Whitebox on Risk & Risk Management

There must be something in the Whitebox water supply: it's producing an army of investment math nerds with acute self-awareness and sensibilities, led by their fearless leader Andy Redleaf. Those of you who have not yet seen Whitebox's "10 Enduring Principles To Interpret Constant Market Change" are missing out -- it is absolutely worth three minutes of your day. The text below is extracted from a Jan 2015 Andy Redleaf article titled "Getting Past the Romance of Risk":

“The courage to ‘take a chance.’ The fearlessness of being a ‘risk taker.’ Risk as the force of entrepreneurship. These ideas are so ingrained in the American psyche that in the investment industry they have become dogma: to increase returns the investor must be willing to accept more risk. That is the core result of Modern Portfolio Theory, even if it is hedged with theories about how to accept risk systematically on the “efficient frontier.”

Given this persistent quasi-romance with risk, we have to ask: What great investor or entrepreneur ever succeeded by deliberately taking on more risk?

...the entrepreneur’s goal should always be to create asymmetries of risk and reward in which there is far more to be gained than lost. We strongly believe all investment managers should be doing the same, which is why the first of Whitebox’s 10 Investment Principles is: The source of investment return is the efficient reduction of risk.

If risk is not the basis of return, should an investor strive to take no risk at all? No. There is no such thing as a risk-free portfolio. We believe that the right goal is to reduce risk efficiently: reduce the risks of a position more than one reduces its potential return. One can do this in various ways, but it comes down to the investor striving to own only and exactly what he wants to own…

How do we believe an investor can own only and exactly what he wants to own? In practical terms, what does this look like?

In reality, most securities, taken individually, are bundles of both good and bad qualities. Even a stock that presents generally favorable prospects for potentially good returns is likely to contain at least some unfavorable qualities; the same is generally true for bonds. As such, we believe the key – and the whole point of alternative investing – is to be able to identify and isolate the good from the bad, so that you own only and exactly what you want.

How is this achieved? Sometimes this is done at the security level, by buying securities with desirable qualities and canceling out the undesirable qualities through carefully constructed positions in our short book. Sometimes it is done at the portfolio level, by combining investment “themes” in ways that retain the attractive qualities of an investment idea while, hopefully, canceling out the risks.

Sometimes, it can be achieved by striving to identify and implement hedges that are in themselves what we perceive as sound, attractive investments, the goal being to reduce risk through tactics and decisions that are themselves potentially return-generating investments…

Viewing risk-reduction in itself as a source of potential returns is in stark contrast to a more traditional approach, which we believe accepts some measure of loss in exchange for potential payoff.

Exercising sound judgment in investing, we believe, involves choosing the particular over the abstract. This can mean the difference between buying up “lots” of securities in bundles (often to satisfy a predetermined allocation percentage, for example) versus sorting through individual names, looking for nuances lurking beyond-the-obvious that enhance value, and identifying idiosyncratic dislocations – even among securities that are bought and sold in “lots.” It means looking at risk specifically, not from a high level of abstraction, striving to reduce that risk efficiently through a hedge that in itself is an investment with potential payoff.

Put another way, we believe efficient reduction of risk begins with and cannot be separated from the investment process. To us, every investment decision, therefore, should be a decision about risk. We reject the concept of risk management as an “overlay.”

Most of all, we believe this investment principle entails viewing risk and risk mitigation as a matter of judgment. We feel confident in our belief that investors who exercise good judgment are more likely to prosper than investors who do not…

Seen from this perspective, the concept of risk is somewhat reframed. We simply reject the idea that says “the greater the risk, the greater potential for return.” To us, a truly alternative approach to investing involves what we believe to be a fairly straightforward endeavor: efficiently reduce risk so as to own only and exactly what you want to own.”

On efficient markets: “We believe this…approach to investing isn’t safe, mostly because we see it as lazy. On every point listed above, we’re convinced that money managers who go along with these dogmas are saving themselves work, but risking investors’ money.”

