By Benjamin Appen and James Hall
In December 2007, Magnitude outlined its commitment to assessing the culture of investment firms (and managing its own investment culture). This essay is adapted from that communication.
Most of the time, when we write about how Magnitude selects managers, we focus on the easier part. Magnitude tries to find unusually attractive opportunities in the markets and managers with a tangible edge in exploiting them. We carefully evaluate the risks taken by managers in our portfolios, limiting passive exposures and searching for diversifying shock risks. This sort of analysis is our wheelhouse. Our backgrounds help us be confident that we can make good decisions once we have good information. So we focus our attention on areas where the bulk of the investment decision is driven by data we can evaluate concretely.
Unfortunately, that’s never enough, and sometimes it’s not much at all. The more difficult part of investing in hedge funds is making subjective judgments about people and the cultures they create. Making great decisions requires a good understanding of which cultures predict persistent investment success. By success, we mean generating substantial risk-adjusted value for clients in aggregate over a long period of time.
Instinct, intuition, hunches: these all strike immediate negative reactions from us at Magnitude. Reliance on such vague terms impairs the analytical process essential to good decision-making. They make teamwork more difficult because they’re so challenging to communicate precisely. They can’t be easily weighed against other factors or clearly tested with concrete data. But it can’t be denied that subjective assessments of character traits like discipline, ethics, intelligence, originality, and passion are crucial. Because markets, managers, and strategies are guaranteed to change, a clear understanding of character can be a better guide to a manager’s success over the long run than even the best evaluation of current market opportunities and firm infrastructure.
We need to make these subjective evaluations concrete enough that they are subject to an analytical process. In this essay we try to outline how we do this (and in doing so, to make this process more concrete than it was before). We also hope to give you a flavor for how Magnitude has developed its own culture. The things we like to see in good investment managers are of course the things we try to live every day.
Investing Culture: Values
Culture is what people believe and what they do. To understand the culture of the people and firms we invest with, we try to assess their values and the institutions they create to reinforce their values. Obviously, there’s no finite list of values that is sufficient to explain observed patterns of investment success. Nevertheless, we’ve identified five values which we think matter most (while acknowledging that any such list is a bit arbitrary). We’ve never come up with any consensus ranking of their importance, so don’t read anything into their order below. We’ll initially discuss the importance of these values as personal characteristics, and then discuss some norms and institutions which embody these values for a hedge fund management company.
Because of the difficulty of adding value in modern markets, we believe that investors capable of extraordinary levels of analytical precision are most likely to offer sustainable success. While intelligence isn’t remotely sufficient for investment results, its opposite definitely makes persistent success improbable.
Investing well requires the ability to see something that is not obvious to others. In general, security prices discount forward the consensus distribution of possible outcomes, leaving approximately equal amounts of expected risk on both sides of the current market. Seeing where such consensus distribution estimates err requires the skepticism to reject what’s visible and false combined with the creativity to envision what’s invisible and true.
At the end of the day, good investing requires good people. Only human beings have the sophisticated pattern recognition capability that builds good judgment over time, and judgment is the keystone of investing. Without it, the edifice is unstable—it may stand for a while, but not forever. Because people matter, motivation matters. People not only need skills, they need the drive to get the best results from the skills they have. And in our experience, the most successful investors are incredibly passionate about what they do, generating results much better than individuals endowed with similar talents who may not be similarly driven.
By discipline, we mean the same things meant in ordinary speech: the setting of high standards and the application of rigor and effort to achieve these standards. It encompasses a commitment whenever possible to clarity rather than ambiguity; measurement rather than estimation; attention to detail in thought, speech, and writing; hard work; and reliability. In hedge fund management, we believe it also encompasses patience and prudence. Disciplined managers don’t risk capital where they don’t have an edge, and are careful to make decisions that maximize risk-adjusted economic value for clients.
We believe that unethical behavior is wrong for us as people and uneconomic for us and our clients. We try to select hedge funds that not only follow the letter of the law, but act in a way that would not harm society if it were generalized. At the same time, we do not view hedge funds as mechanisms to act for social good, but as entities in pursuit of economic gain. In other words, funds engaged in socially positive activities don’t get extra points, but we don’t want to work with firms and people we don’t trust.
