By Paul Marshall, Apr/2020 (128p.)
In this relatively short book (readable in one sitting), Paul Marshal offers 11 lessons from his experience as a hedge fund manager, with a chapter dedicated to each lesson. Marshall is co-founder and chairman of Marshall Wace, which describes itself as “a leading global alternative investment manager specialising in long/short equity”. With nearly $40 billion in AUM and 350 people in London, New York, and Hong Kong – the firm is known for combining fundamental and quantitative strategies. It was started in 1997 with $50 million in seed capital, half of which was from George Soros.
The book was enlightening and instructive – but I admit to being an enthusiast on the subject. I can see how someone might think it was a bit self-promotional, but I chose to look right through that. Given how quickly it can be consumed – I would still recommend it. Lessons 7 (shorts are different from longs), and 10 (size matters), were my favorites – but they were all insightful.
LESSON 1: MARKETS ARE INEFFICIENT
LESSON 2: HUMANS ARE IRRATIONAL
LESSON 3: INVESTMENT SKILL IS MEASURABLE AND PERSISTENT
LESSON 4: IN THE SHORT TERM THE MARKET IS A VOTING MACHINE, IN THE LONG TERM IT IS A WEIGHING MACHINE
LESSON 5: SEEK CHANGE
LESSON 6: THE BEST PORTFOLIO CONSTRUCTION COMBINES CONCENTRATION WITH DIVERSIFICATION
LESSON 7: SHORTS ARE DIFFERENT FROM LONGS
LESSON 8: A MACHINE BEATS A MAN, BUT A MAN PLUS MACHINE BEATS A MACHINE
LESSON 9: RISK MANAGEMENT – RESPECT UNCERTAINTY
LESSON 10: SIZE MATTERS
LESSON 10 ½: MOST FUND MANAGEMENT CAREERS END IN FAILURE
In lesson 5 (Seek Change), Marshall indirectly admits to being more of a long-term growth guy (Phil Fisher style, which he calls a “lazy” way of investing), while his partner Ian is the mean-reverter – but he doesn’t speak of any individual investment (which is smart and extends the book’s shelf life). On Bloomberg, the firm shows up as having 2,663 positions (typical for a quant fund) – although the top positions have a quality/growth tilt, with Amazon as the top position, followed by Microsoft and Zoetis.
Source: Bloomberg
Below are my highlighted excerpts for each of the chapters. There are some classic one-liners, such as: “We tend to discover that bad assets are more correlated than one might have expected, because they share a common factor – they are all bad,” and “Stupidity is a very basic symptom of the human condition,” and “Being a dedicated short seller is a vocation – it is certainly not a great career choice.” But my favorite quote he left for last: “Ultimately, of course, it is all about character. If you do not begin your fund management career with a sense of your fallibility, you are likely to learn it. If you do not learn it, you are likely to fail.” Indeed, there is scant room hubris, and no mercy for failure of character, in investing.
Cheers,
Adriano
Highlighted Passages:
PREFACE
This small publication [] is not intended to be comprehensive, nor is it intended to be formulaic. The nature of investing is that to be successful you need to constantly adapt. Markets and market participants are continuously evolving. To beat the markets, to generate alpha, you have to beat the other participants. And as they change, so you too need to evolve. That is why I call them ‘lessons from experience’. We keep learning.
Ultimately, any investment management firm is dependent on the commitment and confidence of its clients. We are their servants– and it is only thanks to their unfailing support for over twenty years that we have been able to invest, deliver and evolve.
INTRODUCTION: THE GREAT DISCONNECT
The axiomatic, or what some call Rationalist, tradition has continued to flourish in the post- Second World War period, led by the Chicago School, and it remains to this day remarkably disconnected from financial market practice. It is facing increasing challenge, though, not least from behavioural economics and from a new school called ‘complexity economics’.
