i3 Insights: Via Negativa and the Art of Fund Manager Selection

We’ve probably all heard the familiar refrain that even if some fund managers do beat the market, it’s impossible to pick the winners in advance. I wrote about this in the bonus material for my series on synthesising the active versus passive debate.

My answer was that the best way to improve your odds of picking a winning fund manager is to flip the manager research question upside down. In other words, look for losing fund managers and boost your odds of success by excluding them from your search. I3 Insights thought that this was an interesting idea that was worth exploring further, so here are a few thoughts on the subject.

 I call this method the Via Negativa approach to fund manager selection. You might be wondering what is Via Negativa?

“Via negativa is a Latin phrase used in Christian theology to explain a way of describing God by focusing on what he is not, rather than what he is; understanding Deity’s positive qualities is a task deemed impossible for the finite minds of humans” (just like forecasting the future, which is essentially what you’re trying to do when selecting a fund manager MF).

“Via negativa can also be used to describe a similarly ‘negative’ way of improving one’s life; instead of concentrating on what you do, the focus turns to what you don’t do. This path has two main thrusts: stripping bad habits and situations out of your life, and avoiding bad habits/situations in the first place.”

OK, why should we approach problem solving in such a seemingly backward way? I’ll let Charlie Munger explain:

Think forwards and backwards — invert, always invert.” “Many hard problems are best solved when they are addressed backward.” “The way complex adaptive systems work and the way mental constructs work is that problems frequently get easier, I’d even say usually are easier to solve, if you turn them around in reverse. In other words, if you want to help India, the question you should ask is not “how can I help India,” it’s “what is doing the worst damage in India? What will automatically do the worst damage and how do I avoid it?” “Figure out what you don’t want and avoid it and you’ll get what you do want. How can you best get what you want? The answer: Deserve what you want! How can it be any other way?

Even if Some Fund Managers do Win, you can’t Pick the Winners in Advance

For those of you that haven’t read the bonus material, here’s the section on selecting a fund manager:

That’s true of most things in life. I think this is the logical equivalent of saying: “you don’t know where the fish are, so why go fishing? While it’s true that nobody knows where the fish are, we do know which species are commonly found in the area, their habits (e.g. deep sea) and what they like to eat. Even though you aren’t guaranteed to catch a fish every time, it happens often enough to be a worthwhile activity. And who can deny that some people are genuinely skilled at fishing, even if they don’t always catch a fish?

In a similar way, we know many of the factors come together to create a successful investment strategy. Much more importantly, we know the factors that ruin our chances of success, such as:

  • High fees
  • High turnover
  • Benchmark hugging
  • Managing too much money

Trying to find the “best” fund manager is usually a waste of time. It’s just like trying to pick a winner in a horse race, the best horse winds up being the favourite, is heavily backed by most punters and consequently even if you’re right you end up making very little money.

Instead, look for weaker markets, and behavioural edges, invert, exclude the losers then pick the cheapest of what’s left. A better way to invest actively is to prioritise areas of the market where active management is more likely to work, for example a micro-cap strategy. Identify the behaviours that promote successful investing. Behaviours are far more persistent that performance, so it makes sense to base your search strategy on them.

The next step is to flip or invert the behaviours around and work out all of the wrong behaviours that investors need to avoid. I then screen the universe of fund managers for these bad behaviours and remove any managers that repeatedly engage in them. The final step is to then select the cheapest manager out of the remaining group of shortlisted managers.

The goal of this process is to maximise the expected value of active management for the investor, not the fund manager (see my earlier post). Most people I share this approach with think I’m crazy. I can see from the expression on their face that they’re thinking it’s just wrong to not try and pick the best, or that I’m just settling for the cheapest fund manager (not true!).

The truth is that it’s hard for most people to accept that it might be easier to avoid a bad fund manager than it is to find a good one; especially when they are being paid a lot of money to find a good one. Then there are behavioural biases such as over-confidence that come into play. This quote from Warren Buffett’s 2016 Berkshire Hathaway annual letter sums the problem up nicely.

