Tough Minded Investment Manager Analysis

Listening to Professor Corey.
Professor Irwin Corey: The World’s Foremost Authority is a wonderful comedian and bullshitter, brighter and funnier than Chris Rock on a good day.  Over the years, I’ve worked with a number of Hedge Fund and Fund of Fund managers who really seemed to believe they were The World’s Foremost Authority.  My coworker ‘Bob’, for example, was an expert or pretended to be an expert on everything or, at least, everything that affected investing.  There was no business fact or investment theory Bob did not know or did not know why it was not important.
 
When Bob wasn’t trying to be The World’s Foremost Authority, he wasn’t a bad guy and he certainly wasn’t as silly as he was on this issue.  I decided to try to help him.  “Don’t be an idiot all my life,” I explained.  “Almost everything affects investing.  The local library acquires more books and magazines in a month than you can read in a lifetime.  Knowledge is growing at an exponential rate and the rate itself is increasing sharply.”  Unfortunately, Bob was not impressed with my sensitive, caring approach to his psychological problems.  He still knew everything.

Bob is still in this business, bizarrely enough.  Bizarre because, unless a HF manager really and truly doesn’t care about his performance, every bullshit, every lie, makes him a worse manager.  Every lie, every bullshit must be defended.
 
For the HF or FOF manager who is seriously interested in making money, I would suggest another, humbler approach; you don’t know everything, you never will, you don’t have to.  What HF and FOF managers need, I submit, is nothing more than an advantage in knowledge and technique over their competition.  This implies that degrees and certifications, such as CFAs and CMTs can be beginnings, at best.  The knowledge and skills such certifications provide are real, but common.  And anything known by thousands of other investors cannot provide much of a competitive advantage.
 
This also implies that learning must be a constant, ongoing commitment; a manager’s competition may not be as casual about learning as he might be.  At least, assuming otherwise is just short of suicidal.  Considering that Hedge Fund and Fund of Fund managers rank among the most competitive people on this planet, it is surprising how casual most of us are about learning.  Or perhaps not.  Learning may not be necessary when you already know everything.
 HF manager’s need for a competitive advantage also implies that managers must set three types of learning goals.  First, and most obviously, managers must learn how to do better what they already do well.  This is harder than it seems.  As part of my FOF work, I talk with HF managers.  Judging by my talks, most have no clue what they do well.  When I ask, most HF managers reply with either industry cant they hope will impress me (“I apply a proprietary version of option pricing theory to convertible bond arbitrage”), or with detailed method (“I buy when the five day moving  average rises above the twenty day moving average”), or with raw ego (“I can see the future”).  I rarely get an answer that reveals skills such as, “I understand how to break corporate legal issues into their components and make reasonable guesses as to how these issues will resolve themselves in court.  This allows me to make reasonable bets on companies in legal jeopardy.”
 
I can usually find a HF manager’s real skills by reverse engineering his trades and comparing the results to his explanations, such as they are.  When I don’t have access to his trades, I can sometimes find a HF manager’s skills by asking the manager about his background and interests.  If the manager is a CPA who now builds financial models of potential takeover candidates, for example, I have found a strength.  Conversely, if he is an accountant who now works as a technical analyst, I haven’t yet found his strength.  He may not have any real investment skills.  Not every investment professional does.
 
You can do something similar without me.  Some career guides provide questionnaires that attempt to reveal skill and aptitudes.  Ask yourself what kind of non-investment jobs you might do well at and, most important, why.  Are the skills you would use in these jobs skills you can apply to investing?  If you don’t have any investment skills that have non-investment analogues, then either you aren’t looking hard enough, you have misidentified your skills or you don’t have any investment skills.  No offense.  Misidentifying your skills is the worst of the possibilities, in many ways.  If you don’t know what your skills really are, it’s going to be hard for you to figure out what you need to do next.

The next step is to find where your skills do not meet your investment needs as well as they could.  In the case of the CPA above, it might mean reading the accounting journals to keep up with the issues or it might involve taking courses on statistical modeling or both.
 
Second, a manager has to learn what he doesn’t know he needs to learn.  Part of the problem here is psychological.  All of us tend to believe that the skills and knowledge we have are the most important.  In the case of Bob above, the fact that he is still in the business suggests that there is something wrong or, at least, incomplete with my analysis.  Perhaps he has skills I can’t see.  Or maybe he just cooks his books.
 
In the CPA example above, the accountant, if he resembles the rest of us, would be inclined to keep up with the accounting issues and ignore the modeling issues.  A HF or FOF manager with intellectual discipline will identify those areas he is most likely to ignore and deliberately go after knowledge there.

Part of the problem is just plain ignorance; we don’t know what we don’t know.  Part of the solution, therefore, is to take risks, to try something new.  Another part of the solution is to steal, excuse me, to adapt, techniques from other industries and disciplines.  Our own industry is lousy at this.  Other industries are not and this is the first thing we should steal.  Several decades ago, I worked at Syntex, the pharmaceutical company, as a statistical programmer.  In the research area, every job candidate above a certain level had to make a presentation to the department on a technical issue of his choice.  This gave management another chance to judge the candidate’s sophistication and skills and gave the department’s members an introduction to a technique or an area of research they may not have known about.
 
Besides job candidates, suppliers of various types, brokers, for example, can often be coerced into giving lectures.  If you are not a line manager and you can’t convince your manager to start this kind of program, probably the best you can do is try to guess what other industries and disciplines have solved your problems and read their literatures.  This technique has worked extremely well for me, but the cost is high.  In my case, fortunately, I have an extremely high tolerance for pain and boredom.

One of the things that occasionally stops us from using such techniques is paranoia or, perhaps, an all too reasonable unwillingness to have our ignorance exposed.  Bob used to classify industry publications such as Managed Account Reports as secret and lock them away from every one else in the department.  Honest.

Third and finally, managers have to learn how to learn.  This wouldn’t seem necessary; didn’t we all go through this as toddlers?  Unfortunately, our ability to learn can easily calcify, even with the best of intentions, even with the most aggressive efforts to learn to do better what we already do well and to learn what we don’t know we need to learn.  When that happens to a CEO, the company falls apart or, at best, rots and the stock price rises when the CEO finally dies.  When this happens to an investment manager, as it did with the late Richard Donchian, the man who almost single handedly invented the managed futures funds industry, the results are years of disappointing performance.

As management guru Peter Drucker notes, musicians solved this problem decades, perhaps centuries, ago.  Professional musicians have a repertoire, a portfolio of pieces they practice and perform regularly.  Every few years, a musician will drop one of the pieces in his repertoire and replace it with another. What constitutes a piece for a HF manager and how often one should be replaced depends on the HF manager’s approach to trading, of course.  For an analytic trader of the CFA school, for example, dropping one industry and adding another will probably suffice.  For a mechanical, technical trader like Donchian, industry means nothing.  Donchian would have had to have started studying portfolio theory or, perhaps, market fundamentals.

All of the above is work.  Much worse, it costs time, which could be devoted to trading.  And if the HF manager makes enough money fast enough, if he retires rich, it isn’t necessary.  But if, like the rest of us, the manager needs or wants to stay in this business, he needs to learn.  Professor Corey, as was so often the case, had words of advice for those who would not learn.  In his own kindly, collegiate manner, he would advise them, “When your IQ gets to 37 sell!”