Friday, February 23, 2018

The "3 by 5 index card" on what you need to know about the February VIX spike

University of Chicago professor Harold Pollack in an interview a few years ago mentioned that the best money advice can fit on a three-by-five inch index card. He was then challenged to write the card. His financial advice went viral. We follow this tradition by focusing on a simple "three-by-five index card" on the VIX volatility spike earlier the month.

What is your focus? Schwerpunkt - the center of gravity for your investment efforts

“An oper­a­tion with­out Schw­er­punkt is like a man with­out character.”
–Field Mar­shal Paul von Hindenburg

Schwerpundt is a German word meaning main focus, center of gravity, or focal point. The term came from Von Clausewitz's "On War" and refers to the strategic objective or goal of any military campaign or battle. It is the place of greatest importance against an adversary.

I love this word because it can also be applied to any number of investment decisions or problems. For all the work done to develop the right portfolio or all the techniques used to model decision-making, there still needs a focus on schwerpundt; what is the essence of what needs to done and what is it that is most critical. 

For risk management, the focal point, is not losing money or protecting principal. All of the talk about risk management principles is important but has to be directed at the goal of protecting wealth. For value investing, it is finding cheap securities that have limited downside and the opportunity for significant gain. For portfolio management, it is finding the highest risk-adjusted diversified returns.

Each investor or portfolio manager may have different goals but identifying their focus should be straightforward, direct, and easily explained to anyone. The essence of investing should be easily understood. Just like in a battle, the center of gravity for winning should be identified and the focus for resources and attention.

Wednesday, February 21, 2018

Psychopaths are not good hedge fund managers, neither are narcissists - Who would have thought?

Wall Street is filled with characters and "personality". I have met my share, but a key question is whether some of these personality extremes actually lead to better returns. I have written about this in my posting The Wisdom of Psychopaths and Trading. Some have suggested that the characteristics of psychopaths if directed toward good goals may lead to successful outcomes. The core idea is that a lack of empathy or emotion found in psychopaths is actually good for some jobs. Certainly, there is a strong strain of thinking that trading should be without emotion. Hence, personality characteristics such as less emotion or empathy may be good for return generation. You just may not want to have them as your boss.

However, the data suggest that having certain personality traits may actually hinder hedge fund performance. Research published last year that classifies the personality traits of hedge fund managers and then followed their returns shows that psychopaths generate lower returns and narcissists have lower risk-adjusted returns. (See Hedge Fund Managers With Psychopathic Tendencies Make for Worse Investors.While I have not looked closely at all of the data, it suggests a nuanced story about personality and return generation. Perhaps negative personality traits come out of the woodwork when there are pressures at the extreme, or the psychopath who has to work in a team or with others proves to be a hindrance to return generation.

It does suggest that effective due diligence should go beyond the numbers and make an assessment about the personality and character of the hedge fund manager. There is a critical need for references and background checks. However, we know that psychopaths and narcissists are not always easy to spot given the limited time spent with a hedge fund manager in due diligence.  

There is no question that likability is an important trait for raising money for asset management firms, but we also know that high returns are forgiving for aberrant personalities. After a decline in returns or firm failure, many will bring up personality issues, but that does not help when doing due diligence. 

Nevertheless, the classic test of having a meal with managers still seems to work. It is time consuming, but you learn a lot about a person especially when you see them interact with serving staff. But, is rudeness a disqualification for allocation? I would say yes, but you will be cutting a large universe of managers.

Saturday, February 17, 2018

Generating tilts around core bonds - Changing the correlation, yield, and risk exposures to bond sectors offers opportunities for portfolio refinements

Some may say, "A bond is a bond, is a bond". Investors may place risky assets in one category and then have bonds in a less risky category. This dichotomy does not focus on the important distinctions between bond groups and the roles that different bond categories may play nor does it present the possible trade-offs between return, risk, and correlation within a portfolio from different bonds. 

While there has been a movement to unconstrained bond funds, there have not been many good frameworks for thinking about the trade-off within the bond universe. The following graphs provide a view on the issue with bond allocation choices. 

Investors can increase return in credit through holding more risk. Further refinements can be made based on duration, business cycle, and inflation. With more volatility, higher yields, and less intervention by central banks, the dispersion in bond opportunities will further increase.

One could think of the Barclay Aggregate index as the passive no information core portfolio. If there is a no view on bond categories, hold the Aggregate index. Around this fulcrum, investors can move along three dimensions, yield, risk, and correlation to equities as the risky asset.

You can have greater diversification at the sacrifice of yield. You can increase yield through holding more credit sensitive investments at the cost of more correlation with equities. 

There is greater return potential with thinking about bond sector bets around a core allocation. Additionally, investors can adjust their diversification against a risky portfolio through changing bond sector exposures.