Does Your Hedge Fund Have An Investment Process? Do You?

Note: This is part of my hedge fund series. Click for the Introduction. and Part 1, “What I Learned Working At A Hedge Fund”, and Part 2, “Career Advice From a Hedge Fund Pro”

From the outside looking in, hedge funds are quite an enigma.

The average person on the street is not even sure exactly what they do, only that hedge funds makes tons of money. The people running big funds routinely top lists of the richest people in the world.

 

What is the secret sauce behind their success? And what does this have to do with you?

 

What do you have to do in your business or your own trading to capture that secret sauce?

 

First of all, the mystique that surrounds the famous managers is partially justified: Think about George Soros, who was able generate $1 billion of profits in a week breaking the Bank of England; or John Paulson, who presciently shorted the entire US housing market. It’s easy to get star-struck by the numbers and personalities and thus to forget about the day-to-day reality. Hedge fund managers are trying to do what they have always tried to do—to generate big returns and to raise money from investors. In summary, they’re trying to run a business.

 

If you think about it, why should the hedge fund industry be different from any other business? Just like a normal business, there are customers—the investors. There is a product—the fund and the returns that it produces. There is a price—the fees that the manager charges. There are people who work on the product production line—the investment team. While the monetary sums can be astronomical, the reality remains mundane. A hedge fund is a business and its product is investment returns. And an investment process remains the best way to get those returns.

 

The Business Is In The Process

 

What separates a large, successful business from a struggling, one-man shop? When you think of the successful business, do you think of everything running according to plan, with lots of people occupied by their own part of the machine? Or do you think of a panicked person running around like crazy, trying frantically to do everything? Of course not—the idea is ridiculous.

 

The difference is simple. Successful businesses have procedures and processes that they adhere to. In order to make and sell a product, they can move things effortlessly from Steps A and B through to C and D. Hence how Coca-Cola can produce millions and millions of cans of soda a year, pack them and ship them without breaking a sweat. It has invented and refined a variety of processes to get these results, and it sticks to them. Instead of having to think about what the plan is and trying to reinvent the wheel every day, the assembly line workers are free to come in and just execute on it.

 

Now of course, say the words “investment process” and most people’s eyes will roll. Anyone who has spent a decent amount of time in the hedge fund community has heard this team used ad nauseam. If anything, the term “investment process” has been overused many times in the investment community, both at hedge funds and at traditional asset managers, to the point where it has become devoid of a lot of its meaning. It recalls images of annoying flow charts and jargon. It calls to mind an endless chain of boring “process-driven” meetings. One thing is sure –no one really knows what it means and stands for.

 

Moreover, a lot of investment managers themselves would like to downplay the idea of an investment process. After all, where’s the glory in one? It’s the antithesis of the myth of the lone, brilliant hedge fund manager, courageously and mysteriously making gobs of money. Think of Michael Lewis’ book The Big Short—the managers profiled in there are so compelling precisely because they are plying their trade in obscurity, working hard in some corner of the country to uncover the best investments. Or think of George Soros, who was almost silent on his investments and strategy and yet produced staggering returns.

An image as a swashbuckling, successful, independent trader is flattering and ego-gratifying. But it also serves a business function. The mystique and secrecy spark curiosity and interest amongst the public. The lack of disclosure leaves them two alternatives—invest and be in the know and share in your returns, or be left out entirely. Potential investors think “I’m not sure what this guy is doing to make so much money, and the only way that I can find out is to invest”. Such investors are reluctant to talk about “a rigorous investment process” because it would kill the whole myth to say “Oh, actually, it’s a big team effort and we just stick rigidly to our system”.  Hence, hedge fund managers in general are going to go for maintaining the mystique.

 

While a fund manager may be reluctant to talk about it, an investment process is still the key thing to understand about hedge funds, because it forms the core of every investment-related firm. It describes how you “make” your key product—your fund and its returns. It charts the life cycle of an investment, from what you look for in a potential investment; how you get in to and out of positions; and how you structure a portfolio. An investment process isn’t a silly document nor is it a box-ticking exercise—it is the core of a hedge fund business.