That professional, however, faces a problem. Can you imagine an investment consultant telling clients, year after year, to keep adding to an index fund replicating the S&P 500? That would be career suicide. Large fees flow to these hyper-helpers, however, if they recommend small managerial shifts every year or so. That advice is often delivered in esoteric gibberish that explains why fashionable investment “styles” or current economic trends make the shift appropriate.

 Michael Mauboussin has observed that the simplest definition of whether or not the outcome of an activity is due to luck or skill is this: can you lose on purpose? If you can’t deliberately lose, then the outcome is dominated by luck.  So, if we can’t identify bad managers, we’re really just getting paid for random outcomes. Something to pause and reflect on.

There are four ideas in the quote above that are worth elaborating on:

  1. Focus on weak markets
  2. Invert the search process (Via Negativa)
  3. Look for a behavioural edge
  4. Maximise the expected value of active management

Focus on Weak Markets

What is a weak game? And how can we find them? In this context, “weak” refers to the level of competition. For example, a fit and healthy adult playing tennis against a 13-year-old is a weak game that the adult is likely to win.  But what makes a game weak is highly dependent on the context. To illustrate, imagine that the 13-year-old tennis player is the junior Australian Open champion. Now, it’s the adult that’s the weak competition!

Our focus should be on finding niches within the universe of active investment opportunities where the fund manager’s skills and experience compare favourably with those of the competition. In other words, the best way to beat Roger Federer is not to play him at tennis!

There’s also a subtler lesson: following the herd is a really dumb idea if your peers have a very different competitive position due to a different set of skills, experiences and circumstances.

We should be looking for games that are weak for us, given our skills, experience and circumstancesRemember, this is always context dependent.

One way to do this is to become a “triple threat”. The idea is this: it’s a lot easier to develop above-average skills and experience in 3 areas than it is to become a world-class expert in a single area. Becoming a strong all-rounder can put you in a class of your own, as there are relatively few people that have mastered the same group of skills to a similar level.

Probably the most thoughtful exploration of idea of weak games is by Michael Mauboussin of Credit Suisse, Columbia Business School and the Santa Fe Institute. Mauboussin presents a clear and logical way to measure the opportunity for active management to add value in 3 must-read papers:

Invert the Search Process (Via Negativa)

The CFA Institute Research Foundation guide to Manager Selection describes the traditional approach as (emphasis added):

These characteristics should be reviewed in the due diligence process, which is often called an analysis of people, philosophy, and process and is carried out by sophisticated investors or pension consultants. The goal of due diligence is to confirm that an investment organization has the expertise to deliver superior performance. Due diligence includes questioning the source of added value and exploring how the manager is going to capture that source within a diversified, live portfolio, after costs. It also includes studying staff training and experience. There is still no guarantee that a manager who satisfies an investors due diligence criteria will have superior performance, but it is a good start.

There are 3 ideas implicit in this quote:

  1. Manager selection is hard, so you need to be/hire an expert to help you
  2. The objective is to look for the best, i.e. fund managers with “expertise” to deliver “superior performance”
  3. There are no guarantees that this will work

I started researching fund managers about ten years ago. Back then, my approach was very similar to the “3 P’s” (people, philosophy and process) described above, except that my version had a fourth P: Performance. The worst kept secret in intuitional investment, a secret that few are willing to admit, is this: it’s virtually impossible convince a board or a committee to hire a fund manager that’s currently underperforming.

I developed an extensive checklist of questions designed to help me investigate each of the 3 (really 4) P’s. Eventually, I realized over time that this approach didn’t make sense because as the quote above points out: “There is still no guarantee that a manager who satisfies an investor’s due diligence criteria will have superior performance, but it is a good start.”

