The Investor's Consigliere

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.

Obama's Name, and the Power of Bias

Sorry to get off-topic, but this article resonates with this American named Nadav Natan Manham.

Hang on a minute . . . maybe it's not so off-topic.  This blog is ultimately about how to evaluate people--the people who are investing your capital.  A difficult task, for many reasons.  Perhaps the most difficult reason for us to confront is the fact that we the evaluators are so deficient in many ways.  All kinds of biases and prejudices we hide from ourselves get in the way of the rational evaluation of others.

One bias is the simple similarity bias.  We like people who are like us--who look like us, talk like us, have names likes ours, etc.  I'd be willing to bet that if even the most sophisticated money manager selectors (those who spend many millions of dollars of time and effort to evaluate investors strictly on the basis of merit and expected return) were to examine their money managers, they'd find evidence of similarity bias:  the same background, same religion, same college attended, same way of speaking, whatever. 

If you don't take pains to identify and root out your own similarity bias and other biases, you're setting yourself up to be a sub-optimal people evaluator. 

 

New Category: Judging Investment Pitches

Introducing a new category--Judging Investment Pitches:

As a soi-disant (a word I learned recently) judge of money managers, I try to hone my judging skills to razor sharpness.  One way to do this is to read and evaluate the various investment pitches available in the media.  I define an investment pitch as a reasonably long (that rules out a lot of what's on Seeking Alpha) and detailed argument by a professional investor in favor of a particular position he/she holds.  Sometimes you'll find them in the popular business press, which have free websites, but more often in more specialized publications like Outstanding Investor Digest or Value Investor Insight.  These latter two are not (at all) free so I will do my utmost to respect their intellectual property--I don't want a rabid Whitney Tilson knocking down my cyberdoor.

In my opinion, you can't evaluate a money manager, especially a young one with little to no track record, only by his numbers.  There is no substitute for the hard work of trying to figure out how he thinks, how smart he is, how he makes decisions, his integrity.  These unmeasureable factors ultimately matter more because

• By the time the measureable factors--historical returns, volatility of returns, etc.--become meaningful, it's often too late for you.  Either the fund is closed, or everyone knows it's good, or it's gone and raised so much money that it won't likely repeat its past record.  
• The measureable factors are commodities.  Too many people can calculate the return statistics of a hedge fund or PE fund, and if they can't their computers can.  You're not adding value as a judge of money managers if you're just doing that.

I realize that most of the "fund selector" industry--funds of funds, hedge fund consultants, etc.--may not think this way, but I take comfort that people like David Swensen and Edward Lampert do. 

Short of a face-to-face meeting, reading investment pitches is the best way to measure these important intangible factors.  So I'll judge them, and you can judge me.