Portfolio Management – Page 37

An Internship at a Hedge Fund

Posted on 11 January 201412 January 2014 by David Merkel

Here’s a letter from a reader:

Hi David,

Hope all is well.

I will be starting an internship with a hedge fund soon and want to contribute;. Any advice?. Are there any skills that I should learn/ brush up on so I ?can be productive.?

Thanks a lot.

In one sense, an internship at a hedge fund is like an internship at any job.? Here’s the easy stuff:

Be on time.
Dress like those you work with, or just a little better.
Listen carefully, and keep a notebook, so that you can remember things, or write down questions to ask later.
You are new to the social hierarchy, and sorry, you are at the bottom of it.? You may get garbage jobs that the junior analysts don’t want to do.? Do those garbage jobs with as much flair as you can.
Don’t waste time.
Do ask questions, particularly intelligent ones.? If you are not sure, ask.? If it is still not clear, ask.
Spend extra time if you need to research something for the business outside of business hours.
If you can program, and there are projects that could benefit from programming, offer to write some code now to aid processes after you are gone.
Don’t look down on anyone.
Be willing to speak up in meetings, but only when you have something of high quality to say.? If they ask you your opinion, and you don’t know, say that you don’t know.
Try to find some friendly mid-level person who can give you advice.

Now for things that are hedge-fund specific:

Make an effort to understand how the hedge fund intends to make money.? Once you know that, try to read up on their particular strategy.? Ask those with experience where you can learn more.
Realize that they are doing you a favor, and not vice-versa.? At the hedge fund I once worked at, we always paid interns, but only one intern out of many was ever worth the cost of paying and training.? So be grateful, and do what they ask, so long as it is not illegal or unethical.
Show interest in what others do, and learn from them.? People like to talk about their work, so when you have the opportunity, ask good questions.
It’s possible that they may play some practical jokes on you; bear with that in a graceful way.
Hedge funds are entrepreneurial, so if you do well, they will throw harder tasks at you.? Don’t be shy; do your best.

So what is the payoff for your hard efforts?

References for a real job, so impress those that you intern for.
Advisers on how to find a job if you did a good job for them, but there are no openings.
Also, they might rather hire privately, rather than expose the firm to risks from advertising a job publicly.? As such, if you showed that you could do great work for them, they very well might hire you.? Stay in touch with them.

That’s what I think you should do.? The comments section is open for more advice to the young man.

Why Great CEOs Look at their Stock Price Every Now and Then

Posted on 9 January 2014 by David Merkel

I was doing my daily reading, when I bumped across the article, Why great CEOs ignore their stock price.? Yeah, I know it is the USA Today, so it has to be simplistic.? Most of the article is correct.? I am not in favor of short-termism, and much less managements managing only to maximize their compensation.

Back in July, I wrote a piece called The Stock Price Matters, Regardless.? Though the whole piece is good, let me give you one quotation from it:

If management/board thinks the price of the stock is undervalued, they will be among those buying shares in the secondary market, improving the value of the shares for the remaining shareholders.

If management/board thinks the price of the stock is overvalued, they may look at other companies to buy that are reasonably priced or cheap that will make their firm more useful.? At that point, their stock is a useful currency for acquisitions.

There is a lot of value that can be derived from the current stock price, to a management team that is focused on creating value.? Buying back stock when it is cheap, and issuing stock to strategically acquire companies cheaply are important ways of creating value for shareholders.

Part of the job of an investment analyst is to analyze the management team and see if they are managing for themselves or for shareholders.? If they don’t use free cash flow well, it is not a good company to own.

One more problem of the USA Today article is that most large investments by corporations tend to do badly, whereas small investments tend to do well.? Management teams need to be careful about investing, and ask whether the investments are worth the risk.

Though there are innovative companies that have promising opportunities, such that they do not pay dividends or buy back stock, that’s not true of most corporations — reinvestment opportunities are limited.

It’s wrong to look at a bunch of special companies, and assume that all companies can do the same thing.? What I insist from the companies that I own is that they follow portfolio rule six.

Analyze the use of cash flow by management, to avoid companies that invest or buy back their stock when it dilutes value, and purchase those that enhance value through intelligent buybacks and investment.

