By GFIA Team, led by Peter Douglas
The monthly “thinkpiece” as we call it in GFIA, is 
usually a qualitative commentary on what we’re seeing at the moment in our world. This month, however, we’re going to go over some of our learnings from 28 years’ exposure to the world of professional investing (and including the experience of our many analysts over the years, perhaps an aggregate 50 or 60 years).
This was triggered by a combination of a review of the management of some funds of funds that we ran in the mid-2000’s, and some long plane rides catching up on a mix of great research and product pitches. I hope the following at least gives some thought. It was, personally, a useful exercise to reiterate them.
1. Size matters
For alpha-seeking investors, this is the first commandment. Alpha comes in small packets. An investment proposition with a certain set of characteristics, $x of assets will not be the same at $y of assets. A simple thought experiment: in a market of say US$1bn market capitalisation, an investment of US$1bn is the market, and hence is pure beta. An investment of zero is pure alpha (it has no correlation to the market). Scaling any investment up ad absurdum will change alpha into beta. The question, of course, is at what point does your scarce alpha start to morph into beta. GFIA has done much research over the years in its own backyard (see previous reports), but each market, asset class, or strategy, will have its own level. Be aware of it.
Remember that in a market dislocation (which is when your risk management process, whatever it may be, is tested, measured, and results in the continuation of your account, job, or business…) that level of liquidity is likely to be quite different. You scale your investment according to extraordinary market conditions not normal markets.
Size also matters in the organisation. Fiduciary organisations, such as fund management companies, are in business to look after other people’s money as their primary and overriding responsibility. In our experience the larger the organisation the harder this becomes (as the organisation may have to protect shareholders first – a legal requirement – or its own people’s careers, ahead of its clients). So be aware of whether the scale of the organisation that you are dealing with is appropriate given your level of dependence on their fiduciary probity. The more you may need the organisation to prioritise your interests in a difficult situation, the smaller it should be. The financial crisis of 2008 provided excellent empirical evidence; overwhelmingly the firms that protected their interests ahead of their clients were the large asset gatherers and not the boutiques.
2. The “investment management” business is misnamed
It’s the “risk management” business. Perhaps for the same reason that “Greenland” is thus called (as opposed to “cold, dark, and remote-land”), “investment” sounds sexy. But only in the case of some very specific arbitrages can we control investment return, and then only within the parameters of some often volatile “constants”. Generally, Mr. Market, in some form, gives or denies an investment return, not a smart CFA sitting at a Bloomberg terminal. What we can do is control the types (most importantly) and amount (secondarily) of the risks we’re prepared to accept in order to achieve the potential of a return.
For example, in allocating to any investment strategy, it is always and invariably objectively and factually accurate to say “I do not know how this investment will pan out”. Any opposite statement is, as a politician might say “a misstatement of the facts”. However, we can say that we have done enough due diligence to accept the risks that, for example, (i) the manager may be lying about their adherence to their pitchbook process (ii) the firm that manages the portfolio may not be a stable organisation (iii) the service providers to the portfolio may place their interests ahead of the portfolio’s (iv) the market environment may change in such a way as to invalidate the investment premises inherent… & etc. We can get comfortable, or at least evaluate our degree of discomfort with, the risks governing the shape of our investment, no more.
3. Volatility is a return metric, and has little to do with risk
Volatility – the amount by which a price wiggles in the short term – is normally a good thing. If, as investment professionals, we’ve done our job correctly, we will have found asymmetric investments, where the potential upside is greater than the potential downside (and/or, upside movements are greater than downside movements). Price movements in a well-chosen investment therefore should, on average, be in our favour. Return-seeking investors should seek volatility.
Volatility is not a risk metric. If you’re a quantitative believer, you know this because volatility is predicated on a normal distribution of returns, a state of affairs rarely seen in the investment world. If (like us) you’re more of a pragmatist than a quantitative dreamer, you’ll still understand this point. Catastrophic risk is the possibility of losing capital; investment risk is the possibility of not achieving the desired return over the period of the investment. Neither of those risks is described by volatility or its derivatives.
We all know how easy it is to “game” an investment’s Sharpe ratio and yet we’re mesmerised by the metric. We all headline a fund’s characteristics in terms of its annualised return and volatility. The concept of volatility as the summary risk metric is embedded in our professional doctrine. But it’s wrong.