LESSON 1: MARKETS ARE INEFFICIENT
Supply and demand are virtually never in complete equilibrium. Disequilibria are resolved through price movements. Sometimes, in the case of excess supply, price movements are not enough to create equilibrium. A stock of surplus inventory is just left unsold. The opportunities to make money in business and in markets lie precisely in the points of disequilibrium.
Mandelbrot argued that prices had a memory, of sorts. Today does, in fact, influence tomorrow. And different price series exhibit different degrees of memory. Mandelbrot chose not to try to explain why today’s price may influence tomorrow’s. But the obvious explanation, obvious at least to anyone who works in markets, is that market participants are human beings, and humans, driven by fear and greed, are swayed by price movements.
LESSON 2: HUMANS ARE IRRATIONAL
Hyman Minsky was an American academic, not from the Chicago School. His focus was on the causes of financial crises and this led him to explore how fragility accumulated in human systems. His central insight was that long periods of financial stability could ultimately lead to instability because they promoted complacency and excessive leverage and risk- taking. Paul McCulley of PIMCO first coined the phrase ‘Minsky moment’ in relation to the Russian financial crisis of 1998. But an even better example of the phenomenon was the financial crisis of 2007– 8, as this collapse stemmed in many ways from the ‘Great Moderation’, the period of extended financial buoyancy created by the monetary accommodation of Alan Greenspan and leading to the accumulation of too much leverage and speculation throughout the financial system.
Arguably, the exceptional period of financial stability following the Great Financial Crisis was a Minsky moment in reverse, as market participants were slow to redeploy risk, but more importantly, authorities and central banks did everything in their power to assure stability for asset prices.
There is no such thing as a Stupidity Principle but there should be. Stupidity is a very basic symptom of the human condition. People can be equipped with all necessary information but still make the wrong decision. We all make decisions that we come to view as stupid with hindsight. I suffer from it, not only in relation to my own personal circumstances but also to my investments. I am too easily romanced by new stories and new opportunities and will too often want to go with the momentum of an idea until the momentum breaks.
The sunk cost fallacy is sometimes known as the ‘Concorde fallacy’, in reference to the stubbornness of the British and French governments in continuing to fund the joint development of Concorde even after it became apparent that it was a commercial disaster. Decision makers were too heavily influenced by the fact they had already ‘sunk costs’ in the project, even though these costs should make no difference to ongoing investment decisions. Politicians are highly vulnerable to the sunk cost fallacy. It can be applied to a multitude of errors by the British government. But there is a more subtle form of sunk cost fallacy, relating to the irrational weight given to the time an investor has spent analysing an opportunity. This must be even more of a temptation in private equity, where investors can spend weeks or months evaluating an opportunity. It is certainly true in public equity management. The main capacity constraint on an equity analyst is always his or her time. In any given day analysts have to decide which company to focus their time on, and before making the investment the analyst or fund manager will have spent many hours on the case. Given the amount of time consumed, it becomes increasingly difficult for the manager then to pass on the investment. But the time spent should be irrelevant. Analytical time should be viewed as a separate resource, with the expectation that only a certain percentage of opportunities will pass from due diligence to actual investment. Unfortunately, that is not normally how it happens.
LESSON 3: INVESTMENT SKILL IS MEASURABLE AND PERSISTENT
You can make a good career in fund management if your Information Ratio or Sharpe Ratio is consistently above 1 × over time. Most Marshall Wace funds deliver Sharpe Ratios consistently above 1.5 ×.
Luck is a key factor in fund management, just as it is in competitive sport.
We have found that the most important ratio for digging below the surface is the success ratio (the percentage of winning trades– the Americans call it the ‘batting average’). We have for twenty years analysed each portfolio for its success ratio, both in relation to absolute returns and alpha. An alpha success ratio of 52– 53 per cent is already very good if it is consistent through time. A truly great manager will have a success ratio of 55 per cent (in other words you can be wrong 45 per cent of the time and still be a truly great manager). Not only can we look at the overall success ratio, we can look at it by country, by sector, by longs, by shorts, in up markets and down markets, to build a deep profile over time of a manager’s strengths and weaknesses and to establish his/ her consistency.
