The Sugar Cookie


Many moons ago, we shared with you this matrix highlighting the importance of focusing on process over outcome.


In every investor’s lifetime, there will inevitably be one or more instances of “bad breaks” – when the investment process was solid, but the outcome was nonetheless bad. If that has ever happened to you, then you know what it feels like to be a sugar cookie.

What the heck is a sugar cookie? Here is the definition as explained by Naval Admiral William H. McRaven in a recent speech given at the University of Texas:

“Several times a week, the instructors would line up the class and do a uniform inspection.  It was exceptionally thorough. Your hat had to be perfectly starched, your uniform immaculately pressed and your belt buckle shiny and void of any smudges. But it seemed that no matter how much effort you put into starching your hat, or pressing your uniform or polishing your belt buckle--- it just wasn't good enough. The instructors would fine ‘something’ wrong.

For failing the uniform inspection, the student had to run, fully clothed into the surf zone and then, wet from head to toe, roll around on the beach until every part of your body was covered with sand. The effect was known as a ‘sugar cookie.’ You stayed in that uniform the rest of the day, cold, wet and sandy. There were many a student who just couldn't accept the fact that all their effort was in vain. That no matter how hard they tried to get the uniform right, it was unappreciated.

Those students didn't make it through training. Those students didn't understand the purpose of the drill.  You were never going to succeed.  You were never going to have a perfect uniform. Sometimes no matter how well you prepare or how well you perform you still end up as a sugar cookie. It's just the way life is sometimes. If you want to change the world get over being a sugar cookie and keep moving forward.


How Selective Is Too Selective?


A very smart friend and I were trading emails recently (comparing notes on a particularly hairy investment) and our conversation veered toward the issue of selectivity in an increasingly expensive and upward moving market. We reminisced about the good ol’ days (2008-2010) when fairly good businesses would trade at 5x FCF, or banks with clean balance sheets and decent ROEs were trading at 50% of book value. Whereas today, the cheap names usually come with patches of ingrown hairs. So I asked him, “Does it bother you that the market is pushing you into hairy stuff like this? Selectivity standards have obviously come down since a few years ago, but how far down are you willing to let them go?”

His answer: “I've been thinking a lot about how the market is pushing us into crappier stuff. The problem is, I think this is closer to normal. 2008 and the following years were something we get only a few times during our careers. Downturns like the summer of 2011 probably happen with more frequency. So in between, we have to figure out how to scrape together money generating ideas. I think this makes your focus on portfolio management more valuable. Portfolio construction is going to be more important.”

All too often we hear cautionary tales of selectivity & patient opportunism, but the actual implementation is far trickier. Howard Marks summed this up nicely a few months ago: “You have to learn lessons from history, but you have to learn the right lessons. The lesson can’t be that we are only going to have a portfolio that can withstand a re-run of 2008, because then you could not have much of a portfolio.” 

Perhaps the take-away here is that greed can lead to sub-optimal results in both directions. Greed in keeping your selectivity standards too high can lead to the risk of returns foregone. Greed in letting your selectivity standards slip as markets & prices move higher can lead to the risk of overloading your portfolio with unmanifested-risk and future losses.

Once again, investing forces us to delicately balance two opposing forces, which brings to mind Charlie Munger's quote: "It’s not supposed to be easy. Anyone who finds it easy is stupid."


Asymmetry Revisited


Return asymmetry is a topic that emerges over and over again on PM Jar. It’s a topic that spans across investments strategies and philosophies (see the end of this article for links to previous PM Jar articles on return asymmetry). This is no coincidence – creating (positive) return asymmetry over time is the hallmark of great investors. So why is it so important to achieve positive return asymmetry (through decreasing the number of left tail / negative return occurrences)? Because positive return asymmetry saves investors from wasting valuable time and effort digging out of the negative return hole (compounding math is not symmetric: losing 50% in one period requires gaining 100% in the next period just to breakeven). This holds true for all investors, regardless of investment strategy and philosophy, hence why the theme of return asymmetry comes up so often.

Our last article on Howard Marks discussing the ability of a fund manager to outperform and add-value by reducing risk reminded me of article that a kind Reader sent me earlier this summer (Comgest Commentary 2013 July) in which the author describes with refreshing clarity the importance of creating positive return asymmetry and the interplay between compounding, capital preservation, and risk management. Compounding, Capital Preservation, Trackrecord

“The Asymmetry of Returns Dictates the Compounding of Returns:

Berkshire Hathaway CEO and legendary investor Warren Buffett is often quoted as saying, “Rule No.1: Never lose money. Rule No. 2: Never forget rule No. 1.” But why are these the most important two (well, one) rules of investing? The answer lies in the inherent asymmetry of returns, which is the basis for how returns compound over time.