The Illusion That Returns Are Enough

"I believed if we delivered high double-digit returns at relatively low volatility, the rest of the business would take care of itself. I have been cured of that illusion." --Andy Redleaf, Whitebox Anyone who believes that investment acumen alone is enough to build a successful investment management business should read the article below. Excerpts are derived from Andy Redleaf's April 2014 Commentary.

“Back in 1999 when I launched Whitebox, I was determined to build an investment organization full of intellectually passionate, creative money managers who by working together would perform better than as individuals—with the side benefit of an enormously fun and stimulating place to work. We would be organized around a shared investment philosophy, driven by unconventional investment ideas, and settle disagreements by reasoned argument and persuasion, not reversion to status and testosterone wars. If we had a cult it would be a cult of ideas, not of personality.

When I left Deephaven Capital Management I was in a position financially to do pretty much what I liked, including going back to what I had done for most of my career: make a nice living trading on my own account. I knew I didn’t want to do that. I liked coming up with investment ideas; figuring out what the market was thinking and how to respond, but I didn’t like doing those things alone. I wanted camaraderie. I wanted the stimulation of debate and discussion with other smart people who shared my interests but who knew things I didn’t or had skills I lacked.

So I launched Whitebox as a collaborative, intellectually dynamic organization. It was always intended not as a fund but as a fund family. And it was never my intention to manage any Whitebox fund directly…I wanted to work with people who would be better fund managers than I. My job would be to articulate our investment philosophy, foster collaboration, and propose or critique investment ideas and strategies in a way that would not discourage the flow of ideas but promote it."

"That was always the Whitebox idea. Gather together outstanding managers like Rob, Jason, Paul and our about three dozen investment professionals and talk to each other for fun and business. Twenty of those professionals—myself, the three Global Strategy Heads, and 16 “Senior Portfolio Managers”—are authorized, at need, to trade on their own authority without asking anyone’s permission. Of course they rarely do except in routine matters, because discussion and collaboration is at the core of what we do...I have no data, but I’d guess the average age of senior investment people at Whitebox is on the high side for any hedge fund that has more than a handful. People stay here.

Of those 16 Senior Portfolio Managers, by the way, none of them has an independent P&L. There are firms, even successful firms, that handle talent by giving the talent a little capital, waiting a quarter to see if they lose money or make money and then firing them or giving them more capital accordingly. It’s supposed to be a ruthlessly rational way of evaluating talent, just as the market is supposed to be ruthlessly efficient. I think it is a great way to court disaster. The Hedge Fund as Band of Quasi-Independent Gun Slingers goes against everything we set out to accomplish at Whitebox. It encourages secrecy and all the bad things that come with that. It also wastes people’s brains.

Maybe Einstein orNewton needed to work in splendid solitude, but most pretty-smart people benefit from some intellectual back and forth and the mutual support of a team. Solitude especially makes no sense for an organization focused primarily on arbitraging relative value relationships often across markets or even geographies. Metcalfe’s Law says the value of the network is the square of the nodes. Whitebox is a network of professionals. Their outbound focus may be on a particular strategy or asset class—in that sense we get the benefits of specialization. But looking in or across the network, their job is to share information so that collectively the organization has a broad view of multiple market relationships.

In any case, the fact that 16 SPMs have independent trading authority gives some sense of their stature in the firm and to what extent we have succeeded in building the collaborative, non-hierarchical, principle-based and idea-driven organization we set out to build almost 15 years ago. Our approach to the Investment Committee is another example. Ninety percent of our work is done outside of our weekly meeting in daily ongoing discussion. Even in meetings we don’t vote and no one has a veto—we discuss until we reach consensus."

"When I launched Whitebox I believed if we delivered high double-digit returns at relatively low volatility, the rest of the business would take care of itself. I have been cured of that illusion.

