The Investor's Consigliere

James Montier on Risk

A nice essay on how risk should be evaluated from a value investor's point of view.

Deutsche Bank Alternative Investment Survey and the Coming Disappearance of Smaller Hedge Funds

According to this article about Deutsche Bank's annual Alternative Investment Survey, over 50% of hedge fund investors will only invest in funds with $1 billion or more in assets under management:

“It means that smaller hedge funds will disappear,” observes Andrew Ang, professor of finance and economics at Columbia University’s business school. Bigger funds are in a better position to have good risk management and can borrow more cheaply, he points out, and are more likely to have a track record.

“There is a magic number where economies of scale really kick in,” Mr. Ang adds. “It’s at about $2 billion to $3 billion. With funds smaller than that, it’s much harder to get significant rewards.”

I disagree with Professor Ang, and with any hedge fund investor that limits itself to $1 billion+ funds.  Taking Professor Ang's points in turn:

1)  Why are big funds in a better position to have good risk management?  What does he mean by good risk management?  If he means larger funds are more able to hire dedicated risk managers, I think that's more likely to provide only the appearance of risk management rather than the reality, as Ken Akoundi explains in detail.  The ultimate guarantor of good risk management is when the investment process is joined at the hip with the risk management process, which is usually truest when one very competent person is doing both. 

2)  Bigger funds can borrow more cheaply than smaller funds.  With "advantages" like this, it seems to me, you don't need disadvantages. 

3)  Bigger funds are more likely to have a track record.  Yes, but fund size is a very lazy heuristic to use to screen for track records.  If you the hedge fund investor wish to confine yourself to funds with longer track records--a legitimate aim--the way to do that is to screen for funds with longer track records, not to use fund size as a proxy for track record. 

4)  Larger hedge funds benefit more from economies of scale.  Yes, but the benefits of these economies of scale accrue to the hedge fund itself, not to the hedge fund investors.  If anything, hedge fund investors face diseconomies of scale as the size of their funds grows:

      a)  As a fund grows its universe of opportunities shrinks.

      b)  If a fund grows by adding new investors, those investors are less likely to share the investing philosophy and expectations of the original partners.

      c)  Because of a) and b), larger funds are more likely to experience unfavorable style drift.

Cialdini on Madoff

An essay on Madoff, by the master of the psychology of persuasion himself, Dr. Robert Cialdini.

El-Erian on Manager Selection

From his latest FT column:

What does that mean for investors? The implications go well beyond another phase of pressure on asset prices. As difficult as it already is, it is no longer sufficient for investors just to come up with the right asset allocation and responsive risk management; they must also undertake more rigorous assessment of investor managers to ensure investment and business models are sustainable.

To do so, investors should look for firms that remain profitable and, equally importantly, are playing defensively upfront so that they can play offensively later in a sustainable fashion. They should also look for firms that are positioning their business to take advantage of some big strategic and human resource opportunities that will arise as others stumble.

A Quant's Eye View of Manager Selection

Thanks to Felix Salmon, who sent me this essay by D-squared Digest.  I understood . . . much of it.  An excerpt:

A somewhat overcomplicated estimator for talent. So basically, a really excellent fund manager would have the characteristic that changes in his trading strategy anticipated changes in V. Investment in this view is a problem of forecasting structural breaks or regime changes. So if I had unlimited resources of data and mathematical ability, I would take data on securities prices, and on the trading positions of the fund under analysis. I would use a STOPBREAK (stochastic permanent breaks) model to identify regime changes in both, giving me a vector of dated regime-changes in the equity returns series, and a vector of dated regime-changes in the trading strategy series. I'd then use the normal toolkit to estimate the lead-lag relationship between the two series. Obviously a lead of the trading strategy series over the returns breaks series would be ideal, but a short lag would also be worth knowing about - while the man who can tell you when a big change is coming is a gem of great price to be treasured, the man who can spot when something's going wrong and stop losing, is also a highly useful lad to have around, and perhaps a bit more realistic to hope for. So that's what I'd do if I were in the manager research game.