If you start with $100 and subsequently gain 10% and then lose 10%, it may be surprising that you don’t end up back with the same $100 you had at the beginning. The reason is that your 10% loss hurt more, because it came off the larger asset base you had after your 10% gain. In sequence: $100 → gain 10% ($10) → $110 → lose 10% ($11) → $99. You can reverse the order of the gain and loss and the end result is still the same: $100 → $90 → $99, where your percentage loss is still based on a higher amount of capital than is your percentage gain. The end result is a net loss of 1%, hence the asymmetry – gains and losses of equal percentages have different impacts. As your returns swings get larger, this effect becomes more pronounced. For instance, starting with $100 and then gaining/losing 20% leaves you with a net loss of 4%, while gaining/losing 50% leaves you with a net loss of 25%. At the extreme, gaining/losing 100% leaves you with a net loss of 100% – all your capital, resulting on complete ruin. It doesn’t matter what any of the other payoffs are for someone who at any one point loses his or her entire bankroll.

Another way to look at this is to see what kind of return is necessary to get back to even after a loss. If you lose 10%, you need an 11% gain to get back to even. If you lose 20%, you need a 25% gain to close the gap. Losing 50% requires a doubling of your money, while losing 90% means you need a 900% return (!) to compensate. While 100% losses are rare in equity portfolios and thus true ruin is unlikely, this exercise shows how large losses cripple the long-term returns of a portfolio.”

“...the goal is to avoid an 'extinction' event, which I’ve put in quotes because extinction for an investment portfolio doesn’t only mean complete disappearance. It can also be seen as irreparable damage to a long-term track record.”


“Risk Management and Higher Math Are Not Natural Partners:

…The prevailing view of risk management in today’s investment world seems to be that it must be done with a lot of math and only a set of numbers, preferably from a complicated model, can describe an approach to risk. That’s just not how we see it. Instead, we think understanding the companies’ profitability characteristics is a far more effective way to understand the risk embedded in a portfolio. We side with James Montier, who wrote, “The obsession with the quantification of risk (beta, standard deviation, VaR) has replaced a more fundamental, intuitive, and important approach to the subject. Risk clearly isn’t a number. It is a multifaceted concept, and it is foolhardy to try to reduce it to a single figure.” Even the revered father of modern security analysis, Benjamin Graham, tips his cap to a more fundamental and less market-price-driven approach to risk: “Real investment risk is measured… by the danger of a loss of quality and earnings power through economic changes or deterioration in management.” It’s important to realize that our view of risk is at the fundamental security level, while standard industry risk models start from price volatility and covariance matrices, which are market-level inputs. In other words, we focus on what’s happening in the business, not what’s going on in the market, to understand risk. We think that our approach to risk management, that of decreasing the left tail of the distribution of potential outcomes by buying quality stocks is a more time-tested approach that runs a far lower risk of model specification error.”

In case you'd like some related reading, here is what Howard Marks, Stanley Druckenmiller, Warren Buffett, and others have said about return asymmetry.


An Anecdotal Gem


The following anecdote comes from WkndNotes by Eric Peters (a treasure trove of humor and investment insight) and touches upon Tesla. Our readers know that PM Jar does not discuss ideas, and we have no intention of jumping into the Tesla debate or to declare ourselves Musk-lovers. The reason why we are showcasing this excerpt is because reading it, especially the last sentence, struck a chord. Enjoy. " 'Driverless electric Tesla’s, powered by Google, dispatched by Uber will shuttle people around continuously – the technology already exists, this future is inevitable,' explained the brilliant macro CIO, basking in California’s bright sunlight, whisking me 20yrs forward. Of course, regulations need to catch up. They will. 'And annual car sales will collapse from today’s 100mm pace to just 20mm.' You see automobiles are driven only 3% of the time, meaning the world needs far fewer once we harness technology to utilize them more efficiently, continuously. 'In that future, with Tesla as the world’s #2 auto company, it’ll be worth $100bln versus today’s $20bln market cap.' He’s owned Tesla for years, but is now nearly flat, waiting for a pull back. 'Most buyers today think it will be another BMW and with that rather modest ambition, it’s now aggressively priced.' Anyhow, the world is changing rapidly. Accelerating. So equity investors clamor to buy disruptive companies that’ll shape it, drive it. 'Maynard Keynes said in 100yrs, people will need to work 4hrs per week to meet their needs, and here we are.' Naturally, the growth in our 'needs' has far outpaced productivity gains. So we’re working harder than ever. But a radically new phase has begun, where robotics dominate production, services too. Thus the owners of capital and machines will accumulate vastly disproportionate wealth, while the middle class sinks. The poor drown. And governments race to redistribute or face riots, revolution. 'Viewed in this context, Obama-care was inevitable.' So I asked what theme most interests him. You see, he’s developed a series of simple rules to identify errors people make in their investment theses. 'I’m looking for opportunities in areas distorted by people who are afraid of change, yearning for things that are simply never coming back.' "


