We Had The Same Crazy Idea
December 18, 2018·9 comments·Money
Investors pay millions to the world's smartest fund managers for access and information. Yet when they try to extract what makes those managers successful, by isolating and implementing their "best ideas," the strategy almost never produces the promised results. The mechanism seems logical. The execution breaks down for reasons almost nobody anticipates.
• The size of a position tells you nothing about its contribution to returns. Managers' biggest holdings usually serve as portfolio ballast and risk management, not expressions of high conviction. The positions that actually drive alpha are often small to medium, hidden in plain sight.
• Isolating sector-specific skill creates a false mosaic. A manager who's historically strong in technology has that strength within the context of their entire portfolio. Extracting those positions removes the balancing constraints that made them work in the first place.
• Fund managers themselves rarely know which of their ideas will win. Great investors can't always articulate why they're great. When wholesalers or advisors ask a PM for their best three stock ideas, they're getting a guess dressed up as expertise.
• The problem compounds when skill appears inconsistent because the analysis is incomplete. Investors believe manager skill within sectors is naturally unreliable. What's actually unreliable is the attempt to understand that skill from the outside, without the full context of portfolio construction and risk management.
• This creates a trap: the idea feels logical enough to keep trying, but logical-looking approaches to extracting alpha from other people's success almost never work out of sample. The question becomes whether investors will keep chasing this despite repeated failure.
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Comments
It doesn’t work for all the detailed reasons you note and for this: it’s really no different than picking investments, it’s hard to choose only the good ones, period (or from a “best of” list). Or, as one of my first bosses on a trading desk said: “the best strategy is to only buy the ones that go up and sell the ones that go down, it’s just hard to do.” It has a Yogi Berra insight to it - as did so many things pre-digital-age trading veterans said.
And a variation on the theme is to only go with your own best ideas. When I was working on trading desks, I always felt that if I could trade less and hold back for my better trading ideas, I’d be a better trader / investor. Now that I work for myself, I can report that it works for trading ideas - as long as I practice the discipline of waiting for the few times a year that I have a truly high-conviction trade idea (yup, that’s how many really good timing trade ideas I get a year). And as to investment ideas - I have found no benefit to trying to leverage my own “best of” ideas as, like everyone else, my alpha has come from some of my smallest positions.
Risk parity strategy…It’s not trying to predict what’s next. It’s not trying to create “alpha”. It’s trying to keep you in the game while also trying to keep you from being carried out. —Ben Hunt
The purpose of risk management is not to contemplate and ponder. It is to model risk by anticipating future unwanted events, to assess their likelihood and severity, and to make good decisions about their avoidance, mitigation, transfer or retention.
Bill Belicheck/Munger Risk Analysis narrative…
Other Thoughts….Don’t believe your thoughts. The voice in your head sounds like your voice but that doesn’t make it yours. Trust your inquisitive nature and question things., people and choices, especially if they feel off. Most people fake it, most of the time. Remember what your inner compass feels like. Use that feeling.
The universe is deterministic. But I can affect the zeitgeist, at least a tiny bit…The Money Illusion
Thankfully, I am not a manager of other people’s ‘money’. That’s why I would never seriously look at someone elses results and compare. I’m not smart enough in $$ to understand Graham and Dodd , or Swensen, or Druck, or any of the A-listers who, like hot golfers, have recent results on their side. I just want to pick a few equity winners (10 or more baggers) out of a smallish group so that my longish term net annual gain after inflation is 3-5% without feeling like I’ve been a tool. At this point, I’m certain I’ve been a tool.
Electronic copy available at: http://ssrn.com/abstract=1364827
Cohen study seems to disagree
I found this helpful in looking over my own portfolio as I’m often am trying to implement other investors best ideas. LOL. I’m starting to realize that not even great investors know which of their ideas will be home runs.
I’ve had very similar experiences myself, Mark!
Yep, I remember using this article (and another that I can’t locate at the moment) in my own arguments proposing such a portfolio in the past. Alas, realized experience post-2007 by investors was that (1) mutual funds are not remotely representative of active management more broadly, (2) survivorship bias is a hell of a drug, (3) quarterly rebalancing and information ends up being a damaging simplifying assumption out of sample, (4) the methodology described here is not robust to underlying capitalization biases that typify the confined universe they explored and (5) the 20 years leading up to 2007 could not have been a less representative in-sample period for our current experience.
It’s true. What I think is also true: it doesn’t make them less great!
You’re in good company, then. I don’t allow employees of Second Foundation Partners (the company that publishes Epsilon Theory) to trade individual stocks because I want us to be as unbiased as anyone is capable of being. I don’t allow myself to trade individual stocks because I’m terrible at it.
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