Wednesday, October 21, 2015

How Valeant revealed the dirty little secret of fund management

How would you feel if your equity fund manager lagged the index by 5% in a year? Supposing that you hired the manager, or bought his fund, as part of the diversified equity portion of your portfolio and he missed by 5% in a year. Let's say that you be patient, then he underperforms by another 5% in the next six months. Would you fire someone who lags the market by 10% in 18 months?

Returns vs. business risk
I have met people who say that they love managers who hit the home run and loathe benchmark huggers, but investors get very nervous when their managers lag the market by as little as 5-10% in a relatively short (1-3 years) time frame. From the perspective of the manager, this level of risk tolerance brings up the issue of business risk. How do you maximize performance using your process, or "secret sauce", without taking on excessive business risk that sinks the entire firm?

Risk comes in all shapes and sizes. For an equity portfolio, common sources of risk are sector and industry risk, market cap risk and stock specific risk. To illustrate my example, consider the lowly issue of stock specific risk, which should be diversifiable (at least according to theory).

The recent case of price volatility in Valeant Pharmaceuticals (VRX) is an instructive example in risk control. In the past few weeks, I have spoken to a number of Canadian portfolio managers whose performance was blindsided by specific risk from that one single stock, The outlook for VRX is highly divisive and talking about it is the equivalent of bringing up touchy topics like religion or gun control in polite company. (Incidentally, I have no opinion on the stock.) The chart below depicts the price of VRX in the top panel and the TSX-VRX ratio in the bottom panel, which shows what would have happened to relative performance had a manager had no position in VRX for the past few years.

Despite the fact that the stock got hit today, VRX has shown remarkable returns in the past few years. In the space of about 5 years, the stock has become a 10-bagger and anyone who didn't own it would have underperformed the index (bottom panel). Consider the following effects for a manager who did not hold VRX:
  • If he didn't own it at the end of 2013, relative return shortfall would be over 8% when VRX hit its peak this year. For some investment organizations, that kind of shortfall could be a near-death experience.
  • Even with the pullback, relative performance shortfall would only be back to 2013 levels and he have not made up for the shortfalls in the previous years.

The art of business risk management
The analysis brings up a key question for the business risk for investment management operations. Yes, we would all like to have the courage to bet our investment convictions, but how much business risk is the practice willing to take? Supposing that an operation were to lose half its clients because of a single decision on a stock, what does that do to the bottom line? Revenues would go down by about 50%, but there are fixed costs such as rent, salaries, systems, legals, etc. Profitability would plunge in such an instance, is the investment management business willing to take that kind of risk?

If not, then there are a couple of steps a manager can do. First, he has to decide the appropriate level of stock specific risk he is willing to take against the benchmark. Supposing a stock has a 3.5% weight in the benchmark, would you hold a 0% if you ranked it a "sell" (-3.5% bet), a non-zero weight, such as 2.5% (+/- 1% vs, benchmark) or 1.5% (+/- 2% vs. benchmark)? On the other hand, if your ranked it a "buy", would a 5.5% weight (+/- 2% vs. benchmark) be appropriate? What about 8.5% (+/- 5% vs. benchmark)?

Another way of approaching the problem would be to try and determine the median competitor weight in the stock (with techniques that I have written about before). Then set benchmark weight to be the median competitor weight instead of the index weight.

I show this example as just how a simple decision on a single stock can crash an entire investment management practice. I haven't even gone into all the other ways that risk can rear its ugly head, such as macro factor, sector, size and so on.

Asking too much of managers?
This post also illustrates the dirty little secret of fund management. Investors are asking too much of managers and managers are consequently reacting rationally by closet indexing.

Investors have to ask themselves: How much rope are you willing to give a manager to succeed? Is John Hussman flaming out, or is he a brilliant thinker going through a bad patch? Other well-known managers like Bill Miller and Ken Heebner have had their ups and downs, how patient are you willing to be? If you have a low level of patience, then you are forcing managers to become benchmark huggers because you are not giving them enough room to win.

For managers: Given the realities of the market, how much risk are you willing to take so you don't crash your firm?


Anonymous said...

Hi Cam.
I have no real experience hiring fund managers to manage my paltry sums of money.

But if I had the money, I'd think that absolute performance rather than relative performance against a benchmark index would be the way to go.

And surely the minimal absolute performance that might be expected is that he should at least out-perform the yield on a 10 year Treasury Note or the etf, IEF.

Just saying.
Or am I being too unrealistic?

Curiously Yours ... Peter

Cam Hui, CFA said...

Peter - I can understand that at one level that you may be absolute return focused, but how would you feel about investing in a large cap fund and found that the fund only held two stocks. Consequently its return is going to be radically different from the S&P 500. Would you stay?

Anonymous said...

Dear Cam
Thanks for your kind response.
OK. I can see how a two stock portfolio large cap fund would have a huge marketing challenge in the context of "fund management as a business".

In my idealized world though, I'd love to see funds being set up to beat a fixed annual percentage rate of return (eg 3.0%) rather than try to beat a benchmark index like the S&P 500.

I know. Not going to happen.
Bernie Madoff had a 10% target but it was a Ponzi scheme!

Thanks for hearing me out.
(No obligations to post this comment if I am belaboring the point).

Cheers ... Peter

Unknown said...

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I look forward to your subscription program.

cosimodemedici said...

Great article.The average investor would not think for a moment that in passing the management of his portfolio to a professional firm he might be taking on greater risk simply because of the business risk now in the equation. Hussman to me is a standout,not because of underperformance but because of the thorough fact based research he does and the logical explanations he lucidly sets out.
Clearly there is great business risk and much personal pain in refusing to abandon the strategy he believes will in the long term best protect his investors while allowing them also to participating in any well founded growth in equity values.
I do hope he can see it through and if I had to make a decision now to give my total risk capital to only one fund manager while I went off planet for say 10 years he would get my vote - no competition.