Embracing Chaos & Randomness


Investing is hard on the psyche. Events don’t always make sense, yet external pressures often demand that you make sense of everything seemingly random. This can lead to frustration stemming from cognitive dissonance -- the discomfort experienced when simultaneously holding two or more conflicting ideas, beliefs, values or emotional reactions. Perhaps this is why I enjoyed reading this speech that a man named Dean Williams gave almost exactly 32 years ago, advocating the value of simplicity and keeping an open mind to new possibilities, even if they don’t always make sense at first. Many thanks to my friend Dhawal Nagpal for sending this across. Psychology, Creativity

“The foundation of Newtonian physics was that physical events are governed by physical laws. Laws that we could understand rationally. And if we learned enough about those laws, we could extend our knowledge and influence over our environment. That was also the foundation of most of the security analysis, technical analysis…methods you and I learned about when we first began in this business…if we just tried hard enough…If we learned every detail about a company…If we discovered just the right variables…Earnings and prices and interest rates would all behave in rational and predictable ways. If we just tried hard enough.

In the last fifty years a new physics came along. Quantum, or sub-atomic physics. The clues it left along its trail frustrated the best scientific minds in the world. Evidence began to mount that our knowledge of what governed events on the subatomic level wasn’t nearly what we thought it would be. Those events just didn’t seem subject to rational behavior or prediction…the investment world I think I know anything about is a lot more like quantum physics than it is like Newtonian physics.”

“…we should be more content with probabilities and admit that we really know very little.”

Williams highlights three tenets of successful investing:

1. Respect the virtues of a simple investment plans

“Albert Einstein said that ‘…more of the fundamental ideas of science are essentially simply and may, as a rule, be expressed in a language comprehensible to everyone.’” 

“The reason for dwelling on the virtue of simple investment approaches is that complicated ones, which can’t be explained simply, may be disguising a more basic defect. They may not make any sense. Mastery often expresses itself in simplicity.”

2. Consistent approaches – good discipline and the sense to carry them out consistently

3. Exercise the “Beginner’s Mind” – opens your mind to more possibilities, avoids cognitive dissonance, and the possibility of confirmation bias

“A very special tolerance for the concept of ‘nonsense’…Expertise is great, but has a bad side effect. It tends to create an inability to accept new ideas.”

“In general, physicists don’t deal in nonsense. Most of them spend their professional lives thinking along well-established lines of thought. The ones who establish the established lines of thought, however, are the ones who aren’t afraid to venture into what any fool could have told them is pure nonsense…‘In the beginner’s mind there are many possibilities, but in the expert’s mind there are few.’”

How To Motivate Your Analysts


I've always found it curious why talent turns over so frequently at investment firms (at least in hedge fund land). Investing is a judgment-oriented business, and team turnover can be highly disruptive to the investment process. To retain talent, most people throw money at the problem. The video below will show you why that doesn't always work, and some interesting revelations about what truly motivates people. For those of you short on time, skip straight to 4:45  




Mind of an Achiever


In the competitive world of investing, each of us should constantly be seeking out competitive advantages. Personally, I believe that a certain degree of competitive advantage can be found in the cross-pollination of different schools of investment thought. Many in the value school often deride trading strategies, but they cannot deny the existence of those who practice the trading style of investing and have generated fantastical trackrecords over time, even if the disbelievers cannot understand the basis of how they have done so.

The following excerpts derived from Jack Schwager’s interview with Charles Faulkner in The New Market Wizards relate to trading strategies, but I think many of the psychological and process-focused aspects are also applicable to fundamental investors.

