Tuesday, July 26, 2005

AWJ's Inaugural Post: How to Beat the Market

Alfred Winslow Jones was a financial reporter who is credited with creating the first hedge fund in 1949. Although, today, hedge fund strategies run the gamut and many do not hedge at all, AWJ's innovative strategy was to short securities and use leverage to hedge and enhance returns on his long positions. The majority of hedge funds still employ AWJ's techniques, but the funds that get most of the negative press rarely come from this "Long-Short" category.

As a tribute to AWJ in this inaugural post, I offer quotes on the qualities of market-beating managers and their strategies from some giants of investment management. I expect to post on this Blog about two to three times per week, generously borrowing what I hope you consider to be pithy wisdom.

First up is David F. Swensen, the Chief Investment Officer of Yale University and overseer of its endowment. He just published a book titled "Unconventional Success."

Swensen is widely regarded as one of the smartest and most successful investment managers alive. He also is one of the first university endowment managers to aggressively invest in hedge funds. Since July 1, 1984 he has delivered average annual returns of 16.1 percent for Yale. The following excerpts were found in Institutional Investor's July 2005 Edition:

"Active management success depends on investing with individuals who exhibit the integrity to pursue the often uncomfortable policies that lead to generation of superior investment returns. For example, structuring concentrated porfolios and owning out-of-favor securities generally prove both helpful to investment success and hurtful to personal reputation...

...great investmement managers pursue the business with a passion bordering on obsession...nearly every aspect of life provides grist for the investment manager's mill. Active managers who allow the markets to permeate their lives enjoy a greater likelihood of investment (if not personal) success...

...market-beating managers express their insights in concentrated portfolios that differ dramatically from the character of the broad market. Steadfastness proves absolutely necessary when managing a concentrated portfolio. In the inevitable periods that produce disappointing results, managers either hold on, allowing for the possibility of ultimate vindication, or bail out, locking in the certainty of disappointment...

...Perhaps the most powerful incentive for an agent to serve client interests lies in substantial side-by-side investment. Co-investment (say, by a mutual-fund manager in the fund itself) places the agent (fund manager) on the same page as the principal (fund shareholder), as the fact of co-investment actually transforms the agent into principal. Many high quality investment managers pride themselves on 'eating their own cooking'..."

In Chapter 10, Swensen describes a mutal fund complex that he said "exhibits a number of extremely attractive, investor-friendly behavioral attributes." The management company is called Southeastern Asset Management, which runs Longleaf Partners.

Swensen describes several of Longleaf's attributes, many of which make it sound like a hedge fund. These attributes (with hedge fund counterpart attributes in parentheses) include management behaving as principal (co-investing); having a long-term focus, clear strategy, and attracting a stable client base that has a minimum three-year investment horizon (lock up of capital with minimum investment terms); and "recognizing the 'importance of concentration,'" (strategy focus).

Swensen and Longleaf are not the only investment managers that understand the importance of concentrated portfolios and investment focus. Warren Buffet, no slouch investor himself, once said:
"Wide diversification is only required when investors do not understand what they are doing."
He also said:
"...if you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk. I cannot understand why an investor of that sort elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices--the businesses he understands best and that present the least risk, along with the greatest profit potential."

Sound advice from a couple of the best.