By Simon Kerr, Principal of Enhance Consulting
1. The team with the fewest errors is often the winner at the biggest occasions in sport.
In this year’s Super Bowl the Denver Broncos turned the ball over five times, conceded a safety from the first snap, and threw two interceptions. It is hard for a sports team to win a major prize without momentum in the season and within a match. Errors killed the Broncos as much as the Seattle Seahawks did.
Hedge fund managers should make active efforts to eliminate errors. Errors in operations are being reduced by straight-through-processing and early stage matching of bargains. On the investment side managers should periodically review their tactics as well as their strategies. Soros has kept a trading diary for review – that is a fine precedent. Theorema Asset Management systematically review every position after it has been closed for lessons (good and bad). If a manager’s return analysis shows that a sector or sub-strategy has not been profitable it should be eliminated, unless it is hedging.
2. Having a vastly more experienced quarterback does not guarantee anything.
Peyton Manning has a winners ring and a long, acclaimed career behind him. Russell Wilson, his opposite number is in only his second season as a professional ball player. In the Super Bowl Manning achieved a record 34 completions. Wilson was the winner in the big game.
Institutional investors know that the academic evidence clearly shows that smaller, middle-aged hedge funds do better than larger long standing hedge funds on average. To date they have not acted on it much. Manning could not win the Super Bowl on his own. In particular he needed much better pass protection. As hedge fund management companies get larger the quality of the lieutenants becomes more important relative to the quality of the guy whose name is over the door.
3. Top teams are capable of winning different ways.
Pete Carroll built a team which could win in a variety of ways. In the Super Bowl his leading rusher Marshawn Lynch was limited to 39 yards in 15 carries – partly by the Broncos’ defense, but also by the choice of the offensive coach of the Seahawks. However the QB and wide receivers were good enough to play some ariel football and come out ahead, even though the offense was perceived to be all about a running game.
Whatever investment category a hedge fund manager falls into they have to have sub-strategies within the broader label that enable them to make money most of the time. Otherwise they are not absolute return vehicles. Classically that is what event driven managers do by combining merger arbitrage and distressed investing – the two operate on complementary economic/capital market cycles. The same should apply to all managers through bucketing trades into different categories – value/growth/recoveries, or upstream/downstream, or late stage/early stage companies.
The same even applies to specialist managers. If a financials specialist only buys/shorts banks how do they get diversification? They need to buy/sell banks on different cycles, so maybe in another country, or ones that has been privatised or spun out of a conglomerate that have different operating characteristics, maybe universal banks and monoline banks; regional banks and multi-national banks; or investment banks and commercial banks. The banks held in the fund need to be employing different business models to give diversification – revenue maximisers, market share takers, wholesale funders and those funded by deposits. Whichever the sub-strategies the shares in each bucket have to act differently to give potential for absolute returns most of the time.
4. Buy with a plan.
The Seattle Seahawks acquisition policy has a clear intent. Head coach Pete Carroll wanted to play football a specific way and acquired the players to fit the plan – for example he wants an aggressive defence in the secondary so brought in big athletic safetys and cornerbacks with ball handling skills (of whom Richard Sherman is the loudest and best).
It is obvious that hedge fund managers will only put on positions that suit their style. Pete Carroll also has a habit of acquiring players that other teams have left behind – players picked up late in the draft or who are free agents. 11 of the SB squad of Seattle fall into these categories. Carroll is then able to motivate these players who others did not think good enough through how they came to the franchise. In hedge fund land it would be good to see managers take on staff who have something to bring to the party themselves through their life experience rather than the cookie cutter MBA clones that dominate the analytical teams.
5. New tactics or plays keep the team fresh and the opposition on the back foot.
The Seahwaks had an ace in the hole in returning receiver Percy Harvin. Harvin had barely played in the regular season, so the Broncos defence had no current film with which to prepare themselves. Harvin’s known talent was fulfilled in the big game as he returned a kick for an 87-yard TD run.
At the least, markets adapt to how participants operate. Also what was a unique edge tends not to remain unique if it is a data source or trading technique. These phenomena mean that hedge fund managers have to make efforts to refresh their approach by trying new ways to trade and make money. Standing still and doing exactly the same thing for multiple years will tend to generate lower returns through time.