 

Do you have an investment process?

 

Moreover, this should matter to you, whether you work at an institutional money manager or you’re just trading your own account. You need to think in terms of an investment process to bring some shape and definition to your trading, to make it more like a business process rather than a collection of haphazard, random bets. As we have looked at before, good trading really is about making good risk/reward decisions; in this case, your investment process is the tool that keeps you on track, making good decisions and avoiding bad ones.

 

One way to think about an investment process is that it’s a funnel. It’s very broad at the top, taking in a lot, but eventually only a little trickle leaves at the other end. This is how to whittle down the huge universe of possible investments down to a few that make the grade and are in your portfolio. In fact, you should want it this way- to discard the noise and the many, many bad or marginal trades and just to be left with the best of the best.

 

There are a few stages or steps in defining or checking whether or not you have an investment process

  1. The first step is defining which markets you will be looking at it and investing in.

Here, you have to strike a balance between being specific enough that you’re handling a manageable number of potential of investments, versus being so specific that there aren’t enough real opportunities.

Take where you have experience and start from there. If your background is fixed income, trading both government and corporate bonds, then define that as your playing field. If you have experience trading equities in Latin America, then that’s your scope. If you are just starting out, then you might want to have a small universe to start out on, but nonetheless, you’ll want to determine one. By defining your universe, you’re doing two things at once: understanding and reinforcing your areas of strength and avoiding other areas, where presumably you would be weaker.

The reason is obvious. If you’re a Latin Amercia specialist and a broker suggests an interesting trade in Petrobras, then you would definitely take a look at it, because it’s your expertise. If that same broker suggests a trade in the shares of Tesla, the electric car company, then you would quickly realize that you have no real edge there and not look any further. Understand where you have an advantage and do it; if it falls outside of your circle of competence, then just pass.

By defining your universe, you’ve built the first part of the funnel. You know that you’re going to narrow your focus to an area where you have a good understanding.

 

  1. 2.       What are you looking for in a potential trade?

Now that you have your universe defined, you will want to sort through the universe in some way to look for interesting opportunities. To do that, you need to have clear in your own mind what constitutes a good trade. What are you looking for?  How would you describe a good trade? What is absolutely essential to see? What is helpful but not necessarily critical? What kind of trade would you NOT do?

When you read in books like “Market Wizards” about traders having a methodology, this is the real nuts and bolts of it. While different traders are looking for different criteria before getting into any position, they all have some criteria in mind.

Think of it like a checklist. You have a few things that need to be there before you are ready to put on an investment. You look at an investment and check those boxes. There are a few more that you would like to see. You check those additional boxes. If it meets your criteria then you put it on.

In his book The Checklist Manifesto, the famous surgeon Atul Gawande introduces pre-operation checklists into all of his operating rooms, with transformational results. By writing down it all down on paper and systemizing things, it made it easier to get everyone on the same page and remember what needed doing. Surgeons are obviously very smart people, so this is not done to compensate for their low intelligence. Rather, it’s meant to spare them the effort of trying to remember everything pre-operation; instead, they can just focus on the difficult operation-related tasks. As the book demonstrates, just this simple exercise helped them to remember everything that they needed to do pre-operation and to do it right. Having this little gameplan in place dramatically reduced the amount of preventable errors during operations, leading to improved patient outcomes. It reminds of the famous quip—“failing to plan is planning to fail”.

The cumulative effect was huge because instead of having to reinvent the wheel every time they did an operation, they could just rely on a piece of paper to standardize and systematize its implementation. What’s more, the more junior doctors and nurses could refer to the checklist and were empowered to stop a procedure if something had been skipped over. The result? A standardized process, which everyone uses and contributes to—just like in any other successful business. This is exactly what we should do with our investing.

To concretize this a bit more, let’s use the William J O’Neill CANSLIM system. It’s a methodology designed for investing in stocks in developed markets. There are seven pillars to his investment philosophy, which could be defined as

C—Current quarterly earnings. Companies should have high growth in earnings per share this quarter.