Not all corporate investment is good.? Think of the long-term oriented managements in Japan back in the late ’80s.? At that time I thought, “How can accepting low returns on equity be a bright idea?”? There is always the possibility of wasting money via overinvestment.

I look for intelligence in the management teams in stocks that I own, and am quick to sell those that destroy value through bad investments, or bad buybacks.? I try to think like a businessman in all that I do as an investor.? It leads to good results.? As Buffett said,

?I am a better investor because I am a businessman, and a better businessman because I am an investor.?

Don’t look for simple metrics to analyze investments.? Embrace complexity, and realize that you have to consider how management teams use their free cash, whether to reward investors, or invest for the future, hopefully in productive ways.

What are Safe Assets?

Posted on 27 December 2013 by David Merkel

When I was young, my paternal grandfather retired, and made my Dad and my Uncle, who worked for him,? buy him out of his firm.? They did so, and laid out a lot of cash to do it, which my grandfather invested in certificates of deposit at various banks.? In the ’70s, he looked like a genius, while my mother, who was beating the market with her half Growth At a Reasonable Price, half utilities strategy, still lagged behind CD returns.

But when the ’80s came, there was no contest.? CD yields fell, fell, and fell.? Stocks gave high returns, and the returns more than outpaced CDs over the two decades combined.

So what are safe assets?? Part of it depends on time horizons.? If you have a short time horizon for when you will need to use the money, then you have to only look at money market funds, and high-quality short-term debt.

If the time horizon is long, it becomes a question of margin of safety.? What is the worst outcome reasonably possible?? Assets that are risky are at their safest point at the bottom of a bear market, and their riskiest point at the top of a bull market.? The difference is margin of safety.? But it doesn’t feel that way.

For those with a long time horizon, the safest assets are those that are misunderstood and hated, with low prices relative to intrinsic value.? The downside is clipped, and the upside could be considerable, with decent probability.

That is one reason why I think that for those with long time horizons risk and return are negatively correlated.? Take less risk, get more return, within reason.? There are times when the market is irrationally bearish.? That is the best time to invest, but wait until things stop getting worse before investing.

Moderate risk-taking tends to win in the long run. If markets mean-revert, a 50-50 mix of stocks and bonds will beat a 100% stock portfolio.

Beyond that, in an environment like this, where there is more capital than there are good places to deploy it, we should see a lot of IPOs to absorb excess capital into mostly unprofitable ideas.? Much as I like Twitter as a service, I don’t see how it grows into its current valuation.? This feels a little like 1998-2000, but only a little.? We need more of a frenzy of IPOs offering dubious value to suck up the capital of those who are foolish.

What does make this situation more like 1998-2000 is the Q-ratio, which is at its highest point since 1998-2000.? This is the second-highest peak for the Q-ratio, which measures the value of stocks versus their replacement cost.? This means that equity returns are likely to be negative/low for the next 5-10 years.

So at a time like this, where can your assets be safe?? Bond interest rates are low, and don’t reflect the risks.? Stocks have high valuations, and I invest in the few stocks with low valuations.? The alternative is to earn nothing in cash.? At present, that is the safest option, and may return the best over the next year.

I know, no one can do market timing well, but at present, the odds are tilted against risk.? I’m thinking of buying a hedge against my taxable brokerage account.

Safe assets are those that avoid loss, and behold, safe assets often offer better returns as well, if purchased during a time of fear.

Protect Your Older Family & Friends

Posted on 26 December 2013 by David Merkel

This article was spurred by this article in the Wall Street Journal:?Financial Scammers Increasingly Target Elderly Americans. ?The elderly are indeed a target because of three reasons:

The poor elderly need to make money, and they become prone to scams that offer easy earnings, while milking them for “startup costs” and things like that.
The middle class elderly need to stretch the meager incomes that they have amid low interest rates (courtesy of the Fed), and are tempted by those offering plans where they can earn more on their assets.
The rich elderly have money — they are prime targets even if they are smart.