It was tough to accept I couldn’t guarantee that I’ll pick well. After all, everyone wants to feel that they’re good at their job. But finally realising that my success rate was far from perfect freed me up to find a better approach.

I realised that I may not be able to always pick the “best” fund manager. This got me thinking. Can I reduce the risk that I’ll pick badly? And can I minimise the cost of my inevitable errors? In other words, can I apply the concept of via negativa and invert the investment process?

Turns out that reducing the probability of making a bad choice is easier to do. It also results in more consistent and reliable outcomes. There are several reasons why I believe this is true.

For example, you are less likely to make the mistake of “judging a book by its cover”. Looking for the “best” carries with it the danger of focusing on style over substance.  In contrast, the via negativa approach doesn’t look for reasons to be impressed by a fund manager. Its emphasis is on making sure that a fund manager isn’t doing anything that’s likely to compromise performance. There is a subtle but important shift in emphasis between the two approaches.

The best way to illustrate the difference between the two approaches is with an example. The CFA Institute Research Foundation guide to Manager Selection suggests that we should assess the “people” factor this way:

 The factor of basic intelligence can be measured using IQ tests, standardized aptitude exams, and school grades. Knowledge can be evaluated by considering years of schooling, the conferment of advanced degrees, the length and type of work experience, certifications, and scores on achievement tests. Ability to focus and the degree of focus are difficult to measure but can be proxied by the number of hours in an individual’s work week. The degree of alignment of interests can be explored by, among other things, examining the compensation scheme for the fund manager. Long-term thinking requires the formulation of a strategic process, and independent thinking is associated with self-confidence and self-esteem. Finally, many of these characteristics can be related to a person’s entrepreneurial drive, which can be measured by using questionnaires.

What are the problems with this approach? Firstly, it’s far too obvious. All of your competitors are almost certainly assessing skills and experience this way. This means that it’s unlikely to give you an edge in finding a better fund manager. Secondly, fund managers have figured out that clients are looking for impressive people, so they fill their firms with Ivy League, Phi Beta Kappa types.

Pretty soon it becomes like paying for priority boarding on a Ryanair flight. Everyone pays the extra €5 to get ahead and they all end up boarding together! What’s more, you don’t arrive at your destination any sooner because the plane doesn’t leave until the last person has boarded.

Thirdly, all of the measures described in the above quote are really just complicated sophisticated ways of judging a book by its cover. Probably the best description of why the usual approach makes no sense comes from Nassim Nicholas Taleb, author of several books including Fooled by Randomness and The Black Swan, in his post Surgeons Should Not Look Like Surgeons (emphasis added):

Say you had the choice between two surgeons of similar rank in the same department in some hospital. The first is highly refined in appearance; he wears silver-rimmed glasses, has a thin built, delicate hands, a measured speech, and elegant gestures. His hair is silver and well combed. He is the person you would put in a movie if you needed to impersonate a surgeon. His office prominently boasts an Ivy League diploma, both for his undergraduate and medical schools.

The second one looks like a butcher; he is overweight, with large hands, uncouth speech and an unkempt appearance. His shirt is dangling from the back. No known tailor in the East Coast of the U.S. is capable of making his shirt button at the neck. He speaks unapologetically with a strong New Yawk accent, as if he wasn’t aware of it. He even has a gold tooth showing when he opens his mouth. The absence of diploma on the wall hints at the lack of pride in his education: he perhaps went to some local college. In a movie, you would expect him to impersonate a retired bodyguard for a junior congressman, or a third-generation cook in a New Jersey cafeteria.

Now if I had to pick, I would overcome my suckerproneness and take the butcher any minute. Even more: I would seek the butcher as a third option if my choice was between two doctors who looked like doctors. Why? Simply the one who doesn’t look the part, conditional of having made a (sort of) successful career in his profession, had to have much to overcome in terms of perception. And if we are lucky enough to have people who do not look the part, it is thanks to the presence of some skin in the game, the contact with reality that filters out incompetence, as reality is blind to looks.

