Distinguishing Alpha from Noise: Resurrecting the Role of Investment Philosophy in Evaluating Investment Managers; “In the long run X always wins”, where X could be dividend yield, earnings growth, quality of management, yet managers are unable cite a reason why X should be systematically under-priced by the market.

17 Jul

Distinguishing Alpha from Noise

David J. Merkel

I read a paper today that I thought was pretty interesting — A Consultant’s Perspective on Distinguishing Alpha from Noise. [8 pages PDF]  I have been on both sides of the table in my life.  I have hired managers, and I have tried to sell my equity management services. In general, managers that thought would offer value would venture off the beaten path.  They might own some well-known names, but they would own far more that would make me say, “Who is that?”  The companies would be less known because they are smaller, foreign, have a control investor, etc. Those portfolios would look a lot different than an index fund.  They would be more concentrated by sector, industry and company.  They would have a process that analyzes what the market is misvaluing, whether by sector, industry, or company.  They would stick to their discipline through thick and thin, realizing that all anomalies in the market go in and out of favor.The process would specify what anomalies of the market, or what information advantages the fund would attempt to exploit.  But once you specify that, you stick to that as your strategy.  There is no room for tossing an asset in “because it looks good.”

There is a balance in good strategies that allows for minor modifications around core principles.  All good strategies have to adapt, but there has to be a strategic core from which the strategy will never vary.  Absent that core, the strategy will give in to fear and greed — buying high and selling low.

Quoting from the paper:

I am amazed at all the managers that make an assertion of the type “In the long run X always wins”, where X could be dividend yield, earnings growth, quality of management, a quantitative factor or mix of factors, etc., yet are unable cite a reason why X should be systematically under-priced by the market.

My view is twofold.  There are some ugly situations involving financial stress that most investors don’t want to take on.  There are also less glamorous companies that few want to buy.  Those can be excellent investments.  My second point is tougher to make, but industries go in and out of favor.  So do market factors.  Buy that which is safe, and out-of-favor.

Now, for managers, I would recommend keeping a trading journal, where you record why you think your investment hypothesis will succeed.  If your investments succeed for reasons that you specified in advance, that is an indication of skill.  There is a lot of what is called “luck” in investing.  If you are beating the market, and it is not for reasons that you specified in advance, you do not have skill, you have luck, and luck strongly tends to mean revert.

My view comes down to this: I like to see a long track record of outperformance, an unusual portfolio, and a strategy that convinces me that you have discipline, and a constructive way of finding undervalued assets.   Absent that, I will probably think that you are a pretender than an outperformer.  There are always some that outperform for a short time, and then underperform as the underlying economics shift.  Markets are volatile enough that there are always some with three-year track records that are stunning, and very lucky.

Separating luck from skill — that is the toughest aspect of investing.  But it is needed because there are so many investment managers touting skill, and what do they really offer?

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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