Seniors are targets, and not just by those who are regarded as fraudsters. ?I had an older friend who was approached by the sales professionals of a major bank to manage her $3 million portfolio, which was already well-managed. ?They made all manner of promises of what they would do for her, in exchange for a fee on assets — 3%/year.

At that level of expense, there are a lot of things that could benefit the Senior in question, but the nice-looking, unctuous people from the bank sell an expensive mirage. ?I’ve never seen a bank that was genuinely good at asset management, and certainly not to the degree of charging a 3% fee.

Every elderly person needs a younger skeptical friend who is sharp enough to be able sense when a deal is sketchy, and the elderly person needs to have the discipline to run things by their younger friend.

As I so often say, “Don’t buy what someone wants to sell you. ?Buy what you have researched for yourself.” ?The elderly should develop a hatred of marketers. ?Hang up on anyone who is offering something that is “too good to be true” because it almost always is too good to be true.

To those who Lead Churches

I am an elder in my Reformed Presbyterian congregation. ?I have served my denomination on the boards of its college, denominational trustees, finance committee, and pension board. ?In my congregation, we watch out for our elderly members. ?We make their requests a priority. ?If they need financial advice, I give it to them for free. ?God rewards those who aid widows.

I encourage Church leaders who have enough financial sense to be able to know when something financial “feels funny” to gather their elderly congregants, and tell them to call you if they are tempted by slick-talking salesmen to make them part with money.

To those who Love Elderly Family or Friends

Take the time to tell them to be careful, and that you are available to help them whenever someone calls them out of the blue, where that party will benefit from money from the senior, no matter what it is. ?This isn’t as tough as telling them to give up the car keys (been through that once). ?But they do need to be sensitized to two things:

There are people out there who want to cheat them, and
You love them, and will help them in any situation like that.

We’re supposed to take care of and honor elderly people anyway. ?Societies that don’t do that tend to fail. ?So look out for your elderly friends to the degree consonant with your relationship to them.

Unconstrained Will Get Overdone

Posted on 24 December 201325 December 2013 by David Merkel

Maybe I’ve just had a couple of unusual random draws from the information urn, but it seems to me that unconstrained mandates are getting more favorable investment attention from investment consultants than they used to. ?The “style box” is breaking down a little, and I think that is a good thing.

My view of the investing world starts with industries, not market cap size, and not even growth/value. ?Much as I end up on the value side, I am flexible on what constitutes value in different industries. ?I range from growth at a reasonable price to deep value. ?It depends on the state of the industry.

All that said, let me talk a little about what it takes to be a good unconstrained manager. ?Organizationally, you have to understand a lot of things better than the rest of the world. ?Do you understand the market, factor, and industry cycles, as well as asset level misvaluations? Investors have the choice of the informationless index, which typically does well versus the average active manager.

As consultants analyze unconstrained managers, their models will get stretched. ?The more degrees of freedom a manager has, the tougher it is to evaluate them. ?If an unconstrained manager made a brilliant tactical move once, can he do it twice? ?Three times? ?More?

Think of the few market players that got short prior to the 1987 crash. ?Aside from Elaine Garzarelli, none were heard from again, and Garzarelli never had a second episode like that in 1987.

It is really tough to come up with significant ideas that will make a huge difference in security returns. ?Home run hitters usually do not hit for average.

What I suspect will happen is this: the initial unconstrained managers will do well, but they will reach capacity limits, and lesser managers will put out “me too” products. ?Consultants will buy into those products to some degree, and a decent number of them will fail to meet expectations. ?The investors hiring the consultants will wonder why they hired them. ?If there is no skill to picking unconstrained managers, then why not pick them directly themselves, or just go back to indexes?

I write this as one that mostly manages equities, long-only. ?I like having no constraint on market cap, value factors, industry, and country selection. ?I like to roam the world in search of value. ?I like to concentrate on industries when I have a good thesis. ?Why should I have non-economic criteria limiting my choices, if I reason well?

That’s why I like unconstrained mandates. ?I run one for upper-middle class individuals, and small institutions. ?But every manager will not do well with it, because most investment organizations are not designed to think that broadly.

