Skill and Luck 2

One time I was with a colleague in Japan interviewing managers. My colleague Patrick knew his way around Tokyo, well, somewhat, so we only spent 25% of the time lost instead of the usual 50%. This was early 2006 when Japanese hedge funds were facing a particularly horrible time. The January and February losses on the broad market were about 7% each on each downleg. Taking into account some upside volatility the market actually only lost slightly over 5% from the beginning of the year till mid February.

Hedge funds trading Japan from Japan had mostly sustained double digit losses and were facing tough questions from their investors. In the latter half of 2005, the fund of funds community, that is the people who invested on behalf of investors into hedge funds, had been very bullish about prospects for Japanese hedge funds. They had piled into Japanese hedge funds rather exuberantly.

At the annual Goldman Sachs Asian hedge fund conference usually held in November in Tokyo, the mood was upbeat and investors outnumbered hedge funds by several multiples. Some 600 over people showed up, some uninvited, hedge funds and investors both. Times like this I get nervous. I have no reason to be. No good reason at least. But human beings are like lemmings sometimes. In November 2005 we were being told that the smart money was already invested but that the party would continue. I was and am of the view that this was the correct view to take and this story is not one about contrarian investing. This story is about a particular hedge fund.


(Throughout this Blog names of people and companies are changed, so are particular circumstances so don't bother trying to figure out who I am talking about. Usually the characters are composite characters, sometimes reflecting the schizophrenic nature of some managers, but more often because it makes for more colorful description.


John was the manager of a Japan equity long short fund. In Asian markets, equities are the most liquid and visible of markets. The dominance of bank lending has stifled the growth of corporate debt although this has changed considerably since the 1990s. Still, the majority of hedge funds in Asia will be involved in trading equities. Local currency debt is a growing market. Emerging market managers trading in Asian markets but sitting in London or New York mostly participate in the hard currency soveriegn and sometimes corporate market for debt but these rely more on macro economic analysis than bottom up stock selection.

Anyway, John was an experienced trader who had cut his teeth trading at such intitutions as HSBC, Citigroup and Merrill Lynch. He had grown up in Asia despite his African American / Japanese ethnicity. He spoke fluent Japanese and he had an excellent network in Japan.

Following a pretty good career at Citi, John joined a hedge fund launched by a big name trader who had come off the proprietary trading desk of Deutsche Bank. The fund launched with some fanfare and raised 500 million USD in capital. It traded for a year and then came unstuck. Prop desk traders are in hot demand when it comes to hedge fund start ups, but there are risks. There are always risks. With prop traders the risk is that the guy was never a very good fund manager to begin with. Maybe he was just a psychotic risk taker and his success at some investment bank was down to the quality of risk management and not to his own skill. Any prop trader leaving to set up his own fund will tell you that this is not the case. They will tell you how risk management in an investment bank is stifling and does not understand the true nature of risk, does not understand the structure of the market, or the intricacies of trading. Success at Goldman Sachs, Morgan Stanley or JP Morgan on the prop desk does not automatically translate into success at one's own hedge fund. In any case, John's new venture collapesed in a cloud of redemptions as investors sought to cut their losses and exposure to further losses.

When I went to see John, he had just completed his separation from the ill fated hedge fund and started his own firm. In the course of the interview I began to suspect that John was actually a very good investor. Having traded Japan myself I was in a position to discuss at the position level, his current portfolio and understand his rationale for each position. Subsequent reference checks in the days following allowed me to confirm that the damage at his previous shop was due to poor risk management on the debt side of the portfolio. John was good and the implosion of his old shop was not his fault. It was bad luck that he had saddled up with the wrong posse and got burned.

Unfazed, John picked himself up, dusted himself down and re-launched himself with his own capital. The investment in the business totalled over a million USD and he had another 3 million USD to invest in his own fund. Unfortunately for John, he launched his new business at the end of 2005. His first 3 months were horrible and saw losses totalling 17% by March. Losses do strange things to people. His natural instinct told him to stick to his knitting and he would recover but as he was at the stage of raising capital, courting funds of funds as investors, he changed the way he managed money. By June the losses were nearly catastrophic.

I kept in touch with John throughout and followed his investment strategy through the months. They were sound and would eventually turn his way. Unfortunately, as the great Lord Keynes said, the markets can stay irrational longer than one can stay solvent. I have lost track of John now and he may have thrown in the towel. I hope he hasn't because he was a skilful investor on a bad roll. At least that was my opinion.

The first question is, how do you distinguish between bad luck and poor skill? If one has traded the same markets or strategies one can empathize with the manager. What if the strategy is alien and one is learning about it for the first time. Technical competence and skill are very different things. Competence can be learnt. Skill takes experience to learn, sometimes painful experience. Here again, skill could be discerned if one knew enough of the strategy and had sufficient information (transparency) to understand the rationale behind the positions.

A more difficult question as an investor is how long do you tolerate bad luck?

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Skill and Luck 1.

In the investment business, the need to distinguish between skill and luck is very important. But why?