A less complicated and perhaps more sensible estimator: This is a bit of a sledgehammer to crack a nut approach though. I would guess (and could probably prove if I had three weeks spare time and masochism to devote to relearning a load of stochastic processes again) that a reasonably good robust non-parametric estimator for the lead-lag based talent measure suggested above, would be the number of >10% drawdowns, which is a statistic that lots of funds will put in their risk disclosures anyway. I'd specifically divide the average return per year, by the average number of drawdowns per year, and give myself a measure of how much return these guys made per "mistake". I'd then take a look at >20% drawdowns and see whether they were prone to making big mistakes.

Howard Marks Memo, March 2009

Read it here.  He writes about fixing the financial system, macro, politics, etc., but his main point, in underlined boldface, is:

The only things we have to fall back on at this juncture are intrinsic value, company survival, and our own staying power as investors. 

Two Buffett Transcripts

Via the Manual of Ideas blog.  Here is Buffett on manager selection:

In 1969, I wound up my partnership and I had to help people find someone to manage their money. I recommended Bill Ruane of Sequoia Fund, Sandy Gottesman, who is currently on the board at Berkshire, and Walter Schloss, who I wrote about in “The Superinvestors of Graham and Dodds-ville”. There’s no way they could miss.

But I don’t know many of the newer investors, they’re not my contemporaries. It’s not enough to just look at track records. They aren’t predictive and there will always be a few people that do well. I know guys who can make 50% a year with $5 million, but not with $1 billion. The problem with guys that do well is they attract so much money that it neutralizes their advantage. It’s hard to identify them, and even harder to make a deal to keep them from attracting other capital. It’s like betting on a 12 year old horse that won at 3 years old. It’s also important to avoid managers who use leverage. It’s the reason that investors with 160 IQs flame out.

Richard Feynman Interview

Off topic:  The best things in life are free--like listening to this interview with the late Richard Feynman, courtesy of the Manual of Ideas blog.  Awesome.

By the way, Feynman was a great student and practitioner of seduction--the naughty kind, not investor seduction. 

Update: Actually, not so off-topic.  In addition to being a great scientist, Feynman was one of the best students of the philosophy of science, of the scientific method and, perhaps most importantly, of the many human and institutional enemies of the scientific method.  How do we know what we think we know?  What factors can get in the way of knowing?  These questions are important to ask of any self-styled expert, including investment managers.

When Good Investors Say Bad Things

Anthony Bolton, a legendary mutual fund manager in Britain, tries to call a bottom:

Fidelity's Anthony Bolton, the nearest thing this country has to a Warren Buffett, told the National Association of Pension Funds on Wednesday that stock markets were "at or near lows", echoing a call he made at the turn of the year.

And again here:

One investor confident that equities have seen the worst is Anthony Bolton, president of investments at Fidelity International.

In a video interview with the FT this week, Mr Bolton called a bottom in stocks and the start of a new bull market. Mr Bolton made the same call late last year, before a renewed sell-off.

He says sentiment, valuations and the historical analysis of past bear markets, shows they reached an extreme last November and again last week.

"My strong message [for investors] is don't give up now, you're giving up, you know, really at the last fence," says Mr Bolton.

"I'm not saying there isn't going to be any more negative news," he adds, but says the news should be much better by the second quarter.

Spencer Jakab on Value Investing

In the FT.  A sample:

"You could argue that value investors could have invested with a greater margin of safety," said John Buckingham, who manages the value-oriented Al Frank Fund.

Tantalising opportunities to buy seemingly enduring franchises such as Bear Stearns or Fannie Mae for pennies on the dollar became painful lessons in risk management and diversification.

"The problem that value managers face is that we're closet quants," said Mr Buckingham. "When you're looking at what has worked historically and what valuations were at that time, you want to back up the truck and go in."