Psychology, Portfolio Management

“Natural Learning Processes [NPL]…the study of human excellence…studies great achievers to pinpoint their mental programs – that is, to learn how great achievers use their brains to product results…The key was to identify…the essence of their skills – so it could be taught to others. In NPL we call that essence a model.”

“If one person can do it, anyone else can learn to do it…Excellence and achievement have a structure that can be copied. By modeling successful people, we can learn from the experience of those who have already succeeded. If we can learn to use our brains in the same way as the exceptionally talented person, we can possess the essence of that talent.”

This is the goal of Portfolio Management Jar: to study the rationale behind portfolio management decisions of great investors, and perhaps one day generate returns the way they do. Notice, there’s a distinction between observing the actions and decisions vs. analyzing the rationale behind those actions & decisions. The true treasure trove is the latter – the way they use their brains.

Process Over Outcome, Psychology, Portfolio Management

On characteristics of successful traders:

“Another important element is that they have a perceptual filter that they know well and that they use. By perceptual filter I mean a methodology, an approach, or a system to understanding market behavior…In our research, we found that the type of perceptual filter doesn’t really make much of a difference…all these methods appear to work, provided the person knows the perceptual filter thoroughly and follows it.”

“People need to have a perceptual filter that matches the way they think. The appropriate perceptual filter for a trader has more to do with how well it fits a trader’s mental strategy, his mode of thinking and decision making, than how well it accounts for market activity. When a person gets to know any perceptual filter deeply, it helps develop his or her intuition. There’s no substitution for experience.”

Interestingly, this is very applicable to portfolio management. Because the portfolio management process has so many inputs and differs depending on the person and situation, in order to master the art of portfolio management, investors need to figure out what works for them depending on “mental strategy, his mode of thinking and decision making.” It helps to observe and analyze the thought processes of the greats who came before you, but there’s “no substitute for experience.”

Process Over Outcome, Luck, Psychology

“…if a trader does very well in one period and only average in the next, he might feel like he failed. On the other hand, if the trader does very poorly in one period, but average in the next, he’ll probably feel like he’s doing dramatically better. In either case, the trader is very likely to attribute the change of results to his system…rather than to a natural statistical tendency. The failure to appreciate this concept will lead the trader to create an inaccurate mental map of his trading ability. For example, if the trader switches from one system to another when he’s doing particularly poorly, the odds are that he’ll do better at that point in time even if the new system is only of equal merit, or possibly even if it is inferior. Yet the trader will attribute his improvement to his new system…Incidentally, the same phenomenon also explains why so many people say they do better after they have gone to a motivational seminar. When are they going to go to a motivational seminar? When they’re feeling particularly low…statistically, on average, these people will do better in the period afterwards anyway – whether or not they attended the seminar. But since they did, they’ll attribute the change to the seminar.”

“Medical science researchers take the view that the placebo effect is something bad…However, Bandler and Grinder [founders of NPL] looked at it differently. They saw the placebo effect as a natural human ability – the ability of the brain to heal the rest of the body.”

Mistakes, Process Over Outcome, Psychology

Traders seem to place a lot of value on “emotional objectivity,” a term I found interesting since it’s definitely something that’s applicable to fundamental investors especially in situations involving mistakes.

“We’ve all been in trading situations where the market moved dramatically against our position. The question is: How unsettling or disconcerting was it? What happens when you’re in a similar situation a couple of weeks or even a couple months later? If you begin to experience some of the same unsettling feelings just thinking about it, you’ve conditioned yourself just like Pavlov’s dogs.”

“Manage of one’s emotional state is critical. The truly exceptional traders can stand up to anything. Instead of getting emotional when things don’t go their way, they remain clam and act in accordance with their approach. This state of mind may come naturally. Or some people may have ways of controlling or dissipating their emotions. In either case, they know they want to be emotionally detached from feelings regarding their positions.”

Is important question is how to un-condition oneself, to remain emotionally objective when mistakes have been made. Of course, since each of us is mentally programmed differently, the answer to this question likely differs from person to person.

Psychology, Capital Preservation, Risk

“There are two different types of motivation…either toward what we want or away from what we don’t want. For example, consider how people respond to waking up in the morning…The person who wouldn’t get up until he saw images like his boss yelling at him has an ‘Away From’ motivational direction. His motivation is to get away from pain, discomfort, and negative consequences…He moves away from what he doesn’t want. The person who can’t wait to get out of bed has a ‘Toward’ motivational direction. He moves toward pleasure, rewards, goals…he moves toward what he wants. People can have both types of motivation…but most people specialize in one or the other. They are very different ways to getting motivated, and both are useful in different situations.”