I am in the investment business. My job is to find and invest with fund managers whom I consider to be good investors. But what makes a good investor? This is a length subject which has been dealt with by others. Matthew Ridley, who manages a fund of funds at Consulta has written an excellent book entitled How to Invest in Hedge Funds which goes into great depth what makes a good investor.

My interest is in separating skill from luck and even before that, asking if it is important at all to distinguish between the two.

In my search for investment managers I once visited a manager in New York who was reputed to be an excellent investor. As someone responsible for investing with managers it was my job to figure out if this guy was going to be able to make us money. Phil, let's call him Phil, was a distinguished guy in his late 40's or early 50's, it was difficult to look beyond his perma tan. We met at his office in Midtown Manhattan with a view over Central Park. Phil was clearly a successful manager. The fund he ran had over 1 billion USD in assets and he was generating good returns for the last three years.

Phil began by rattling off his CV. So many years at Drexel with Michael Milken and his group, that's how you really learn the business, so many years at Morgan Stanley, that's how you understand the institutional business, so many years at XXX Capital, one of the largest hedge and most respected hedge funds... It was very impressive.

Next, Phil launched into his investment strategy. He was always long volatility, he had a team of analysts who took a bottom up approach to investing and understood the portfolio companies as well as the CFO's of the companies did. He had a network of fellow investors whom he hob-nobbed with. Risk management? A Russian PhD in mathematics ran risk management.

Phil and his fund were very impressive but they would not discuss positions or the current or even a slightly outdated portfolio. He would not discuss example trades but spoke very generally of being long volatility, never taking tail risk, monitoring correlations, being long convexity, buying cheap optionality etc etc. Without going into some of the details of the portfolio, without access to his traders and without the opportunity to understand the motivation behind old successful or losing trades, all I had to go on was the track record of the fund. Phil was saying, trust me, look how much I have made for others before, I can do the same for you.


I was very impressed by the numbers, the CVs, the presentation, Phil's bespoke suit and expensive address. I told him I would take some time to think about it and that I would have follow up questions. Phil was all sweetness and light. In this crazy industry he was doing us a favour by taking our money. Call me any time, he said. Anything you need, just let me know. Yet all he would give me were sweeping generalities, not an insight into how he thought and how he invested. The number he was printing looked fantastic. 20+% returns every year in the last three years was good performance. I just couldn't tell if it was luck or skill.

Here's my problem with making money by accident. First of all, investing in hedge funds is expensive business. Fees are typically 2% of assets per annum plus a 20% share of profits. Find a skilful manager and that's cheap. Find a flukey one and 1% is expensive. When I invest with a manager who is skilled, they, and I, know why they made money at a given time. They also know why they lost money. That means that when things go wrong, they know how to react. Flukey Luke Capital who makes money by accident is risk because if they don't know how they make money, they certainly don't know why they lose it, and they don't know what to do when they are in a losing streak. When in a winning streak, its easy. Stand on your position or increase it.

So how do you tell skill from luck? Well, I know when I have no chance of telling between them and that is when the manager is not willing to talk to me about their investment rationale in some detail. Transparency is a concept that has been discussed ad nauseum in our industry. Transparency has its uses. Understanding the strategy is one of them. It should be used wisely, however. Trying to make sense of a 15000 position portfolio list of ISINs is not helpful.

Also, it involves a lot of homework. I can usually conduct a coherent interview with an equity trader. Imagine if I was interviewing the manager of an Art Fund that invested in Asian Tribal Art. One has to know a bit about the particular industy in which the manager is involved in order to conduct a coherent discussion. If you don't know, very soon the manager knows you don't know and you are quickly at the mercy of their goodwill. Commonsense goes a long way. Whenever I can't understand a particular strategy I go back to basics. There are limits, however, to the interviewee's patience and good charity, and to one's own professional reputation. Manager's welcome intelligent questions. Don't expect a tutorial on the dividend discount model or on discounted cash flow valuations.

Even after all this, its bloody difficult. Until today, the assessment of skill is more art than science. Very often it is a hunch that demands corroboration and evidence. Sorry I don't have a recipe for distinguishing between skill and luck. Besides the obvious one: they did not know how they made or lost that money... It would make life so much easier if I had a checklist that I could fill that at the end said, this here manager has skill, or this here manager is just plain lucky, but alas, life is just not like that.

I would like to add one further thought: How do you tell poor skill from bad luck?

Singapore Real Estate

An ex-colleague of mine sent me an email today. He was trying to interest me in investing in an apartment in Singapore somewhere near the Singapore River. This was good news and bad news.

Calling the direction of a market is usually a perilous endeavor. When I moved to London in 1999 I thought that the property market was overheated and due for a sharp correction. It turned out that I was mistaken and due for a sharp correction. The market rallied for another 7 years and is still rising. There have been a couple of hiccups along the way but nothing anyone would call even a mild correction. My opinion on London real estate led me to underinvest in 2000. As a result I have been somewhat 'left behind' by the London property market. Fortunately I did buy a small apartment to live in which has provided me with some exposure to the rising property market. Today I continue to look at the London property market in disbelief. I do not believe it can go any further and I expect a correction but I have been quite wrong in calling this market, so mine may not be the best advice.