Thus I expect that investment consultants will revert to the “style box” (or something new like it) once they realize that few managers can consistently generate alpha over a full market cycle whether unconstrained of constrained. ?At least with constrained, the variation when they do badly is more limited, which protects the consultant, who also does not want to end up in the fourth quartile, where business is lost.

Post 2300 — On Business Issues

Posted on 24 December 2013 by David Merkel

Every 100 posts or so, I take a moment to think about the broader aspects of what I do.? As a blogger, my goal is to educate, and I think I have covered many issues well here.

As an asset manager, my goal is to serve existing clients well.? Most of my assets under management stem from value investing, and 2013 has certainly been good to my clients and me.? 2013 has made up for 2011-12, and then some.

What has surprised me is how existing clients have added to their assets with me.? I expected growth to mainly come through new clients, but at present, most is coming from existing clients.

Another thing that surprised me is that a number of my clients said have said something like this to me, “I really appreciate that you don’t press us to give all of our assets to you.? But you help us as if you have all our assets.”

I know that I have to do marketing, but I don’t like it, and so I do as little of it as possible.? Part of it is the unpredictability of investing.? I have a good track record, but does that really mean I will do better than the index in the future?? Markets are fickle, and much more is due to favorable providence than most of us imagine.

All of us say, “Past performance is not indicative of future returns,” but few of us truly act as if we believe it.? How many consultants? will bring forth managers that are underperforming but have good prospects?? Isn’t the proof in the pudding?? Past may not be prologue, but it is incredibly difficult to get in the door with those who advise individual and institutional investors if you don’t have a winning track record.

Why is that?? Secretly, everyone believes that “Past performance IS indicative of future returns.”? Success breeds success, right?? The man with the hot hand will remain hot, no?

Sadly, no.? Though momentum effects sometimes work in the stock market, there is no evidence for manager outperformance persistence, outside of Graham-and-Doddsville.? But you can’t get naive buyers to think otherwise.? Almost all individual and institutional investors choose managers at least partially on past performance.? That’s the sad truth, and all the disclaimers in the world can’t change that.

I am grateful for the trust my readers place in me.? I am grateful for the trust my investors place in me.? And I hope that I never disappoint you badly.

Sincerely,

David

Classic: Financials are Different

Posted on 21 December 201322 December 2013 by David Merkel

The following was published at RealMoney in March 2006:

When you are a corporate bond manager, one of the lessons that you learn early is that financial companies (or, financials) are different from industrials or utilities.? Why?? First, the novice manager wants to buy a lot of financials, because they yield more at equivalent ratings.? Second, you have a staff of analysts, and you realize that only a few of them can do financials, whereas almost all of them can do industrials or utilities.? Again, why?? Here are a number of related reasons:

