Institutional Investor Teach-in Part 1: Investment Philosophy

This teach-in details our investment philosophy and is intended to resonate well with our institutional readers/clients. We assume a client persona that wants to be 100% invested and is long-only. As will be illustrated, this does not mean that the client necessarily has any real (or net) “exposure” to a particular equity index. In other words, what this paper really hopes to expound on is the art and science behind an absolute return strategy. Lastly, it is worth mentioning that a long-short version of this paper can be adapted for hedge funds with just a few basic changes.

Our Investment Philosophy

“Safety-first” forms the foundation of our investment philosophy. It is similar to the Hippocratic Oath to which every medical doctor must ascribe. The spirit of that oath is to, “do no harm.”  Keep in mind how the asset manager and other stakeholders work together to attain this goal.  We work with stakeholders to gauge their risk “appetite.” Based on that risk appetite, a risk-band is established for the client. Internal risk models are then used to vary risk along this pre-specified band in light of market conditions.

Most investment management firms look at risk under a single light. For most, risk is defined as the day-to-day variability in returns. That is a very valid approach to viewing risk, but it is not without flaws (as will be demonstrated). But we focus on a more intuitive notion of risk, and define it in terms of potential drawdown in wealth. Drawdown is defined as the peak-to-trough decline between any two levels of wealth. From a risk standpoint, we believe that it is ultimately drawdown that investors care about (“What is the most I could expect to lose?”). Consider The Following Chart:

Would it not be perfectly acceptable to have wealth increase along a line that isn’t “straight” (i.e. one that has a lot of variability)? Of course! Would it somehow be acceptable to have wealth decline in a straight line? After all, there is no variability in a straight line. The answer is, of course not!

Now consider the following fact: most risk models see the orange line (above) as having more desirable risk characteristics. The blue line (above) would be penalized for having more “zigs and zags.” Thus, despite the fact that the blue line has about half the drawdown as the orange line, the blue line would be deemed riskier. Even Wall Street has fallen for this trap. The reason for this is that variability is an easier metric to build risk models around. We are not about building risk models that are convenient. We have gone the extra mile to ensure that portfolios are robust to large drawdowns as well.

Here is another way to look at drawdown. As mentioned, most risk models are flawed because they only consider the day-to-day (week-to-week) variability in returns. They don’t consider that it is the incremental compounding of consistently negative returns (the orange line) that lead to undesirable investor outcomes – large drawdowns.

We believe that to prosper as an investor, one has to position an investment portfolio to minimize the probability of large drawdowns. Drawdowns have another important implication, they make the probability of ever getting “back to even” significantly lower. Think about how the compounding of returns works. It is helpful to illustrate this principle by utilizing an extreme example. If an investor loses 50% of her wealth, say $1M falls to $500K; then in order to get back to even, they need a 100% return ($500K back to $1M)! It should be clear now that it is drawdown which is the real enemy of investing. It should also be clear that drawdowns are not only unpleasant because people don’t like losing money, but because the burden becomes ever greater to recoup those losses. This is not a trivial observation. Consider the chart below:

Consider the fact that both lines in this chart have the same average return. The same arithmetic average. Starting from the $100 level, both lines averaged exactly 16.67% over the next three measuring points. But here the orange line dominates the blue line. Why? Less drawdown. By experiencing a maximum drawdown of only 20%, the orange line only had to gain 25% to “get back to even”. The blue line, having declined by 50%, needed a 100% return to do the same.

In the next section, we describe how to construct a portfolio to minimize drawdown.

Key Takeaway:

The “safety-first” principal has real mathematical underpinnings in the investing domain. It should be clear that we are not just stating the obvious by saying that avoiding large drawdowns in wealth is the key to prospering as an investor.

So how do we determine if market conditions are favorable enough that we would be willing to take more risk, or whether they are exhibiting the exact opposite condition? The answer to that question will come in the next two sections. As you’ll see, we are unique in that we actually form an opinion about the overall market based on the health of its constituents – a true “bottoms-up” process.