Over the past year or so we’ve been engaged in a monumental effort—still ongoing—to strengthen everything else about the business. Doubling the size of the Marketing Group to improve the customer experience has been part of that. I think it is beginning to show. Certainly we know many of our investors better than we did a year ago, and have more frequent contact. More recently we have expanded the responsibilities of our Communication Group to work more closely with Marketing in refining the tools we use to communicate with investors and prospective investors so that they begin to know us better as well….

Since launching Whitebox nearly 15 years ago, I believe we have built a durable organization, rooted in a set of beliefs, even an ethic, that is the real source of our ongoing success. Whitebox is not just an investment company, it is an investment culture. Helping to build that is what I’d like to be known for."

Wisdom from Whitebox's Andy Redleaf

Ever experience those humbling moments when you read something and think: “Wow, this person is way smarter than me” – happens to me every single day, most recently while reading a Feb 2013 Whitebox client letter during which Andy Redleaf & Jonathan Wood devoted a refreshing amount of text to the discussion of portfolio management considerations (excerpts below). Enjoy!

Hedging, Exposure, Mistakes

“The job of the arbitrageur, as we see it, is to isolate the desired element, the desired asset claim, which in turn is usually desirable because it trades at a different price from a similar claim appearing under some other form. The purpose of a hedge in this view is not to lay off the bet but to sharpen it by isolating the desired element in a security from all the other elements in that security.

If we think about it this way, then alternative investing can be defined as owning precisely what the investor wants to own, in the purest possible form. Sadly, owning just what one wants to own is no guarantee that one will own good things rather than bad. But at least a true alternative investor has eliminated one whole set of mistakes – owning stupid things by accident. If the alternative investor owns stupid things at least he owns them on purpose.

The really bad place to be is where all too many investors find themselves much of the time, owning the wrong things by accident. They do want to own something in particular; often they want to own something quite sensible. They end up owning something else instead.”

Volatility

“Consider, for instance, the stocks of consumer staples companies. Because no one can do without staples, these stocks are often assumed to be insensitive to the economy. And because they are, on the whole, boring companies without much of a story they generally fall on the value side of the great glamour/value divide. Precisely these characteristics, however, recently have caused them to be heavily bought by safety-conscious investors so that as a group they are now priced to perfection…

Throughout markets today the most powerful recurrent theme is the inversion of risk and stability; almost universally securities traditionally regarded as safe and stable are neither. We are less confident in opining that securities traditionally regarded as speculative have now become safe. Still the thought is worth following out… Tech is traditionally thought of as speculative, but Big Tech today is not the Tech of the go-go years. These days Big Tech is mostly just another sub-sector of industrials.”

A great example for why historical volatility is not indicative of future volatility (as so many models across the finance world assume).

Volatility is driven by fundamentals and the behavioral actions of market participants – all subject to the ebb and flow of changing seasons. If fundamentals and the reasons driving behavioral actions change, then the volatility profile of securities will also change.

Diversification, Risk

“Speaking of looking for safety in all the wrong places, diversification is widely regarded as a defensive measure. This is a misunderstanding. Diversification in itself is neither defensive nor aggressive. It is a substitute for knowledge; the less one knows the more one diversifies…In our credit strategies, diversification was the watchword for 2009. We bought essentially every performing bond priced below 40 cents (an extraordinary number of such being available in that extraordinary time). We did this because collective the expected payoff on such bonds was enormous…It made no sense to pick and choose. Making fine distinctions about value in an inherently irrational situation more likely would have led us astray. In that situation diversification, rather than blunting the investment thesis, actually helped us focus on the best on the interesting factor: the market-wide loss of faith in the bankruptcy process.”

I think it's an interesting nuance that diversification itself doesn't necessarily "blunt" the potency of ideas. In certain instances, such as the one outlined above, diversification lends courage to investors to size up ideas without committing to one or two specific firms or assets.

In his 1996 letter, Seth Klarman has discussed something similar, using diversification to mitigate unfamiliarity risk by purchasing a basket of securities exposed to the same underlying thesis and opportunity set.

Diversification, Volatility, Expected Return

“The downside of a concentrated portfolio is that returns tend to be lumpy and dependent on events.”