Investing Culture: Behavior and Institutions
While human values are one part of the investment culture equation, it’s also important to observe how those values are embedded in the processes and structures of the management company. When a company spends resources to achieve cultural goals with remote financial payoffs, it is a strong signal that the company assigns high values to these cultural goals.
One of the most frequently observed elements of the most successful investment firms is the explicit creation of a culture of excellence. Great investors make themselves better by surrounding themselves with people who are smart, creative, and excited about what they do. Great investment firms devote substantial sums to make this possible. They work hard to attract the most talented and skillful potential employees. They are diligent in selecting the best from among these prospects. They take great care to develop and train employees. Finally, great firms work tirelessly to create an environment which incentivizes their most productive people to stay at the firm, by enabling them to grow professionally and by sharing the rewards of success widely.
The investment business makes this easier than many other businesses. First, because the business offers unusually attractive financial rewards, so there is plenty to share. Second, because there are more concrete metrics that can be used to assess the productivity of individual employees than are typical, so there’s less ambiguity about where value is added. Finally, because the flexibility of the business allows individual growth to be more easily balanced with growth in responsibility than is normal. (Try to set up a new semiconductor fab for each of your best ten managers, and you will wish you were in the fund management business where you can assign them each a VaR limit and let them go.) Unfortunately, those same factors (large potential for financial gain, value created by individuals is relatively separable from value created by the franchise, and low barriers to entry in many parts of a business) also create attractive opportunities for people to leave. So again, culture enters the equation, as a non-financial element of employee retention. Great people want to work with other great people, and recognize how hard it is to find situations where one is surrounded by them. Great cultures make people reluctant to leave, even when the economic payoff from leaving appears highly attractive.
Investment has always been an interesting marriage of art and science. The art part is the spark of genius that allows a manager to see something with a clarity his/her peers can’t approach. Maximizing the potential genius in an organization is accomplished by attracting and retaining people who are intelligent, original, and passionate. The science part is making sure that the firm gets paid properly for the art part. This is where discipline comes in. Great investment firms assemble a culture of discipline in investment decision-making. They build decision tools that minimize the probability of loss and extract the maximum return from core insights.
Analysts at disciplined investment firms focus on sourcing better opportunities, obtaining more valuable information, and understanding it more deeply than their competitors. Disciplined firms are more likely to make consistent investments in infrastructure (human, technological, and informational) to maintain their culture and success. Such out-of-pocket expenditures by management companies are positive signals of the firm’s culture.
Discipline also manifests itself in risk management, but not always in the way commonly assumed. A volatile track record is not by itself an indication of an undisciplined investor. Disciplined investors can target any level of risk that isn’t inherently self-destructive but will always make risk management decisions backed by economic logic. Sometimes, managers admit to us that they have implemented risk management rules (maximum position sizes at cost, drawdown controls that are insensitive to market context, e.g.) that don’t make economic sense because their investors pressured them for more risk management, and the managers were unwilling to reject irrational decision rules. This is a warning sign; it suggests a culture of ad hoc decisions rather than disciplined investing. Portfolio risk should be tilted so that the greatest risk is taken where there is greatest edge. This has always been one of the primary reasons why a persistent passive exposure in a manager’s performance is a negative signal for us. Any money manager willing to take his largest risk position (being 40% net long the market, e.g.) where he has least edge relative to competitors strikes us as undisciplined. For us, disciplined investing means minimizing exposure to risk where the manager’s analysis adds least value.
Finally, disciplined investing includes a commitment to protect against risks that can’t be accurately measured or predicted in advance. Managers with disciplined investment cultures are more likely to recognize that the risk of severe loss is as great or greater from these unlikely scenarios as it is from more normal scenarios. As a result, they are more likely to take substantial pains to mitigate these risks.
The institutionalization of ethics is a space where it’s difficult to draw fine gradations from the outside, because one sees relatively few instances where people behave unethically. Every manager claims to be clean, tries to look clean, and knows the clean responses to the standard questions. Nevertheless, we look for all kinds of hints that managers put ethics first, and they come through in a thousand ways.