It is possible to be a consistently good manager with a success ratio below 50 per cent if you have a consistent skew towards winning stocks in your position sizing. Some managers are naturally good at concentrating their capital in their best ideas while their longer tail of diversifiers (which may be there more for risk management reasons. This is foolish. Industry selection is a demonstrable skill and cannot easily be replicated by machines (yet).
There is no particular set of attributes which can guarantee a great fund manager. Of course they have to be very smart, focused and driven. But great managers can be optimists, pessimists, mean reverters, growth guys, value guys, short- term traders and long- term holders. Perhaps above all they have to be resilient. Despite the evidence of the persistence of skill there is probably not a single successful manager who has not had at least one bad year (Stanley Druckenmiller is the one exception I can think of). In that bad year, or that bad period, you come under huge pressure. Your mistakes are very public. You question yourself. Others question your judgement. You need to be resilient.
“…the reddest flags for underperformance in are problems in people’s personal lives– the three Ds of death, divorce and disease.
LESSON 4: IN THE SHORT TERM THE MARKET IS A VOTING MACHINE, IN THE LONG TERM IT IS A WEIGHING MACHINE
‘Successful investing is anticipating the anticipations of others.’
LESSON 5: SEEK CHANGE
The greatest opportunities always occur around change. The valuation of a company will not change unless something changes intrinsically about the company (financially, operationally or strategically) or something changes about its economic/ financial context (interest rates, growth, volatility, inflation) to create or destroy value.
Storytelling is only interesting in the genesis of an idea, not in its recounting months later. At Marshall Wace we use ‘narrative investor’ as a pejorative term. For years, the hedge fund industry has been under the spell of the Tiger Cub model, a term used to refer to investors who grew up under the aprons of, or were funded by, Julian Robertson’s Tiger Fund. It is true that several great investors emerged from the Tiger pool. But the model brought with it a lot of hubris and misplaced hero worship. Tiger Cubs hunted in packs, ramping their stocks at Breakers and at the Sohn Conference. Investors fawned. Some funds of funds even invented a model to follow the managers into the individual stocks, doubling up on the herding problem.
Many successful careers have been built on this long- term growth strategy, especially in emerging markets. However, it is essentially lazy. The implicit assumption is that the Competitive Advantage Period of a company (the period during which a company can enjoy superior returns on investment before they fade) will last longer than the market expects and therefore offers an anomaly to be exploited. Arguably the model was pioneered by Philip Fisher, who was himself a great influence on Buffett (Buffett credited him with 15 per cent of all he had learned about investing; the other 85 per cent went to Ben Graham). Fisher sought out companies which were both ‘fortunate’ (in their industry structure and market growth) and ‘able’ (as defined by management strength). This combination would assure super- normal returns on capital over the long term and represented the best core criteria for long- term investments. We leaned heavily on Philip Fisher’s ideas when we launched the Eureka Fund and designated about one- third of our capital for such ‘core’ holdings.
The best that can be said today is that the market is not good at predicting Competitive Advantage Periods and frequently errs in both underestimating and overestimating the speed of change. Scrutiny of industry structure and sector dynamics can generate super- normal returns from industry selection because not enough investors do it.
LESSON 6: THE BEST PORTFOLIO CONSTRUCTION COMBINES CONCENTRATION WITH DIVERSIFICATION
It is a rule applicable to every good fund manager: over time the more concentrated the portfolio, the higher the return.