Tangible assets play only a small role in a financial company.? What constrains the growth of an industrial company?? The fixed assets (plant and equipment) limit the technical amount of product that can be delivered in a year.? With services, workers? Finally, demand is the ultimate limiting factor, but this affects financial, industrial, and services businesses alike.? With a financial company, sometimes the limits are akin to a service business (?If only we had more trained sales reps!?), but more often, capital limits growth.
The cash flow statement plays a big role with industrials and utilities, but almost no role with financials.? One of the great values of the cash flow statement is the ability to attempt to derive estimates of free cash flow.? Free cash flow is the amount of cash that the business generates in a year that could be removed, and the business is as capable of functioning as it was at the start of the fiscal year.? Deducting maintenance capital expenditure from EBITDA often approximates free cash flow.? Cash flow statements for financials cannot in general be used to derive estimates of free cash flow because when new business is written, it requires capital to be set aside against the risks.? Capital is released as business matures.? In order to derive a free cash flow number for a financial company, operating earnings would have to be adjusted by the change in required capital.
Sadly, the change in required capital is not disclosed anywhere in a typical 10K.? Depending on the market environment, even the concept of required capital can change, depending on what entity most closely controls the amount of operating and financial leverage that a financial institution can take on.? Sometimes the federal or state regulators provide the most constraint; this is particularly true for institutions that interact closely with the public, i.e., depositary institutions, life and personal lines insurers.? For entities that raise their capital in the debt markets, or do business that requires a strong claims paying ability rating, the ratings agencies could be the tightest constraint.? Finally, and this is rare, the probability of blowing up the company could be the tightest constraint, which implies loose regulatory structures.? Again, this is rare; many companies do estimates of the economic capital required for business, but usually regulatory or rating agency capital is tighter.
Financial institutions are generally more highly regulated than non-financial institutions.? There are several reasons for this: the government does not want the public exposed to financial risk, systemic risk, guarantee funds are typically implicitly backstopped by the government (think FDIC, FSLIC, state insurance guaranty funds, etc.), and defaults are costly in ways that defaults of non-financials are not.? The last point deserves amplification; in a credit-based economy, confidence in the financial sector is critical to the continued growth and health of the economy.? Confidence can not be allowed to fail.? Also, since many financial institutions pursue similar strategies, or invest in one another, the failure of one institution makes the regulators touchy about everyone else.
Rapid growth is typically a negative; financial businesses are mature, and there is a trade-off between three business factors: price, quantity and quality.? In normal situations, a financial institution can get only two out of three.? In bad times, it would be only one out of three.
Because of the different regulatory regimes, financial institutions tend to form holding companies that own the businesses operating in various jurisdictions.? Typically, borrowing occurs at the holding company; the regulators frown at borrowing at the operating companies, unless the borrowers are clearly subordinate to the public served by the operating company.? This makes the common stock more volatile.? In a crisis, the regulators only want to assure the safety of the operating company; they don?t care if the holding company goes bust, and the common goes to zero.? They just want to make sure that the guaranty funds don?t take a hit, and that confidence is maintained among consumers.

All of these factors together lead to the following conclusion: financials are more complex than other types of companies, and are not correctly analyzed in the same way as non-financials.? Earnings quality is hard to discern, and growth is not always a positive thing.? Bankruptcies are rare, but when they happen, recoveries are poor for common stockholders and holding company debtholders.? Finally, management conservatism and competence are paramount, given the less certain nature of accrual accounting at financial companies, and the inability to calculate free cash flow with any precision.

In part 2 of this two-part series, I will give my approach to analyzing a sector of the insurance space in order to demonstrate some of these ideas.

Classic: The Correlation Trade Gone Wrong

Posted on 21 December 2013 by David Merkel

The following was published at RealMoney on May 23rd, 2005.? It’s a little obscure, but indicative of what can happen when too much money pursues an obscure arbitrage.? If nothing else, the piece tries to explain a complex concept to those with moderate market knowledge.

Because of the market dislocations last week, I want to give a primer on the class of derivatives that really jolted the markets this week: Indexed Synthetic CDOs.? First, some definitions:

1)????? CDO – Collateralized Debt Obligation.? A trust that owns bonds, loans, or credit default swaps.? The ownership in the trust is hierarchical.? There are several classes of certificates that have different interests in the trust, which get defined by which class receives losses from defaults first, second, third, etc.? The earlier that a class (or tranche) receives losses if they occur, the higher the yield a class of certificates receives.

2)????? Synthetic ? a term used in opposition to ?cash.?? One who transacts in corporate bonds participates in the cash market.? The synthetic market in corporate credit is composed of credit default swaps.? It is called ?synthetic? because it transacts in corporate credit risk without making loans to corporations.

3)????? Credit default swaps ? A market participant who buys default protection on a given corporation through the credit default swap market gains the right to deliver a certain amount of defaulted bonds in exchange for the par value of the bonds, when an event of default occurs for the class of bonds covered by the agreement.? In exchange for this privilege, the buyer of protection pays the seller a fixed fee for the term of the swap, which is usually five years, but can vary.

4)????? Spread ? That fixed fee is called the spread.? When the spread falls, the value of a credit default swap to someone who has previously sold protection becomes more valuable, in the same way that a bond price rises when its yield falls.

5)????? Indexed ? A third party puts together a seemingly diversified (or focused) list of companies so that investors can invest in a liquid pool of similar companies that they want exposure to, whether on a debt, synthetic, or equity basis.

