By Joe Peta
At Novus we’ve examined the performance of many hundreds of hedge funds and we’ve found that, by far, the most important skill to possess is the ability to size positions effectively. That’s because unlike Exposure Management, and to a lesser degree Security Selection, the ability to size positions efficiently is the most persistent and consistent alpha-generating skill that a portfolio manager can possess. In short, it’s the most repeatable skill.
Effective position sizing means that a fund’s largest positions had the highest return on capital. When 5% or 7% long positions outperform all of the other positions in the fund, it can paper over a lot of other deficiencies in the area of security selection. For example, a sub-standard, or under .500 batting average can be overcome if the biggest positions are the winners. There are $20 billion dollar hedge funds that owe the vast majority of their cumulative alpha creation to the market-beating compound returns of a handful of their largest positions.
Before we go through an example it’s important to note a subtle difference between the value of Security Selection and the value of Position Sizing. On the surface it appears that both are dependent of dispersion and that’s true – but it’s a different kind of dispersion. For instance, if the median return of the 500 members of the SPX is 33% and the average outperformer is up 80% while the average underperformer is up only 9%, that 71% difference between picking a winner and picking a loser makes effective security selection incredibly valuable. (This is, in fact, the exact environment that existed in 2009, the greatest year ever for PM’s with superior security selection acumen to ply their skills.) However, if every outperformer was up 80% and everyunderperformer was up only 13%, the ability to size positions effectively would have no value. Identifying winners and losers would be important but sizing them would make no difference relative to other winners and losers.
Position Sizing, therefore, is valuable in an environment where there is wide disbursement within the winners and the losers, as opposed to between the winners and the losers.
To determine the favorability of the environment for effective Position Sizing in any single year, we’ll calculate the difference between the return of the average outperforming stock in the population of outperformers overall vs. the underperformers from that group. (The return of the outperforming outperformers less the return of the underperforming outperformers, if you will.) The same calculation will be applied to underperformers.
As with Security Selection, we’ll show 2004’s calculation schema in detail prior to displaying the entire chart:
Average return of all outperforming SPX stocks
Average return of top half of outperformers
Average return of bottom half of outperformers
Once again we see that it just didn’t pay to be good at something if you were a portfolio manager in 2014. On both the short and the long side – especially the long side – the environment didn’t reward those with a history of sizing positions well. Again, historical lows have been hit.
This is a sobering reality for hedge funds and their investors. There were historically low rewards available for those managers with superior skills. In 2014, a PM could have been just as good at timing the market, or picking winners and losers, or sizing those positions effectively as she’d always been but the returns, from an alpha-generation standpoint won’t show it. Worse, investors may conclude that the PM lost ability when that’s not necessarily the case.
No one should blame the fisherman for a sub-standard catch if there are no fish in the water. But that’s what’s going to happen if no one bothers examining the ocean to determine the population of fish available. Then again, if that exercise is performed, once it’s determined that there are a limited amount of fish in the water, it’d be foolish to pay a lot of money to hire the fisherman.
About the Author
Joe is a Managing Director overseeing Novus’ West Coast business development efforts. He joined Novus after 12 years at Lehman Brothers, where he ran biotech trading as a sell-side market maker and later ran the trading desk for a Lehman-sponsored $200+ million long/short equity hedge fund. While recovering from an injury suffered as a pedestrian in New York, Joe wrote a memoir,Trading Bases, a Story About Wall Street, Gambling, and Baseball. Examining the overlap of critical reasoning used in baseball’s front offices and by asset managers. Joe’s widely hailed memoir was named a Top 10 Sports book by Publisher’s Weekly and a Top 10 Business book by the editors at Amazon.
Joe earned his M.B.A. at Stanford University and an accounting degree from Virginia Tech. He has been featured on CNBC, Bloomberg TV, Fortune and the Wall Street Journal. He resides in San Francisco with his wife and two daughters.
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