GFIA’s hierarchy of approach to risk is as follows:
I. What is the likelihood of any event irreversibly eroding capital in this investment. Then,secondly…
II. What is the likely effect of a relevant market dislocation on the value of this asset? Then, thirdly…
III. What is the likelihood of this allocation not contributing sufficiently to the overall return of the portfolio?
Note that all of these “measures” are forward looking and therefore depend on skill, experience, and judgement to create their inputs. We understand that it’s seductive to rely on historic information (it’s accurate! it’s verifiable! the intern can source it cheaply! the spreadsheet will update automatically!) but it’s intellectually lazy, and not very responsible if you’re answerable to other people’s money.
4. Diversification is the only universally effective risk management tool
There is a always a possibility that one of the risks that we accept in making an investment will cause loss. Diversification is the grouping of risks with different characteristics with the intention that adverse developments in one risk will not be reflected in another.
Hedging is a classic diversification strategy, matching some substantial risks in a financial position with “anti-risk”, leaving, in principle, a residual desired net risk position. The possibility that Goldman Sachs may be a criminal organisation that steals the assets of the fund to which it is a prime broker may be unlikely to the point of being statistically insignificant but, mathematically, is not zero. So we see many hedge funds holding assets with multiple prime brokers (of course not just for the triad/mob/mafia/yakuza risk!), and furthermore trying to hold assets with prime brokers subject to different regulators, reflecting the current cold war between developed world regulators and their financial institutions.
However, diversification does not mean “owning lots of different stuff”. It means “owning lots of things that react differently”. It is a forward-looking exercise. The point is to consider each asset or investment in the context of what creates its specific return and risk profile, and to aim to own a mix of assets or investments that will have different drivers of return and risk from the point of investment onwards – in the future, not the past.
For example, in the Asian hedge fund industry in the mid-2000s, a clear thinker would have recognised that pretty much everything was correlated with rising market liquidity. Owning an Indian hedge fund, a China hedge fund, a Japanese hedge fund, was not therefore very helpful in diversifying a portfolio. Owning a long volatility portfolio (then… it might be different in 2013) was however a good hedge against a potential liquidity event (that turned into an actual liquidity event).
At a strategic level, the investment job is about understanding what risks we’re actually taking, going forward, and thinking about which risks we want… and which risks to mitigate, and how. Note, again, that diversification, like so much in our world, is forward looking and dependent on skill, expertise, and judgement; relying solely on historic data for your inputs is sloppy.
5. We are in a qualitative, subjective industry
If you can measure it, it’s in the past and therefore a reference not a definitive decision metric. Please let me repeat that; it’s so obvious and so often ignored. If you can measure it, it’s at the bottom of your list of “good to know” information as an investor.
We know that relationships change and breakdown. We know about discontinuous events. We know about market dislocations. We know about exogenous events. We know how a portfolio’s characteristics change with size and changing market conditions. But we still cling to the Linus-blanket of historic data as a way to get comfortable with the future. Especially at the moment, in late 2013, as we participate in the world’s central banks “five year mission to boldly go [1] where no man has gone before”… using historic data to forecast the future is monumentally misguided.
The future is unknowable. That’s scary, especially as you’re entrusting large amounts of other people’s money to the vagaries of the future… so the need for comfort is very real. But clinging to the fallacy of persistence is an ostrich strategy. The responsible job, as investment professionals, is to say “I don’t know”. Not to say “I know about the past, therefore I know about the future”.
For example: Risk Parity. Allocating across, hopefully diverse, assets so that their risk contribution is broadly similar (and then making investment judgements relative to that risk parity) is an intellectually robust approach, and one that GFIA has used with success in the past. However, constructing a risk-equal portfolio using historic measures of risk, is like taking a great philosophy and reducing it to a screenprint on a cheap t-shirt. Risk Parity based on historic measures will create a portfolio that doesn’t behave as planned because the future will be different from the past. A Risk Parity approach based on forward-looking estimates of risk/reward drivers has a greater chance of success.
6. There is no genius in investment management
The market (whether it’s a financial market like a stock exchange, the market for land in Uruguay, or the market for energy in Europe) is a complex organism composed of many highly motivated players. The concept that one individual, by dint of exceptional intellectual brilliance, can out-think the wisdom of the market is like conjecturing that the processing power of one computer could outrun a massively networked chain of processors. It’s just not credible.
