisoned both glasses and had previously made himself immune to the poison used. Therefore, the whole game of wits was moot.

Similar to trying to beat the market through market timing, the battle of wits Vizzini was engaging in was with himself. Westley instead played the game right by avoiding the game of wits by doing work beforehand. This is exactly what Graham prescribed for investing.

Graham felt through the deep fundamental analysis of individual securities an investor could know with a reasonable degree of confidence what the price/value of a security should be. This value is adjusted to new information that fundamentally changes the business prospects, but most often the investor just patiently waits for Mr. Market to make a mistake. Like Westley, the intelligent investor just waits for Vizzini to drink.

The moral of the story is that to outperform the market you must either do your homework (independent analysis to make yourself immune to the poison of market noise) or do not play the game at all (buy and hold a proper asset allocation and ignore the market noise). In neither case, do you try to use your own emotional intuitions to outthink and time the market.

The views expressed are those of Brinker Capital and are not intended as investment advice or recommendation. For informational purposes only. Brinker Capital, Inc., a Registered Investment Advisor.

Machine Learning’s Growing Pains

Solomon_B 150x150Brad Solomon, Junior Investment Analyst

“Machine learning,” on its surface, sounds nothing short of miraculous.  For anyone who has ever felt overwhelmed when working with a large amount of intractable data, it evokes a certain fantasy: press a button, and let the machine learn. Poof, without any further instruction, your computer spits out relationships in the data seemingly untraceable to the human eye.

Yet paradoxically, there is also a competing perception that only a certain breed of mathematics PhDs and programming prodigies are worthy of using machine learning (ML) techniques.  The field of computer science has never been short on patronization; this post recommends first making sure that you have several advanced degrees and then learning the C or C++ languages, both of which are seen as some of the least user-friendly computer languages and neither of which are the language into which most machine learning is actually incorporated.

Now that machine learning has made its way to the top of Gartner’s Hype Cycle for emerging technologies, and has also become pervasively marketed as part of the tool set of quantitative investment strategies, it’s probably a good time to debunk some misconceptions about what machine learning is, and what it isn’t.

Let’s start with a positive.  ML encompasses a wide range of statistical modeling techniques that can be applied toward facial recognition, predicting credit card fraud, and classifying tumors as malignant or benign, to name just a few implementations.  At the heart of machine learning are a number of different models that all serve as means to the same ends: predicting a value or classifying something categorically.  The list of models themselves is an intimidating mouthful: to name a few, there are neural networks, decision trees, Bayesian ridge regression, and support vector machines.

If your head is spinning, you’re not alone.  However, you might be surprised to learn that you likely covered some elements of machine learning in any introductory statistics course: for instance, ordinary least squares regression (linear regression) also falls under the hood of machine learning. Machine learning practitioners also like to throw around a number of fancy terms that go by other names elsewhere in the realm of broader statistics discipline.  For example, training and test data are analogous to the more familiar terms in-sample and out-of-sample; supervised learning simply means that you are starting with an independent and dependent variable and want to establish a relationship between the two and then apply that relationship to a “fresh” (test) variable.

Now, to debunk one of several myths: ML is not new; the term was coined in 1959 and has been used pervasively in the tech industry for decades.  However, growth in the popularity of the Python programming language, which is open-source, free, and offers a number of user-friendly machine learning packages, has fueled interest in the concept.

One result has been the proliferation of machine learning techniques and their (purported) use in quantitative investment applications.  At Brinker, we’ve come across more than a handful of managers using machine learning: the use of random forest classification to identify the likelihood that a company will cut its dividend, or forecasting of market volatility regimes through Markov chain Monte Carlo methods.  However, we would be remiss to mention that for every manager that usefully employs machine learning, there are a half-dozen others that simply like being able to include it in a slide in their strategy’s pitch-book.  Bloomberg bluntly articulated this recently: “Hedge Funds Beware: Most Machine Learning Talk Is Really ‘Hokum’.”  A healthy dose of skepticism is warranted.

That engenders a second key point: when interacting with managers who profess to use ML in their everyday process, ask as many “dumb” questions as possible.  In layman’s terms, can you describe what’s going on “under the hood”?  Why did you select this model in particular?  While the mathematics behind certain models can be quite hairy, the high-level intuition should not be.  And lastly, while machine learning hasn’t yet been fully commoditized, that doesn’t mean you should be paying a 2 & 20 fee to access its capabilities.

The views expressed are those of Brinker Capital and are not intended as investment advice or recommendation. For informational purposes only. Holdings are subject to change. Brinker Capital, Inc., a Registered Investment Advisor.