Hedge fund manager Seth Klarman was once asked whether investing was an art or a science. He had a thoughtful answer, which essentially came down on the side of art.
But I have a more succinct answer: Investing is an art if you’re winning, but it’s a science if you’re losing. Especially to your boss. Let me explain.
When a professional money manager is riding a hot streak or she’s simply putting up solid number year-after-year, then the usual aphorism applies: leave well enough alone. Ms. Winner’s boss doesn’t need to fix what “ain’t broke”. And the boss is often happy to discuss with others how Ms. Winner’s investment strategy is unique and difficult to replicate (i.e., “hard to understand”).
It’s kind of a forehanded insult to the star portfolio manager, bemoaning the complexity of the manager’s work. But the subtext is clear: Ms. Winner is great and one-of-a-kind – an artist, if you will.
Now fast forward to when Ms. Winner is going through a rough patch – maybe a few quarters or a whole year of underperformance. The marketing department for her firm may actually be quite supportive. Having promoted her strategy and performance for some time, they definitely don’t want the manager to change the former and potentially screw up the latter.
The marketers especially don’t want to have to explain why their erstwhile stock genius suddenly lost the courage of her convictions, especially if doing so means she won’t get paid for “hanging tough” in some of her “underperforming names.”
But when times are tough, Ms. Winner cannot count on walking into her boss’s office for some kind words of reassurance. Oh no. When it’s all gone pear-shaped, the Boss wants answers. Fact-based answers. Science, if you will.
“Why did your biggest position just miss their quarter? Why has your portfolio beta gone from a sleepy 0.90 last year to 1.1 this year? Why don’t you have a position in Polyrazzmatazz, which according to my Bloomberg terminal has accelerating revenue growth, expanding margins and a product line hotter than the surface of the Sun? Why Why Why?!”
Do you think Ms. Winner could put her boss at ease with, “Getting this right consistently is an art.”
No way.
I think this dynamic contributes to the chronic underperformance of professional fund managers versus their benchmarks: the bizarre need to placate a boss or an investment committee by making changes at inopportune times.
Outstanding fund managers like Seth Klarman are great not only because of what they do – assemble a solid, alpha-generating portfolio – but also because of what they don’t do – make changes by reacting to noise as opposed to signal.
As I’ve documented before, the stock market is an overreaction machine and the vast majority of stock price movement is simply noise that has nothing to do with the inherent, profit-making qualities of companies.
Nine times out of ten, if a fund manager is over- or underperforming, it’s a temporary condition driven by market noise. Typically, when a manager is outperforming there’s little pressure to take action. Just as with the aforementioned Ms. Winner, you don’t try to fix what’s working.
That is, you don’t take action. (Though you should – more on this in a moment.) And during underperformance? Well, inaction seems so helpless – hence Ms. Winner’s boss getting up in her grill, demanding that she do something about it. That’s only because his boss knows that things aren’t rosy, and the need for action is simply passed down the chain of command. But what’s required is the reverse: taking advantage of beneficial noise by trimming the winners in a winning portfolio, and standing firm or even ‘topping up’ under-performers in a “losing” portfolio. Any good Chief Investment Officer should understand the mathematics that support this type of portfolio management.
Fortunately at Crabtree, I’m the Chief Investment Officer and the primary portfolio manager. So as PM, there’s no pressure to “do sumthin!’ just for the sake of appearances. And as CIO, I understand portfolio mathematics well enough to let the Crabtree Technology portfolio ride out a rough patch. And there will be rough patches.
As it turns out, March 2013 was not a rough patch for the Crabtree Technology model on Covestor. Overall performance in March was solid: not only on an absolute basis, but also versus all the relevant benchmarks. The model gained 6.2% in the month (net of fees), compared with a 4.4% gain for the Russell 2000 benchmark and a 3.6% gain for the S&P 500 (SPX). Our internal benchmark, the Merrill Lynch Technology 100 (MLO) rose 3.1% during March.
April has brought with it first quarter earnings season and like art, some performances have been eye-catching and one or two have made us want to turn away. We’ll have a full report in our next monthly manager letter. But if you have any questions or comments, you can reach us anytime at info@crabtree-am.com.
Photo Credit: Monica Arellano-Ongpin
