Hedge Funds, Not Profits

From Nick Colas, Chief Strategist at Convergex, comes insight into the investment/research process:


“A dime a dozen” means cheap or common, and despite monetary inflation it has been this way since the 1860s. The Galveston Daily News reported in 1866 that “the city is well stocked with peaches at a dime a dozen”.  Fast forward to 1937, and the Sandusky Register noted that “Smiles were a dime a dozen in the Yankee clubhouse”.  Adjusted for inflation, today that would read “Smiles were $1.67 a dozen…”

Thanks to the Internet stock ideas are a dime a dozen, or less.  There you can find opinions on any popular stock from Wall Street analysts, journalists, online experts and retail investors.  The old New Yorker cartoon of a two canines talking in front of a computer offers up the only real caveat: “On the Internet, nobody knows you’re a dog.” Or recommending one, for that matter.

The most underappreciated skill in money management isn’t actually stock selection; rather, it is position sizing.  Any random list of 30 stocks will typically have 1-2 decent winners, 1-2 horrific losers, and a bunch of go-along, get along names.  Weighting positions to have the best chance of profiting from the winners and minimizing damage from the losers is a big ingredient in the special sauce.

We recently came across a short study published by investment analytics firm Novus that describes the importance of position sizing.  Here are the highlights, with a link to the entire writeup:

  • The analysis uses public ownership data for 1,178 hedge fund managers over 6 years (2010 to 2015) related to their investments in +10,000 securities.
  • The study finds that managers do, on average, make money on sizing decisions. In other words, “The average hedge fund manager outperformed an equal-weight version of themselves”. 
  • From January 2010 to December 2016, 57.5% of hedge fund managers outperformed an equal-weight version of their portfolios while 41% underperformed. The remainder – 1.5% – saw no difference in performance due to sizing.
  • There are wide performance differences even among those managers with demonstrable skill in position sizing. The top 2.5% earned close to 10% incremental alpha annually, and any manager that generated alpha through position sizing added an average 2.77% in performance annually.  That’s essentially the difference between being up 7% or just up a touch over 4%.  A big difference in today’s world.   
  • “Position sizing alpha” for the hedge fund industry as a whole is not consistent year by year. In 2010 and 2012, for example, average alpha from position size was negative.  The two best years were 2011 (an average of just over 1.5% alpha) and 2014 (just shy of 1.0%). 

This study puts a new light on the whole “What’s wrong with hedge fund performance?” question in that it demonstrates what these funds are generally doing right: sizing positions.  Doing more of that would certainly help returns.  The challenge is, of course, risk management.  If your investment process doesn’t allow for anything greater than a 3-5% position size, how do you concentrate your bets enough to deliver alpha? 

How about when an existing position goes against you by, say 50% or more?  Doubling down – buying more – to take advantage of lower prices has a horrible reputation in money management.  The prevailing wisdom is to sell your losers and buy more of your winners.  Buying more of a name where you’ve proven your ignorance is not going to win friends or influence people.  Especially if those people are your risk managers.

One paper by Harvard researcher Jonathan Rhinesmith (“Doubling Down”, 2014), however, shows that doubling down isn’t the kiss of death after all.  Looking at instances from 1990 to September 2013 where hedge fund managers actually did “Double down” on a losing position, he found that these investments returned between 5% and 15% annualized risk-adjusted performance.  The reason for this phenomenon: adding to a losing position requires a very high level of conviction due to “Career risk” if the investment falters even more.  When PMs do ”Double down”, it is only for very high conviction ideas.  And, happily for them, they tend to work out. 

You can read the whole paper here: http://scholar.harvard.edu/files/rhinesmith/files/rhinesmith_2014_doubling_down_0.pdf

In the end, therefore, it is a combination of a good investment/research process AND a sense of conviction that generates sustainable outperformance.  Ideally, you don’t want to have to be in a position where doubling down is the only way to express high levels of confidence, of course.  One idea: only overweight names where you WOULD double down.

Yes, I know. Investment advice like that is a dime a dozen.  Still, you get the idea.

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