“People who move toward goals are greatly valued in our society…However, the Away From direction of motivation has gotten a bad rap…The Toward motivation may be enshrined in success magazines, but the less appreciated Away From motivation individuals can also be very successful…Many outstanding traders reveal an Away From motivation when they talk about ‘protecting themselves’ or ‘playing a great defense.’ They’re only willing to take so much pain in the market before they get out. As Paul Tudor Jones said in your interview, ‘I have a short-term horizon for pain.’”

“Very often they come in with a developed Toward motivation – toward success, toward money – that’s why they got into the markets in the first place. However, those that are primarily Toward motivated must spend the time and energy to develop the Away From motivation required for proper money management. In my studies of traders I’ve found that it’s nearly impossible to be a really successful trader without the motivation to get away from excessive risk.”

Some people are more genetically inclined to focus on capital preservation. Some people are less genetically inclined to control “risk.”

Observations on Correlation


I recently found an old letter sitting at the bottom of an unread pile of papers. A friend had passed it along with a note commenting “pretty cool…quant/technical work that makes intuitive sense.” Feeling guilty for having forgotten about this for so long, I read through the old letter, and thought the following observation on correlation worthwhile sharing:  “Interestingly we have found that high correlations happen in the most extreme way when macro events dominate (recession, depression or other)… In fact, extreme levels of correlation are reached towards the end of a bear market, most of all. Also…this phenomenon does not occur at the end of bull markets. Things are quite different at that point, as bull markets have strong tendency to become more and more narrow, thus resulting in low – and not high! – correlation between stocks.” 

Something to file away into the mental model archives...

Reflections by Anonymous


A friend sent me a fund letter a few months ago, and I ruminated over whether to post the following excerpt. Ultimately, I felt compelled to share it with our Readers given its beautifully written and reflective thoughts. It indirectly illustrates the competitive nature of this business. The author of this article (and many more just like him, or perhaps more intelligent) is your daily competition in this zero sum game. For anyone who believes that he/she has an edge, it would serve him/her well to reconsider that belief – again surfaces our daily struggle for self-awareness, and the delicate balance between arrogance and humility.


Creativity, Psychology

“I meet a lot of inquisitive and extremely intelligent people in this business and I have come to think that maybe this is something of a problem. Perhaps they are just too smart. Perhaps they just try too hard. Rightly or wrongly, the highest return on intellectual capital of any endeavour in the world today comes from the management of other people’s money. So it is entirely rational (especially if you have never met a hedge fund manager) to assume the industry attracts the brightest, smartest minds. The beautiful mind, if you will. But I am not aiming to outsmart George, Stan, Julian, Bruce or the others. I do not think it is logical to try and outsmart the smartest people. Instead, my weapons are irony and paradox. The joy of life is partly in the strange and unexpected. It is in the constant exclamation ‘Who would have thought it?’

Why did ten year treasuries yield 14% under the vice like grip of iron-man Volker but yield just 1.8% under the bookish and most definitely Weimar-like Bernanke? Why does France in 2012 flirt with the notion of electing a socialist president intent on reducing the retirement age, imposing a top rate of tax of 75% and increasing the size of the public sector? Why do we hang on the every word of elected politicians when Luxembourg’s prime minister Jean Claude Junker openly admits, ‘When it becomes serious, you have to lie’?

You cannot make stuff like this up. It is simply too absurd.

That is perhaps a long way of saying that existentialism is alive and well in the 21st century. For, if the last ten years have taught me anything, it must be that the French philosopher Albert Camus, in his search for an understanding of the principals of ethics that can shape and form our behaviour, may have surreptitiously provided us with three basic principles for macro investing. I am perhaps doing him a gross injustice, but I would summarise as follows: God is dead, life is absurd and there are no rules. In other words, you are on your own and you must take ownership of your own destiny.

For me this has always meant being detached from the sell-side community. It is not a question of respect, it is just that I prefer not to engage in their perpetual dialogue of determining where the 'flow' is. I cannot be reached by telephone. I suspect that I am one of the few CIOs who does not maintain daily correspondence with investment bankers and their specialist hedge fund sales teams. Not one buddy, not one phone call, not one instant message. I am not seeking that kind of 'edge.' [Redacted fund name] occupies an area outside the accepted belief system.

