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Understanding the Economic Rationale for Claims of Edge

Jim Doughan Jim Doughan
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Understanding the economic rationale for claims of edge
Nov 30, 2020 7 min read
The fishermen know that the sea is dangerous and the storm terrible, but they have never found these dangers sufficient reason for remaining ashore. - Vincent Van Gogh

I don’t like fishing.  I love the outdoors and the peace of mind that it brings.  I take great pleasure in hiking, cycling and boating.  But for me fishing, like golf, detracts from the experience.  I do, however, like metaphors and my limited understanding of fishermen and their craft won’t stop me from using them as one.  For those of you who know something of fishermen and fishing I extend my apologies in advance.

As an advisor and allocator, I like to imagine investment managers as fishermen – fishermen that need capital.  

When I meet with them for the first time, they are likely engaged in convincing me that I should invest in their enterprise. Continuing the metaphor, I ask myself (and sometimes the manager) is this a good fisherman, or alternatively, is he working a good fishing hole? As allocators we seek attractive return streams – high returns, low variance, poor correlation, stable distributions and predictable use of capital. These return streams can come from a wide variety of assets, strategies and managers.  Invariably, the managers understand these details better than we allocators can hope to.  Our task is to tease out what types of returns we should reasonably expect going forward and whether they will be attractive and appropriate for our portfolios.  We often boil this question down to, “Does this manager have edge?”

My fishing metaphor helps me attend to and focus my views on the question of manager edge.  If the quantity and quality of the return stream (fish) coming from this manager (fisherman) is worth investing in, why is that?  Is the manager a good fisherman?  Does he have unique talents and skills that allow him to find fish where no one else can?  After a long stint at sea does his boat return to harbor with its holds filled with fish when most of the others are empty?  Or is it that he has found a place where others can’t or won’t go to fish?  In other words, is he working a good fishing hole?  To further complicate matters, how can allocators tell the difference between good fishermen and good fishing holes?

It’s quite natural and appropriate to start by examining track records.  

Track records can be helpful – but there are limits to their usefulness.  At an absolute level, historical returns tell us very little.  Without knowing the strategy pursued and the risks accepted, it’s hard to evaluate historical performance.  To the extent good benchmarks are available for the strategy, track records that outperform the benchmark are encouraging.  The benchmark should tell us something about how others in that fishing area have done, so benchmark beating returns can be evidence of skill.  But alternative investing strategies are extremely diverse (many, many fishing holes) so the opportunity for categorical errors abound.  In addition, the benchmarks themselves are often not investible and/or opaque (secret fishing holes are poorly mapped.)  Also, since established strategies are constantly changing, and new strategies are always emerging, even transparent and well-constructed benchmarks may not provide enough meaningful information to take a view on manager quality.  Finally, even the best-intentioned manager may be challenged to present their returns in anything but the most flattering light (most fishermen tell fish stories.)

In fact, there is often so much inter manager variability in returns that focusing on benchmarks and recent track record risks regression to the mean.  If a throng of fishermen work the same waters, some are bound to do better than others on any given day, week or month.  Will they necessarily do better tomorrow? Next week? Next month?  How confident can you be that prior excellent results will be repeated?  It is also important to remember that when we allocate to illiquid managers we are making a time commitment of our capital, and that there is a lag between when we believe we are no longer getting a good return stream and when we can get our capital back.  These fishermen need your capital for a season or more, not just to bring in tomorrow’s catch.  Unfortunately, by the time it’s clear to us that they have lost their touch it may be a while before we can get our capital back.

Another risk to identifying manager skill is that even if you can correctly discern it from statistical noise, it may not be durable.  

This can be because managers learn from other managers (fishing boats follow each other and mimic their techniques) or that new managers join when returns are good (reports of good catches spread far and wide).  It can be that managers fail to keep up with new skills and technologies or that they grow complacent with success.

Together, these things make discerning manager skill a challenging effort at best, and impossible at worst.  We are beset by problems of benchmarking, data quality, veracity of manager claims, statistical inference, increasing competition and durability of skill.  Identifying the best fisherman is daunting, particularly when the fish are moving, and the waters are crowded with boats.  

It is here that we must confront the quote I began this essay with -- Van Gogh’s observation that we can’t count on the fishermen to stop fishing even if it’s risky.  