When the results come from dealing directly with reality rather than through the agency of commentators, image matters less, even if it correlates to skills. But image matters quite a bit when there is hierarchy and standardized “job evaluation”. Consider the chief executive officers of corporations: they not just look the part, but they even look the same. And, worse, when you listen to them talk, they will sound the same, down to the same vocabulary and metaphors. But that’s their jobs: as I keep reminding the reader, counter to the common belief, executives are different from entrepreneurs and are supposed to look like actors.

The idea is this: If you pick the “refined” doctor you, can never be completely sure if he’s succeeded because he looks the part or because he is the real deal. On the other hand, it’s highly unlikely that anyone looking like a “butcher” would ever get to be a surgeon without being good enough to overcome the inevitable bias against their poor appearance.

This matters a lot when the other party doesn’t have skin in the game. When you have an operation, you put your body on the line. You literally have skin in the game. On the other hand, the doctor risks a possible malpractice suit. Not only have the they’ve insured themselves against that outcome, they’ve included your share of the premium cost in your medical bill!

Unfortunately, activities where people can make a lot of money with little or no skin in the game tend to attract the wrong kind of people. Taleb goes on to explain:   

In any type of activity or business divorced from the direct filter of skin in the game, the great majority of people know the jargon, play the part, are intimate with the cosmetic details, but are clueless about the subject…

…  People who are bred, selected, and compensated to find complicated solutions do not have an incentive to implement simplified ones.

Unfortunately, funds management is plagued by a chronic lack of skin in the game, more formally known as the principal and agent problem (see point 4 of my earlier post).

This is why via negativa is so important. Following the conventional path of trying to pick the “best” leaves you at risk of picking the “best looking”. They are not the same thing!

Look for a Behavioural Edge

One of the 3 (or 4 if you include the silent P for performance) P’s is process. It’s very common to see a lot of fund manager research focusing on “idea generation” when assessing the investment process. I used to do this too, but over time I’ve learned to pay more attention to behavioural aspects. That’s because even the best fund managers routinely get between 40-60% of their stock picks wrong.

Can “idea generation” be that important if approximately of your ideas are wrong? Yes, it’s important. But what’s arguably more important is what the fund manager does when their right and what they do when their wrong.

It’s not just the number of correct picks (i.e. buying) that explains success. Position sizing and selling are even more important. And they’re largely behavioural.

Take Amazon (AMZN) as an example. An investment of US$10,000 worth of Amazon shares purchased at the IPO in 1997 was worth $4.9 million 20 years later. Amazon’s 36% p.a. compound return was 155 times larger than the return on the S&P 500 over the same period.

But how many people bought in 1997 and held for 20 years? Not many, as The Australian (courtesy of the Wall St Journal) reports:

As Mr. Batnick points out, Amazon shares have had daily declines of 6 per cent 199 times. The stock has fallen 15 per cent over a three-day span on 107 different occasions. And the damage was far worse over longer time horizons.

Amazon has suffered at least 20 per cent pullbacks in 16 of its 20 years on the public markets. The drawdowns were more than 40 per cent apiece in nearly half of those instances, including a 64 per cent plunge in 2008 during the depths of the financial crisis. Worst of all, shares lost 95 per cent of their value when the tech bubble burst from December 1999 through October 2001.

Most investors just couldn’t ride that out. “There is a very real cost associated with the outperformance that we choose to ignore when looking at a chart,” Mr. Batnick says.

This chart by Bespoke really tells the story. It would have been incredibly hard for any fund manager to decide how much to buy, hold and sell when faced with such volatility. These decisions are heavily influenced by behavioural factors (unless it’s a quantitative strategy).

AMZN

Here’s another reason why looking for a behavioural edge is important. Let’s assume that we can group investment edges into three categories:

  • Informational
  • Behavioural
  • Temporal

The temporal edge is possibly the hardest to achieve in practice, as very few fund managers have managed to build a culture that truly focuses on the long-term. The few that do are relatively easy to identify.