To make concentration really work in a portfolio you need to be sure that as many of your positions as possible are working for you. You cannot afford many ‘sleepers’. And you need a high ‘slugging ratio’. This is another baseball analogy. While the success ratio from Lesson 3, or ‘batting average’, is calculated as the ratio of the number of winning (or positive alpha) trades to losing trades, the slugging ratio is calculated based on the realised gains on winning trades compared to realised losses on losing trades. It is also known as the ‘win/loss ratio’, and maximising your slugging ratio is a key skill of a successful trader. The best exponent of this is probably Stanley Druckenmiller. Druckenmiller is a believer in concentration and has strong, non-consensual, convictions. But he uses technical indicators (i.e. price charts) to seek confirmation from the market that his ideas are performing, and waits to size up his positions until he gets confirmation from the price action.
While concentration maximises your absolute return, one of the keys to delivering outstanding risk-adjusted returns is diversification.
At its best, diversification allows you to enhance the risk-adjusted returns of a pool of good assets. The problem is that diversification also looks like it works to improve the risk characteristics of bad assets, in short runs of data. Over the longer term, we tend to discover that bad assets are more correlated than one might have expected, because they share a common factor – they are all bad! Thus, in the 1980s, Michael Milken used diversification as the foundational rationale for the junk bond market. And then, even more calamitously, diversification was what allowed banks in the 2000s to combine securitised junk mortgages into CDOs and CDO-squared and to sell them on as higherquality credits. Innovation can always be used for good or ill. The tool of diversification is so powerful that it has unfortunately been used too often for ill.
As anyone can spot, the merits of concentration and diversification stand in paradox and almost in contradiction. Famously Warren Buffett disagreed with Ben Graham about the value of diversification. Graham was a staunch advocate of diversification. Buffett dismissed it: ‘Diversification is protection against ignorance. It makes little sense if you know what you are doing.’
LESSON 7: SHORTS ARE DIFFERENT FROM LONGS
So might have said Forrest Gump. But it needs stating even if it is obvious. Most managers find alpha easier to come by from their long positions than their shorts. By way of a proxy for the industry, in the ten years to December 2018, the Eureka Fund (which comprises roughly fifteen strategies in all global regions and sectors) annualised gross long alpha of 8.79 per cent and gross short alpha of 2.81 per cent.
Over the ten years to December 2018, the normalised cost of loan fees for the Eureka Fund was 48 basis points. This represents a significant ‘negative carry’. In contrast, long positions have a positive carry (the dividend plus any buyback) which rewards a fairly passive buy and hold approach.
Shorting is more competitive. Essentially on the short side you are competing with hedge funds, the self-selected elite of the fund management industry. When you short sell a stock, you may be pitting your wits against the whole market – the buyer could be an active long fund, a passive fund or a hedge fund – but in the borrowing market you are up only against hedge funds. That means the price and availability of borrow will be determined by a highly competitive market. Crowdedness of short positions is a positive signal for alpha (i.e. crowded shorts go down by more than the market) but the popularity of the short will usually be reflected in the cost of borrow.
Being a dedicated short seller is a vocation – it is certainly not a great career choice.
As a stock becomes more financially leveraged its financial performance and outlook become more uncertain and the share price more volatile. This may be compounded by the crowdedness of the short position and the skittishness of other investors. Effectively the Sharpe Ratio of the trade is likely to fall.
To be a truly successful short seller you need to actively pursue the criteria which are specific to a great short. The first three examples below are just the reverse image of successful longs. The final two are unique to the short side:
- Industry structure (i.e. a weak or deteriorating industry structure). The trend of many industries is towards concentration and improved pricing power. This is because most management teams are keen to implement the lessons they have imbibed at business school from Michael Porter, Warren Buffett and others and to create moats around their business and consolidate their markets. Industry consolidation leads to stronger pricing power. However, we also live in an era of almost unparalleled creative destruction, driven especially but not only by the forces of digital disruption, and this has created countervailing forces which have plunged many industries into a spiral of falling prices and falling demand. The scale of disruption across so many industries (from retail to advertising to autos) has made this type of creative destruction a rich source of short ideas. Timing can often be challenging. As Bill Gates said, we always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next ten. However, patience invariably rewards long-term structural shorts premised on inexorable changes in industry structure.