Indexed Synthetic CDOs gather together the risk of debt default for a group of corporations, and parcel the risk of default out in a concentrated form to those who hold the ?first loss? certificates, in exchange for a high yield.? Those who hold other certificates in the loss priority get lesser yields commensurate to the risk of taking losses.

Setting the Stage

The Indexed Synthetic CDO market rallied until March 2005.? In most cases, the more risk an investor took, the better that investor did.? The indexes were rallying.? Those willing to offer protection against the default of a wide number of corporations were willing to do so at smaller and smaller spreads.? As I stated previously on RealMoney, those spreads were too small to compensate for the possibility and severity of losses.

Also, until March of 2005, the decline in spreads was fairly uniform.? There weren?t many credits within each index that were not moving in tune with the rally.? This was significant, because it meant that results were particularly good for the ?first loss? investors.? What hurts ?first loss? investors are credits going into default.? If the spread on the index as a whole improves (goes lower), but a small minority of credits diverge (get wider) and then default, the ?first loss? investor can get hurt, while investors with greater loss protection can still do well.

What Happened Last Week

Last week, not only did spreads rise in general, but some credits related to the auto and auto parts industries widened disproportionately.? This wouldn?t have been such a problem, except that a large number of hedge funds participated in the Indexed Synthetic CDO market doing an esoteric arbitrage trade, where the hedge funds when long the ?first loss? piece, and short 2.0-2.5x the ?second loss? piece.? This trade was sometimes called the ?correlation trade? for reasons I will talk about in a moment.

Why do such a trade?? The lure of free money is inexorable, and the trade had been free money for a while.? So long as movements in the spreads of credits in the index remained closely correlated, the hedge would hold between the ?first loss? and ?second loss? pieces, and the hedged investment would earn a high riskless yield, which to a hedge fund is the holy grail; a lot of hedge fund of funds will throw money at a strategy like that.

All arbitrages boil down to buying and selling two similar securities, and attempting to profit from the price or yield spread over the anticipated time horizon of the transaction.? Arbitrages can be intelligent or foolish depending on whether the anticipated total return is large enough to compensate for the negative results if the convergence anticipated in the arbitrage does not occur.

Last week, conditions for the hedge did not hold as the credit default swap spreads on automotive-related credits rose, leading the ?first loss? pieces to fall in value.? Surprisingly, the ?second loss? pieces actually rose in value, as a number of players moved to close out their hedges, which put downward pressure on the prices of the ?first loss? pieces, and upward pressure on the prices of the ?second loss pieces.? This became self-reinforcing for a while until the close on Tuesday.? On Wednesday, hedge funds and investment banks poured fresh capital into the trade, since the risk reward ratio on the hedged trade was now more attractive, bringing the market back to a more normal state.

Effects on the equity market

This put a damper on the equity market for several reasons: first, some players feared that some of the investment banks were caught on the wrong side of the trade, or had lent to those on the wrong side of the trade.? My guess is that?s not true, but if true, it could raise systemic risk issues, which lowers equity values, as it did in 1998 during the LTCM crisis.? The risk controls at the investment banks are far superior to those at most hedge funds now, and far superior to what they were at the investment banks during LTCM.? That doesn?t mean there can?t be crises, but the preparations for a crisis are better now.? The investment banks have laid off more risks to other market participants.? The other main effect on the equity market was that yields on riskier corporate bonds rose, which usually correlates with lower stock prices.

In closing, just be aware that there are other big markets such as the credit default swap market, both in its single-credit, and indexed forms, that can have a big effect on the equity markets.? There is a lot of leverage around, and ?bets gone wrong? can be big enough to knock some confidence out of the markets.? But I offer this hope: so long as the effects of the ?bets gone wrong? do not affect major institutions such as investment banks, commercial banks or insurance companies, the effects on the markets should be transitory, as they were after LTCM.

Risks, not Risk, Again

Posted on 18 December 2013 by David Merkel

One of the most important things I am here to teach readers is that there is no such generic concept as risk. ?There are risks, and they must be handled separately. ?Generic measures of risk such as standard deviation of returns, beta, etc. are unstable. ?This was driven home to me when I heard a presentation from endowment investment advisors, where they talked about their models, and how the models translated current economic statistics into investment decisions.