Informational edges are difficult to sustain, as fund managers are constantly engaged in a struggle to steal a march on the competition. The result is that most fund managers end up with similar access to information. I believe that many of the informational edges of the past have been cancelled out by this arms race.

That’s why I think behavioural edges are so interesting. They are more likely to be THE deciding factor when it comes to success or failure (as the other two edges are easily spotted or short-lived).

Behaviours tend to persist, which is another reason why they are interesting. As a psychology major, I marvelled at the incredible potential of the human mind to change and grow. But I also learned not to bet on big changes because most people rarely make them.

We want to base a manager research process on factors that persist, otherwise our results won’t have much predictive value. We want to identify factors that have a large impact on future results. And we want to focus on factors that make the biggest contribution to relative performance because they are either misunderstood or under-appreciated by other investors. A behavioural edge fits all three criteria.

Michael Mauboussin sets the standard for excellence in how to think about active management. I highly recommend his research paper Thirty Years: Reflections on the Ten Attributes of Great Investors. Attributes 5, 6, 7, 8 and 10 relate directly to managing our behaviour and decision-making.

Maximise the Expected Value of Active Management

I often hear institutional investors say that its “returns net of fees” that matter. This isn’t strictly true. It’s expected returns net of fees that matter. What’s the difference? The expected return takes into account the probability that an excess return will be achieved. It is a function of four variables:

  1. level of active risk
  2. fee paid
  3. fund manager skill (i.e. probability that the fund manager has skill)
  4. your skill in selecting the manager (i.e. probability that you have skill)

Here’s a conversation between myself and a friend (you can read more on this topic in an earlier post) that illustrates how this works:

Friend: What’s the typical institutional fee for a fundamental global equity fund manager?

Me: Between 0.5% and 0.75% basis points depending on the strategy.

Friend: OK, let’s assume the fee is 0.5%. Let’s also assume they’re skilful, that is they have an information ratio of 0.5 over the long-term and they take a reasonable amount of active risk, for example a tracking error of 5%. How much would you expect them to beat the market by?

Me: With a tracking error of 5% and an information ratio of 0.5, I’d expect them to beat the market by 2.5% over the long-term.

Friend: OK, that sounds fair. What percentage of active global equity fund managers under-perform the market over any one-year, three-year or ten-year period?

Me: It varies, but it’s usually between 60-90%.

Friend: Let’s assume it’s 75%. The expected value of your alpha from selecting that manager is expected alpha multiplied by the probability of selecting a manager that out-performs or (5% × 0.5) × (1-0.75) = 0.5%.

In other words, the fund manager has just captured the ENTIRE expected alpha or value added by active management!

A key variable is whether or not you have any skill in selecting a better than average fund manager. It helps if you have a fund manager research process that has a better than ¼ (75% chance of picking a loser = 25% chance of picking a winner) of picking a market-beating manager. Otherwise, it’s the fund manager that’s likely to accrue most of the reward.

Let’s assume that: a) it works, b) it leads to more consistent results and c) few investors use it. IF these assumptions are true, then the idea of using inversion to select fund managers becomes VERY useful.

Via Negativa – An Example

To invert the search process, start by asking yourself this question: Why do investors lose money? Create a list of all the answers that you can think of. Then question yourself further to figure out how to identify the problem implicit in each answer. For example:

Q: Why do investors lose money?

A: Behavioural biases such as overconfidence.

Q: What are the signs of over-confidence?

A: Failure to think probabilistically about the future.

Q: How might I spot this in a fund manager?

A: They over-rely on “target prices” based on cash flows forecast 10 years into the future.

That’s all there is to it. Keep questioning until you identify the negatives that you need to look for so that you can avoid the result that you don’t want. This will improve the chances that you’ll get the result that you do want.

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