In 1996 I was more fortunate. Real estate markets in the Far East, particularly in Hong Kong and Singapore but also in Bangkok and Kuala Lumpur were skyrocketing. My analysis of the nature of demand and supply at the time told me that the market was very stretched. My macro call was to be out of real estate and into cash USD. One could go back and find all sorts of evidence how one was smart and wise and acted with deliberation. My family sold out of its real estate position in 1996 and bought USD with the proceeds. The timing smacked of luck. I will take a profit attributable to luck or skill or an act of God any day.

Singapore has been through some tough times. In 1997 it discovered that for all its achievements, for all its being first in the class (of Asian Tigers), it was vulnerable when Asia as a region stumbled. By 1998 Singapore was in recession with the rest of the lot. 1999 was a year of recovery although few in Singapore felt it. Many were over-levered in real estate and in negative equity. The rebound in real estate was weak and short lived. In 2000 the US equity market bubble burst. Some bear had gone and frightened the living daylights out of Goldilocks. A global recession ensued. On September 11, 2001, planes flew into buildings and it looked as if things could not be worse. Sars was the localized (to Asia) event that made things worse. Further recession for Singapore in 2003. The real estate market sagged further.

At the time (2003), the then Prime Ministed Goh Chok Tong delivered the government's plan for recovery. The plan was simple in principle.

Attract wealth by attracting wealthy people or people who could create wealth. Do this by attracting certain industries such as Wealth Management, Private Banking, Gaming, Education, High value added services. On a capacity constrained island, this makes life a bit difficult for traditional industry and manufacturing. Sacrifices had to be made. The Swiss were being hobbled by the need to integrate albeit informally into Europe. China, the Middle East, India, Indonesia needed a new place to process their newfound wealth.

Execution was another matter. I did not have much faith at the time. The government spoke of creating a cachet like London or New York. That takes decades, centuries if you look in Europe. I did not think it would work.

By 2004 I thought I had better put in some research just in case Singapore succeeded. Never write off the Singapore government. They are possibly the most motivated, deliberate and driven people you will meet. When they set out to do something, expect them to achieve a good proportion of their goals.

Real estate markets as represented by the URA's property price indices bottomed in March 2004. It was difficult at the time to tell if this was another false start in the beleaguered property market. Even today we do not know if it will continue. What we do know is that as of Dec 2006, the index was 15.7% above the March 2004 low.

I could make all sorts of representations about what I believe the market will do. But December 2005 I took a long position. I am revealing my preference. I may be wrong. I hope not but the facts support the hypothesis.

• Singapore is an almost centrally planned economy. How can one say that given that it is clearly a market economy? Simple. The central planner outsources to the market when it is optimal to do so. For the most part, it is optimal to do so. Policy is thus exceptionally effective in Singapore.
• The government is a partner to free enterprise. Again this is because it is effecient to be so in a small economy where information is good.
• The government has restructured the economy from a manufacturing focused economy into a service economy. Of late the focus has been on financial services and wealth management, gaming and education.
• Defined policies, strong fiscal incentives and expeditious regulation and legislation stand behind Singapore's position for the future. It is likely to be successful.
• GDP growth has recovered from 2003 levels. Inflation has been benign and there is no reason to expect it to rise. Unemployment is remarkably low. Per capita income is a very respectable 32,000 SGD.
• The economy is now less dependent on the US and more on Asia and Europe.
• Land is in fixed and short supply on an island like Hong Kong and Singapore. Part of the decline in supply in the last 10 years has been led by demand and part by physical constraints but supply has been steadily falling since 1997.
• Vacancy rates rose in 1997 but have held steady at about 8% until mid 2006. It is now in decline. Expect supply to be adjusted through re-development to meet demand.

General conditions are supportive of real estate in Singapore. But there are of course risks. With real estate, leverage is almost always attached and can range from 2 to 10X. The asset is illiquid exacerbating the leverage risk. Prices in certain sectors have risen 30%-50% in the space of 12 months.

This time is not different. Some of the players are different, some of old hands having been taken out for the count in the last dip back in 2003. Nothing lasts forever, neither bull markets nor bear markets. Nothing goes in a straight line. This bull market will see its share of pullbacks, corrections, surging rallies and deadtime.

There were lessons to be learnt in 1997 , 2000 and 2003. Invest with knowledge and not in ignorance. In the earlier half of the 1990s it was easy to make money. Get your maid to stand in the queue at any (and I mean any) new development so you could reserve your unit when the sales office opened. In 1995 even rusty tours looked good. Buy indiscriminately and leverage blindly. (Leverage? What's that? I don't leverage, I only use a mortgage... excellent.) Many people got blindingly rich by leveraging into a raging bull market. Many of these chaps lost faith in 2003 and look disapprovingly at the current bull market. Some of their sons and daughters will be looking to flip a couple of apartments just as mom and dad did in their hey day. There is a fine line between investing and gambling. (Please, no jokes about the Integrated Resorts.) In a world where astute investors can be separated from their wealth, gambling is not very viable, a gamble is precisely what the uninformed investor undertakes.