          ‘I have striven not to laugh at human actions,           not to weep at them,           not to hate them, but to understand them’           --Baruch Spinoza, Tractatus Politicus, 1676

I attempt to cultivate my own insights and to recognise the precarious uncertainty of global macro trends. I attempt to observe such things first hand through my extensive travel…and seek to understand their significance by investigating how previous societies coped under similar circumstances. But first and foremost, I am always preoccupied with the notion that I just do not have the answer. I am not blessed with the notion of certainty. Someone once said we should think of the world as a sentence with no grammar. If we do I see my job as putting in the punctuation. But above all, my job is to make money.

It's Still A People Business


I recently read an interview in Inc. Magazine on leadership and people management with Bob Sutton, a Stanford professor. Sutton's audience is mainly corporations and other businesses, but his comments are directly applicable to the investment management business. After all, whether we like it or not, the investment management business is still a business that employs people. Even if you run a small firm with 1 employee (not including yourself), you still need to manage your working relationship with that other individual (whether he/she be analyst or partner).

The article starts off a little slow – feel free to skip directly to the section starting with the word Authoritarian. From there, it’s all good stuff. Some highlights include:

  • The best “coaches have to be schizophrenic. There are prima donnas you have to make feel terrible to get them going. And other players who lack self-esteem that need to be built up. So, half the time, he’s being an asshole, and half the time he’s being a nice guy. That’s because he really understands the people he works with.”
  • The best leaders are “moderately assertive” and are “good at reading a situation to know when to turn up the volume in terms of getting in people’s faces” and when to get out of the way.
  • Research has demonstrated that people prefer hierarchy to anarchy. In most instances, a good leader considers input from others but ultimately steps up and makes the decision.
  • Leadership doesn’t mean absolutely having to make a decision for decision’s sake, and that the lack of decision-making is okay in certain circumstances, such as when there are no good solutions available to a problem.

A portfolio manager needs to be able to effectively manage and motivate his/her team to achieve results. Currently, compensation is the most commonly used management and motivation tool in our industry. But the effectiveness of that tool only goes as far as a higher offer elsewhere – hence the high turnover rate at some firms. A team that is continuously turning over is disruptive to the investment process.

Buffett understood, very early on, the importance of managing and motivating people through praise and appreciation (more details to come in a future article). There are undoubtedly other methods that also work well. PM Jar will attempt to feature more articles in the future discussing effective team management methods relevant to portfolio managers.

What's Benchmark Got To Do With It


In the April 14th edition of the Economist, there’s an article titled Gavea Investments: A Shore Thing, about a $7Bn Brazilian Macro hedge fund run by Arminio Fraga. The following passage grabbed my attention especially after the recent post on Seth Klarman and the topic of a proper benchmark given the increasingly global implications of inflation and foreign exchange. The Economist wrote:

“Running a hedge fund in Brazil is rather different from doing so in other places…Interest rates remain high: the benchmark rate is 9.75%. Local hedge funds report their performance relative to that rate. Gavea keeps around 80% of its book in cash and only takes a position when it strongly believes it can beat the risk-free return.”

The language implies that Brazilian hedge funds (regardless of mandate/strategy) use the Brazilian local “risk-free” interest rate as their performance benchmark. In contrast, most US-based hedge funds use domestic equity indices as their performance benchmark (e.g., S&P 500 and Dow)

Over the last 20 years, asset bases have become increasingly diverse and global, as emerging markets have gained prominence and wealth. US-based funds now have many international clients. US-based investors now make international investments (most investment columns seem to advise at least a sliver of international or emerging market allocation).

As East meets West, North meets South, etc., it is time for portfolio managers and fund investors to set aside tradition and industry standard practice, and begin to reconsider the “proper” investment benchmark?

Invisible Hands Encore


Many thanks to Adam Bain of CommonWealth Opportunity Capital for tipping PM Jar about this chapter in Steve Drobny’s Invisible Hands. “The Pensioner” interviewed “runs a major portfolio for one of the largest pension funds in the world.” He seems to define risk (for the most part) as volatility. Regardless of whether you agree with this definition, the chapter is a worthwhile read because he brings the “risk” discussion to the forefront of the portfolio construction and management process – whereas many currently approach and manage risk as a byproduct and afterthought.

Oh, and he also provides some very unique thoughts on liquidity and illiquidity.