Fishermen are trained and paid to fish, and the best of them do it with extraordinary skill and dedication.  But to my experience they rarely take up new endeavors with enthusiasm.  Hemingway knew that when he titled his book “The Old Man and the Sea”.  Who can fault the fisherman for hoping and believing that the fish will fill their nets tomorrow?

So where are we left?  

When it comes to making alternative investment allocations if we can’t reliably identify skilled managers from journeymen what are we to do?   Perhaps instead of looking for the best fishermen we should instead focus on finding fishermen that work in reliably profitable waters.  Waters that they know well.  Good fishing holes.  

There are many things that can make a fishing hole a good one.  It can be hidden so competitors can’t find it and it doesn’t get fished out.  It can be remote and hard to get there and back.  It can be too small for the big boats to get to, or too far out to sea for all but the most seaworthy vessels.  Perhaps one needs special equipment, training or licensing to safely work there.  Maybe like Maine lobstermen the fisherman can get a right to exclude others from their fishing areas.  There are a multitude of potential explanations.  

Here’s where my metaphor kicks in.  

When performing investment due diligence on alternative managers, I believe it is essential to understand and test the economic rationale behind the managers claims of edge.  In essence, I ask the manager to describe his fishing hole and why he believes it’s a good one.  No track record can substitute for a solid understanding of the strategy.  Accordingly, investment managers should be able to cheerfully answer the following – “Why does this opportunity exist and why should I expect my capital will be rewarded for investing?”  They should be able to do this without merely pointing at the track record as evidence.  If a manager can’t explain his fishing hole to you in terms you understand and can repeat to someone else with confidence, it’s possible you’ve been swayed by past performance, pedigree or popularity.   If a manger is annoyed by the question perhaps you should look elsewhere.

Let’s consider equity long/short for a moment.  

Historically, these strategies have provided attractive high Sharpe ratio returns and were a welcome addition to investor portfolios.  Given investor interest, abundant information for analysis, and high liquidity managers flocked to the space. Recently however, investors pursuing these strategies have endured disappointing returns. Many managers that previously generated significant alpha have struggled, and some well-known names have closed.  Nevertheless, some equity long/short managers have persisted and done well.  Are these managers truly skilled?  Should we expect the outperformance of these managers to persist?  It feels as though these waters may be overfished.  If an outperforming manager is using familiar and tested strategies while trading a broad universe of large cap stocks, I would ask myself – “Is it possible they are merely one of the lucky ones?”.  However, if they pursue unique strategies in lightly followed, less liquid names that may be evidence of a good fishing hole.  But how do we gain confidence in our expectation of future manager returns?

It’s a somewhat tactless question to ask a manager “How do you know that you haven’t just been lucky?” and I don’t recommend it.  

All the same, allocators should strive to know the answer to that question.  Perhaps it is more reasonable to ask managers what they attribute their strong performance to.  As you consider the manager’s response, you should keep in mind that it is quite natural for managers (and fishermen) to strive to be the best and to believe that they are better than most.  When they are in the process of trying to convince you to invest in their enterprise, they can’t help but point out why they are better than their competition.  It’s almost impossible for them not to.   In my experience, it’s the least important part of the pitch.  Instead, I want to know how I should expect them to perform if they are of merely average skill.  I’ve yet to encounter a manager that begins his or her pitch with “This opportunity doesn’t require me to be better than the others, and I’m not sure I am.  It’s just that I found a good corner of the marketplace to work.”

A final note.  

It’s possible to find excellent fisherman working in the best fishing holes – I don’t deny that.  In fact, choosing a fishing hole may be the most important test of manager skill.  When the other fishermen are focused on reports coming back from the fleet out at sea, it takes focus, insight and talent to identify a new and better place to fish. But it may also be that the best fishermen are drawn away from such places, since they can’t get the attention their skills demand or draw the capital they feel they deserve when they are laboring in obscurity in an overlooked cove.  It’s hard to say for sure.   But I will always search for a trustworthy fisherman working a good hole over an extraordinary fisherman plying the open seas.

About Jim Doughan

James Doughan is a member of Context Business Lending’s Management Board and is the Chief Investment Officer of the Accord Family Office. Jim has been involved with Context Business Lending since its inception and is a member of its investment committee and the credit committee. Prior to Accord, Jim started and later ran the fixed income trading desk at Susquehanna International Group (SIG); following that he became global head of equity index trading at SIG and was also integrally involved with SIG’s tax and strategic planning. Jim is a Summa Cum Laude graduate of the Wharton School at the University of Pennsylvania with concentrations in Finance and Decision Science.