- Regulatory pressure (a hostile regulatory or political framework which is likely to further pressurise earnings power). Most US companies spend a lot of money making sure the regulatory environment is supportive. The annual lobbying bill in Washington DC is circa $2 billion. But when political fashion is strong enough, some industries simply can’t escape the wrath of the regulator. Tobacco and Big Pharma are most in the firing line at the moment.
- Dodgy accounting. Market scrutiny is such that few companies attempt to play games with their accounting. But cases still exist, more frequently in emerging than developed markets. Such cases require great patience as shorts because the payback may be non-existent for years and then very sudden. The caprice of time is reminiscent of Mike Campbell, Hemingway‘s anti-hero in The Sun Also Rises. Campbell was a former bankrupt. When asked how he went bankrupt, he replied: ‘Two ways. Gradually, then suddenly.
- Weak and deteriorating balance sheets. Weak balance sheets can be a dangerous temptation on the short side, especially in an era of unlimited monetary support. Central banks can keep zombie companies alive for many years, preventing the forces of creative destruction from properly operating. But weak balance sheets can also deliver the best shorts. Financial leverage massively increases the potential downside in a share. The natural conclusion is that the weak balance sheet is not enough. It has to be weak and deteriorating. If a company is operationally and financially challenged, the downside can be considerable, even starting from a low point.
- Weak or deteriorating growth (e.g. due to demographic factors, fashion, disruption, technology change).
LESSON 8: A MACHINE BEATS A MAN, BUT A MAN PLUS MACHINE BEATS A MACHINE
The machines will continue to improve – in coverage and in processing power. Machine learning and AI now drive a significant part of our systematic process and their share will continue to grow, expanding the range of signals we can use and accelerating the speed at which we translate the data into signals and the signals into trades. But machines have not won yet. Machines typically do not fare well in a crisis. They are not good at responding to a new paradigm until the rules of the new paradigm are plugged into them by a human. During the Brexit referendum or around the Trump presidential election our discretionary traders fared much better than our systematic business as they were better suited to make the leap of imagination to understand the implications of what had just happened. Discretionary managers are also much better equipped to vary their risk budgets, to recognise a slam dunk and to make the leap in risk appetite which allows them to make a lot of money once every few years.
LESSON 9: RISK MANAGEMENT – RESPECT UNCERTAINTY
The best hedge against unknown unknowns is structured prudence in the use of liquidity and leverage.
The level of diversification enables us to apply extra leverage to the funds while still generating only very modest volatility. The maximum leverage of any Marshall Wace fund (defined as gross longs plus gross shorts/NAV) is 400 per cent. Some clients push us to take more leverage, to match some of our peers, such as Citadel and Millennium, who run gross leverage typically around 600-700 per cent.
LESSON 10: SIZE MATTERS
Any investment business needs a certain critical mass of assets under management (AUM), not only to pay for the light bulbs but also to pay for a minimum level research and execution capabilities. The entry barrier is rising and it has been estimated the minimum AUM required for a hedge fund to break even has risen seven-fold, from $50m in 1998 to $350m in 2018.
LESSON 10 ½ MOST FUND MANAGEMENT CAREERS END IN FAILURE
You need to keep your foot on the ground at all times and always remember that you are never as good or as bad as you (or others) think you are.
At Marshall Wace, we don’t have any aurigae, but we have developed a number of protections against failure of character. The most important is the partnership structure. Distributed leadership spreads a culture of excellence and challenge. It also makes us each more dispensable.
Granular performance data makes sure that everyone stays anchored in the reality of their fallibility. The numbers can be cruel but they do not lie. As each of us is wrong on at least 45 percent of our trades, the data, used correctly, is a guarantor of humility.
Ultimately, of course, it is all about character. If you do not begin your fund management career with a sense of your fallibility, you are likely to learn it. If you do not learn it, you are likely to fail.