Risk, Expected Return, Diversification

While focusing too much on the (desired) expected return, say 8% per annum, investors lose sight of the actual level of “risk” assumed in the portfolio. The Pensioner believes that “investors on average, are led astray at the beginning of the portfolio construction process by focusing on a return target…the level of risk assumed to achieve that target becomes secondary.”

Currently, it is “common practice” to allocate capital “based on dollar value as opposed to allocating based on a risk budget. Oftentimes, this can lead to asset allocations that appear diversified but really are not…The goal is to build a portfolio that produces the maximum return per unit of risk.” Some may refer to this as maximizing risk-adjusted return.

A good risk management process should incentivize employees to be “cognizant” of risk, and to focus on “risk-adjusted returns, as opposed to just nominal returns…” and “…trade off between the marginal risk consumed by an investment and the investment’s expected return.” This concept is akin to a business’ focus on net income or cash flow, rather than top line revenues.

“Portfolio managers get themselves into trouble when they look at opportunities as standalone risks. The marginal contribution to overall risk is what is most important.”

In essence, “risk needs to be treated as an input, not an output, to the investment process.”

Risk identification is not always straightforward or all that obvious. For example, certain asset classes traditionally considered “nonequity” (such as private equity, real estate, infrastructure, etc.) actually have very equity-like qualities. Fixed income and credit is “really just a slice of the equity risk premium.”


For those interested in the topic of liquidity and illiquidity, I highly recommend the reading of the Pensioner chapter in its entirety. He presents some very interesting and unique perspectives on how to think about both liquidity and illiquidity in a portfolio context.

Perceptions as well as actual liquidity profiles of assets can change depending on the market environment. For example, in 2008, people learned the hard way when “assets that were liquid in good times…became very illiquid in periods of stress, including external managers who threw up gates, credit derivatives whereby whole tranches became toxic, and even crowded trades such as single stocks chosen according to well-known quantitative screens.”

“Illiquidity risk needs to be recognized for what it is, which is just another risk premium amongst many.” But how do you value this risk? That’s the tricky part, with no exact answer, but fun to think about nonetheless…

“By entering into an illiquid investment, you give up the option to sell at the time of your choosing, and as a result, an opportunity cost is incurred. Illiquidity is essentially a short-put option on opportunity cost and, if you were able to estimate the likelihood and value of all future opportunities, then you could estimate the illiquidity risk premium using standard option pricing theory. Of course, this is almost impossible in practice.” So in order to think about the cost of illiquidity, we must consider opportunity cost. Sound familiar? That’s because opportunity cost is also the essential input for the theoretical valuation of cash. For that, see our post on Jim Leitner, who has some wonderfully insightful thoughts on that subject.

Illiquidity is a “negative externality.” The evidence for this claim lies in 2008, when “many liquid managers were shut down, despite excellent future prospects. This was because clients, desperate to raise capital or cut risk and unable to sell their illiquid assets, sold whatever they were able to.” Therefore, illiquidity impacted not only those assets that were illiquid, but spread to negatively impact other asset classes.

Liquidity, Trackrecord, Volatility

Ironically, the illiquid nature and lack of pricing availability of some assets actually improved the volatility profile and trackrecords of some managers due to the “artificial” smoothing provided by the delay in mark to market. So there you have it: illiquid assets can sometimes be used to game the system for both returns and volatility. Disclaimer: PM Jar is not recommending that our Readers try this at home.


PM Jar usually does not highlight mathematical or formulaic concepts. But the unique nature of this concept merits a quick paragraph or two.

Many have characterized the events of 2008 as “nonnormal.” But the Pensioner claims that 2008 events were not “exceedingly ‘fat’ or nonnormal…rather, they exhibited nonconstant volatility…A risk system capable of capturing short-term changes in risk would have gone a long way to reduce losses in 2008.”

The book provides the following explanation for stochastic volatility:

“Stochastic volatility models are used to evaluate various derivatives securities, whereby – as their name implied – they treat the volatility of the underlying securities as a random process. Stochastic volatility models attempt to capture the changing nature of volatility over the life of the derivative contract, something that the traditional Black-Scholes model and other constant volatility models fail to address.”


All assets respond to inflation over the long-term – for better or for worse. However, in the near-term, some assets we commonly believe to be hedges to inflation often don’t work out as expected. For example, “Real estate and equities...get hit hard by unexpected inflation because even though they have real cash flow, they are still businesses, and the central bank response to inflation is to raise rates to slow demand.”