I’m sorry, but the models can not be that good. ?The financial markets are only weakly related to the real economy in the short-run, though the tie gets strong in the long-run.

Economies are unstable; get used to it. ?The concept of equilibrium is also not useful, and it holds economics in thrall, because it makes the math work, even though equilibrium never occurs.

It is far better to look at your investment in an oil refiner and ask “What are the possibilities for where crack spreads will be a year from now,” than to look at the beta, correlations to anything, standard deviations, etc. ?The coefficients aren’t stable.

Many advisors would rather follow a false certainty, than have to think for themselves, and have to deal with the complexity of the markets.

I am a quantitative analyst, and a very good one. ?That is why I pay attention to the limitations of models, and the possibility that past data might be special, and not so relevant to the present. ?It is far better that you pick over your portfolios, and ask what risks they are subject to, than to look at standardized risk measurements that describe the past or present.

Be forward looking. ?What can go wrong? ?Analyze each company. ?Find the three most pertinent risks — read the 10-K if you are having a hard time. ?See if you think the risks are worth taking.

But be assured of this. ?Merely by looking at market price derived variables for stocks, you won’t learn anything valuable about the risks of what you own, or might own. ?You need to think like a businessman, a sole owner, and ask whether the risks can be ably faced.

To the Consultants

Your models are garbage. ?You need to review your managers at the holdings level, or you are doing no good at all. ?All of the aggregate statistics hide the instability. ?Far better to understand the qualitative methods of managers, and analyze whether they have a durable competitive advantage or not.

That may not seem so scientific, but science is put to bad ends in areas where there is no good science.

If I were hiring managers, I would spend a lot of time on process and people, and ignore a lot of other items.

Summary

Mathematics is of limited use in analyzing investments and investment managers. ?It is far better to look for those that have good business sense, and invest with them.

The Prime Directive: Stay Out of the Bottom Quartile

Posted on 14 December 201315 December 2013 by David Merkel

If you are a money manager, you would like to be in the top quartile of managers all of the time, but you know that is virtually impossible. ?So you might set a more achievable goal, staying out of the bottom quartile. ?Now there are two ways to achieve that:

1) Make intelligent asset selections that outperform your competition.

2) Own an index-like portfolio that has low odds of slipping into the fourth quartile.

Now, which of those do you think is easier? ?Right, #2. ?Which do most money managers adopt? ?Right again, #2. ?Charge active management fees for a portfolio that will not perform much different from the index.

I take route #1 for several reasons.

1) If I am charging a fee for active management, I find it unethical to try to hug the index.

2) I am willing to look bad for a year or two, if I believe that my methods will outperform over time, reduce risk, etc.

3) My focus on “margin of safety” keeps me out of the fourth quartile anyway. ?I rarely take large losses on a given stock, even though I do not automatically sell stocks after ?a certain level of loss.

4) If you look hard enough, and are willing to try assets that have issues, but with adequate safety, you can do pretty well.

I would encourage you to look for managers that have a large active share — that is, those that are very different from the index, but with a record of doing well.

Understand the asymmetry of interests between managers and clients. ?You pay fees; they receive fees. ?Thus, look for managers that have a large proportion of their liquid net worth invested in the assets that they manage. ?That imposes a discipline that makes them fight for themselves as well as their clients. ?At present, I am still my firm’s largest client, with over 80% of my liquid net worth invested in my strategies.

If your active investments underperform over long periods of time, and you don’t know where to look, consider an ETF or index fund in the same area. ?My view is to look for managers that successfully take risk over time, and run portfolios that do not look index-like.

An Aside

As for me and my clients, increasingly the portfolio has become global. ?My portfolios don’t have a limit on non-US exposure. ?As I have selected assets the last few times, foreign assets have offered better opportunities than domestic. ?Maybe that implies something regarding US stock overvaluation, and maybe not.

From my angle, many foreign markets seem cheap, even if things don’t seem that great now. ?Regardless, I buy what seems to be best, and if I end up with an entirely foreign portfolio, so be it. ?I don’t aim for that, but if that is what is on sale, I will buy.