A—Annual earnings. Earnings growth should be similarly strong, at least 25% per year.

N—New Products or Services, New Management, New Highs. You want a company that develops new products and services; its stock price should be hitting new highs.

S—Supply and Demand. A product or service that is in demand by the public, which will drive earnings growth.

L—Leadership. The stock should be the leader in its industry group in terms of earnings and stock price performance.

I—Institutional Support. There should be large institutional buyers which are supporting the stock.

M—Market direction. Only buy winning stocks in an uptrending market.

 

(Source: How to Make in Stocks Success Stories by Amy Smith)

 

There represent the seven points on your checklist. You can set up several ways to screen through your universe to find investments that meet these criteria. For instance, you can set up a quantitative screen to find stocks that are trading at 52-week highs, or which have very rapid earnings growth, or which show leadership within their respective industry groups. These screens would produce a smaller list of companies that you would want to concentrate your research on. Then you would dive deeper into the remaining companies and get to know their respective management teams, their businesses, etc and figure out whether or not they really meet all of their criteria.

The point of all of this work is to take the entire equity universe and to apply your own investment criteria to generate a list of possible investments. Obviously, there can be other factors that you look for instead of Wiliam J. O’Neil’s. I’m sure that Warren Buffett’s list of criteria would look quite different, and that’s because his investment process has evolved differently over many decades. The point is that you need several rigorous criteria on which to filter your investment universe and to get to a list of potential investments. You are getting rid of the noise and left just with the signal.

After that, it’s a question of what it takes for you to get in a position. In this sense, you are planning the trade that you will make. In the CANSLIM system, once a company has met the first six criteria, the last point is “Market”. That means you want to wait for an uptrending overall market before buying anything—and preferably, the stock that you buy should be breaking out from a base pattern, suggesting that it will have a big run once you put on the position. Thus, you plan the trade by constructing a list of all the companies that meet your screening criteria, and then the entry point that you would seek, plus the kind of market conditions that you would want to see in order to take risk.

After putting on a trade, you also have the criteria that you need to get out of a position. Think about it—eventually, you will want to close the position, either to take profit or to cut your loss. Closing the position could be about the individual position itself—i.e. the fundamentals have changed or the stock price has run 100%, or it has hit your stop loss. Or it could be about the overall market—the trend shifts, so you decide to exit all outstanding positions. Nonetheless, you have certain criteria that there for exiting a position and you need to be rigorous about executing them.

The overall sum of those two is the portfolio construction. While this is overly simplified, the portfolio is the result of the balance between positions that you are entering and exiting, whether those are due to position-specific factors or overall risk management considerations. At each step of the investment process, you are making decisions according to a set of criteria, which provide rules and guidance for your activities. In a sense, you have a set of rules for “planning the trade”, and then you have them for “managing and getting out of the trade”. These rules, and the flow from one step to another, constitute your investment process.

This thinking applies equally well to people who wouldn’t characterize themselves as hedge funds with a rigorous investment process. Think of intraday equities traders, like the ones at SMB as profiled in The Playbook. They have many filters and checklists that they apply to look for potential trades—stocks that are “in play”; key levels; and order flow and intraday activity in a stock. Moreover, they have evolved a set of guidelines to determine how to manage an existing position, both in terms of dialing up and down the position sizing and also getting out of a position altogether. Thus, at every step of the way there are guidelines or rules that help shape a trader’s decision-making, getting them Step 1 (a broad universe) to the last Step, becoming a consistently profitable trader.

While the topic could sound hopelessly abstract—after all, you can’t exactly touch an investment process!—I hope that this has made it relevant to your activities. There are some questions for self-reflection:

Do you have an investment process?

Is it well-defined?

Could someone replicate it your results by following it? Or at least come close to replicating?

Does it work in all market conditions?

Has it been consistently profitable?

 

 

In light of this discussion, how will you change your thinking about your investing or trading activity ?

 

 

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