The term leverage generally has a negative connotation, but in his mind, there are 4 different types of leverage – some good, some bad:

  1. “Using leverage to hedge liabilities” – GOOD
  2. “Using leverage to improve the diversification of a portfolio” – GOOD
  3. “Levering risky positions to generate even high expected returns” – BAD
  4. “Using off-balance sheet hidden leverage to make risky assets even riskier (i.e., private equity)” – BAD

It’s not leverage itself that’s bad, it’s how you use it – similar to how “guns don’t kill people, people kill people.”

Accounting Leverage – the type of leverage that “shows up directly on a fund’s balance sheet,” such as margin, repo or derivative transactions.

Economic Leverage – the leverage “born indirectly by the fund through some other entity.” Examples include highly levered public securities owned by the fund, or private equity allocations that have highly leveraged underlying holdings.


When people hedge to put a floor on near-term returns, it entails “costs to the fund over the long-term because I am essentially buying insurance on my job and billing my employer for the premium.”


Rules of the Game


A recent discussion led me to remember a WSJ article I read a few months ago on Bill Miller’s incredible trackrecord of beating the S&P 500 for 15 consecutive years. The author of the article pointed out the following:

"Mr. Miller's long spell of winning years was to some degree a quirk of calendars. Over the course of his streak, there were plenty of 12-month periods ending in a month other than December when the fund trailed its benchmark."

Performance and trackrecord is usually judged on an annual calendar year basis. Convention dictates that the annual return period fall between January 1st and December 31st. There is no particular reason behind this convention. Ironically, most of the large university endowments, such as Yale and Harvard, have return periods that end in June each year.

Whether you like it or not, for investors currently managing capital (especially those hoping to woo additional capital), there are definitely rules to this game. Hopefully keeping in mind the rules makes the game easier to play.

Good Deed or Good Tax Planning?


A few weeks ago, the WSJ featured an article titled “A Class Move for an Office” about Bank of America donating an office building in Wilmington, Delaware to a local charter school. “Wilmington’s central business district’s fourth-quarter office vacancy rate stood at 20%…The four-quarter national average was 17.3%. Bank of America weighted a number of options before opting to donate the 282,000 square feet of space, including selling it.”

The article seems to hint at this but, does not state it outright, or perhaps I’m just more cynical than the journalist. I believe BAC was greatly incentivized to donate the building for the following reasons:

  • The expected sale price was substantially lower than the mark of the building currently on its balance sheet, and would have resulted in a charge to its ever precious equity capital.
  • Perhaps there is less scrutiny by the IRS than the OCC/FDIC/Fed on mark to market, thus the current unrealistic mark for the building actually becomes a greater than “fair value” tax benefit.
Of course I am by no means an accounting expert, and would welcome Reader commentary on the actual accounting treatment for the sale vs. donation scenarios.

Regardless, this article led me to wonder, could other investors (especially those that hold illiquid/private assets) emulate this tactic employed by BAC and be better off donating certain assets, particularly in situations where:

  • Investors/funds make annual charitable donations anyway
  • The asset is a long-term cash drain (e.g., non/negative-cash flowing real estate with high maintenance expenses in a market a long way from recovery, time share condos, etc.)
  • Sale of that asset would lead to additional (cash) losses, transaction fees, and/or become the source of much aggravation and headache

Fee & Tax Deferral As Free Float


A Reader recently forwarded to me the marketing documents of an open-end investment fund based in London. The fund had an interesting incentive fee arrangement equal to 20% * (Value at Redemption - Value at Subscription), subject to an annual hurdle rate of XYZ Benchmark + 300 basis points. The incentive fee is deferred until the client decides to pull capital from the fund.

This led me to ponder: since the General Partner doesn’t get paid any incentive fees until redemption, are the taxes payable by the General Partner associated with the incentive fee also deferred until redemption?

If so, does this mean that the fee and tax deferral constitutes a form of “free float”? It would seem so since the manager is able to continue to compound the capital that otherwise would have gone to pay incentive fees and associated taxes at the GP level (a la 401Ks or IRAs).

Interestingly, as pointed out by the Reader, perhaps that’s the reason why Berkshire Hathaway has chosen to not sell some of its long-term public holdings. The cost at sale is not only the tax bill (deferred until now), but also the loss of a form of free float, made so much more valuable by the future compounding power of Berkshire.