Idiosyncratic investment success comes from:
• A sustainable structural edge. For example, a smaller fund in Asia that participates in private credit issuance in Europe may create a sustainable edge because (i) they are included in major bookbuilds even though small, because as an Asian name they add diversity (ii) they trade in Asia, half a day after the issue has opened in Europe so they have information about day-1 trading and (iii) they are small enough that such trades make a difference to their NAV.
• Long professional engagement in a confined niche. An investor who has spent a 15-year career investing into Japanese convertible bonds may well have an internalised sense of the market dynamic that enables them to make consistently better incremental decisions. As a practitioner, we generally look for 10 years’ unbroken p&l
responsibility as a benchmark of professional engagement in a particular niche.
• Liquidity mismatching. An investor with a different time horizon from that of the majority of market participants may create a sustainable edge by being able to take a longer or shorter view than “the market”. A fund with permanent capital and gearing abilities may be able to outperform in a market dominated by shorter-term investors (cf Warren Buffett, although Berkshire Hathaway also has a structural advantage in its
tax treatment as an insurance company). Conversely, a fund with the technology to trade instantaneously, cheaply, and for short periods, may create out-performance in a market dominated by “normal” investors.
• Better analysis. In markets with limited professional analysis, an investor that can throw more analyst-hours into research can therefore create a better understanding of the asset and its likely return drivers and risks. Many small-cap investors would fall into this category, as they invest into an asset class that’s unattractive for the sell-side to allocate analyst resource, and hence can create a sustainable research edge.
• Influence. An investor that can influence the price of her investments clearly will create an advantage. Activist investment would be a common example, as would some forms of distressed debt investing. As a practitioner’s note, often in emerging markets in particular, the investor’s connections with some influential faction are cited; however we invariably avoid these sources of “influence” as ephemeral and reversible.
So for any investment strategy, it’s important to understand why the investor may continue to do well. I guarantee you, if your only answer to this question is “the PM’s brilliance”, it will disappoint.
7. Constraint trumps opportunity
This one is disappointing, but a truth of the investment world. More, many more, investment dollars are allocated on the basis of what’s practical, feasible, and allowable, than are allocated based on what makes optimum investment sense.
An organisation wishing to extract alpha from the inefficiencies of Asian capital markets with good protection from loss of capital, may be best advised to invest in a portfolio of 5-7 diverse strategies each run by experienced specialist boutiques in the region. Whether that organisation has the travel budget to oversee these investments, the headcount to research and monitor them, the legal and tax structure to invest in offshore vehicles, or the organisational governance structure to make the decision to invest with a group of small organisations in a different time zone… these are all likely to be much more important drivers in deciding whether the capital is allocated.
We often hear rants from managers about the stupidity of institutional investors. Generally they’re unfounded: most individuals we’ve met from the institutional investment community are smart, hard-working, and conscientious. It’s the nature of their organisations that leads to “stupid” investments; investment decision that, however, in the context of the organisation, are optimal in balancing all the needs and constraints of that organisation.
While we’ve seen some inspired and sensible investment decisions made by institutional investors into our world, we’ve seen far more sub-optimal allocations, made because of the shape of investment decision-making, the level of resource, or the governance structure.
This is a painful one for GFIA. For fifteen years we’ve always tried to arrive at investment “truths” (and we think have succeeded more often that we’ve failed), but have consistently failed to understand what the realpolitik of institutional investing actually needs in order to get money to work. Hence today we still have a small business not a large business!
About the author: GFIA offers non-discretionary advisory services for hedge fund and absolute return investors. GFIA focuses on managers with clear geographic and knowledge edges based in Asia, Latin America and frontier markets. GFIA does not provide marketing services to funds – it is fully objective in offering non-conflicted research and advice to institutional clients.
GFIA offers a comprehensive range of services, driven by coverage and intensive analysis of skill-based absolute return funds since 1998.
• market intelligence and manager review of funds within GFIA’s universe
• due diligence and manager analysis
• portfolio construction and non-discretionary management
• advisory services
• wealth management services
For more information visit www.gfi a.com.sg or email gfia@gfia.com.sg
[1] ..not my split infinitive!