The most fundamental principle of ethical business is honesty. Each manager owes investors honest communication about the firm’s strengths and weaknesses and the fund’s realistic prospects. This means admitting to mistakes and committing to rectifying them. It means minimizing spin: a marketer has the obligation not only to persuade but to inform fully. Sometimes that means telling difficult truths.
An additional ethical practice is building the business seeking to avoid conflicts of interest. This means reducing incentives for favoritism in allocating resources or opportunities; for example, different investment vehicles managed by the same manager under the same strategy should offer similar payoffs to management. It means sensible limits on personal investing activity by front office personnel. It means generally taking risk with client money as one would like one’s own money managed.
Finally, ethical investing requires treating clients fairly. Ethical managers don’t raise more money than can be prudently invested with existing infrastructure with existing strategies. Ethical managers provide investors with sufficient information about each investment opportunity to allow them to make reasonably well-informed decisions. And ethical managers take a long-term approach to building a relationship of trust with clients by not exploiting changes in relative power situations to clients’ detriment.
Impact of Culture on Magnitude’s Investment Decisions
In general, Magnitude seeks to invest when everything adds up cleanly. We want the opportunity set to be unusually attractive, the manager to have a tangible edge, the passive risk to be minimal, and the shock exposure to be diversifying. We like to find managers who exemplify each of our important values and have built businesses to match. Unfortunately, not only does it not always happen—we can’t think of a single example where the investment has been extraordinary in every one of these dimensions. Investing has always been a business of trade-offs, weighing one thing against another and trying to figure out what’s most important at a given time.
That said, our biggest investment errors (both positive, where we did something that ended badly, and negative, where we failed to do something that turned out well without us) have resulted from an insufficient understanding of a management firm’s culture. Although there’s a chance we’re fooling ourselves, we don’t believe this is because we’re bad at understanding culture. We believe that we made these errors because understanding culture is the most difficult part of hedge fund investing.
Unfortunately, there’s only so much we can do to improve. We can’t read culture more accurately just by deciding to do so, or by identifying the one key factor that will drive everything else, or by hiring a team of culture due diligence experts. All we can do is keep analyzing investment cultures that succeed, understanding how managers can create and nurture them, and trying to evaluate how our managers stack up.
We look forward to being held accountable by our clients to the standards we set forth here. If we can’t keep hiring sharp, creative, careful, honest people who are happy to come in to work each day, it’s a problem. If we lose our track record of retaining them, it’s a problem. If we don’t inspire them to work with discipline in an ethical manner, it’s a problem. And if we ever have these problems and somehow fail to notice that we’ve fallen short, we will be truly grateful to the person who wakes us up.
IMPORTANT INFORMATION ABOUT THIS ESSAY
This essay reflects the opinions and views of the authors and is not intended to describe any strategy, product, or services provided by Magnitude Capital, LLC (“Magnitude”). This essay is for informational purposes only, does not constitute investment advice or an offer to buy or sell securities, and should not be deemed to be a recommendation to make any investment. This essay, insofar as it discusses investment strategies, portfolio construction, and/or other investment-related themes, is general in nature and does not address any individual investor circumstances or risk-tolerances, which may vary significantly. The reader is reminded that an investment in any security is subject to a number of risks, including the risk of a total loss of capital, and that the discussion herein does not contain a list or description of relevant risks. The reader should make an independent investigation of the information described herein, including consulting the reader’s own tax, legal, accounting and other advisors about the matters discussed herein.
The factual information set forth herein has been obtained or derived from sources believed by the authors and Magnitude to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness. Certain of the information in this essay may include estimates, opinions, forward-looking statements, and unverified information. Such information may be generated by Magnitude or obtained from third-party sources. Such information and analytic tools employed by Magnitude in generating such information may be subjective in nature, subject to substantial uncertainty, subject to flaws, and unreliable. Neither Magnitude nor any of its officers, partners, employees, or affiliates, will bear any liability for reliance on such information. Approaches used by Magnitude in the past and those used in the future may be made with a different view of markets, may utilize different strategies, may not have similar characteristics, and may produce different results. Much of the material contained in this essay is subject to change and Magnitude has no obligation to amend or update the information. As always, past performance is no guarantee of future results.
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