How to pick a manager

Perhaps it is actually harder to pick a manager than to pick investments. The general statistics against active management are well-known. In 2012, for example, 63% of large cap mutual funds failed to match the market (even worse less for hedge funds).

As a result, the full choice set for selecting investments includes both asset class as well as manager, and the probability of choosing a good asset class And a good manager is less than a good asset class itself. Given that most investors usually time managers incorrectly, are there some nontraditional metrics which would work?

Tudor's infamous divorce heuristic notwithstanding , what about some more specific methods to pick a manager? How about through the lens of incentives. A manager should be incentivized for long term outperformance.

1) The manager should still be "hungry." If you are already a household name and have "made it" as a big time manager, you cannot have the same drive for performance as before. A key barrier could be $1B AUM, but the idea should be clear.

2) The manager should be focused primarily on investing. If he has a such a large staff that he spends most of the time either buying baseball teams or opening a huge new office which makes headlines.

3) The manager should not be on CNBC etc. enough to be a talking head. If the manager has enough time and/or interest to continually market himself, he/she is too focused on raising money. Raising money/awareness of his/her ideas does not really make performance better.

What other ones could work?

Lampert's Folly?

Edward Lampert's credentials are impeccable - Yale Skull & Bones, Goldman Sachs risk arbitrage under Robert Rubin (Secretary of the Treasury under Clinton), and of course the billion dollar hedge fund ESL Investments that he founded. Billionaire at 41, he even talked his way out of a kidnapping during negotiations to take over Kmart. Before 2007, his culminating merger of K-Mart and Sears was applauded by both the markets and many commentators.

Since then, however, SHLD has floundered. What happened?

While other retailers are recovering (ex-JCP), Sears can't even seem to be make money and more importantly, has been losing sales for the last five years.

A recent BusinessWeek article may hold some of the answers here. After reorganizing Sears into dozens of entities, each with CEO, board and profit/loss statement, the firm has devolved into bureaucratic infighting. With thousands of stores and over 200,000 employees, the firm has chosen to split itself internally into dozens of smaller entities (but not really). Sears has traded inefficient cooperation for efficient (if cutthroat) competition. A former executive describes Lampert's model has

created a “warring tribes” culture. “If you were in a different business unit, we were in two competing companies,” he says. “Cooperation and collaboration aren’t there.”

How did this happen? Lampert has interpreted free market economics and Ayn Rand's philosophy to make decentralization a key component of Sears. Lampert intends to have the invisible hand choose which business units succeed. However, a key non-free market part is Lampert. Because all units ultimately report to him and he disburses funds, this system is more like centralized planning. Units are vying for Lampert's attention, not trying to make SHLD. In fact, by artificially splitting apart Sear's business (which were formed roughly along market lines' of cooperation), he is disrupting the free-market economics that he seeks to follow.

Given this, is Sears's problem actually its Chairman, Lampert?

Conflict of Interest - Unfair but Necessary?

Misaligned incentives seem to be a common trait in selling financial products. After issuer-paid credit ratings and stock exchanges which cater to high frequency traders, even data releases are not immune to such practices. Thomson Reuters is now under investigation for releasing a well-known customer confidence survey two seconds earlier to select clients for a $6K/month fee. In terms of information fairness, they issue is clear - high frequency traders have a huge advantage other short term traders without such information. However, what is the alternative?

Like free email, the market does not support the conflict-free model for these industries. Few customers are willing to pay for basic email or credit ratings. The later is especially difficult to conceal at the high level because of the ease of free-riding (e.g. a AAA for a company only takes three characters to send and the issuer wants it to be as well known as possible). How else can such companies compete when everybody wants it but nobody is willing to pay by themselves? This is not a defense of such practices, but rather an investigation as to the why.

While we may want this:

(Source: http://thinkbeta.com/blog/2012/01/25/thursday-president-obama-fairness/)

It may be very hard to achieve "absolute" fairness without paying for it in some other way.

This brings up a larger question: are the most profitable operations, in finance and beyond, riddled with conflict of interest? Does "fair" mean unprofitable? As Hank Greenberg once said, "All I want in life is an unfair advantage."

Single Family Rentals - Institutional Herding Continues?

I originally got interested in single-family rentals with the spinoffs of Silver Bay Realty (SBY) and Altisource Residential (RESI) in the last half year or so. These companies buy single-family homes with the intention of renting them out. Given that mortgage rates (<5%) are less than rental yields (>5%), it is typically cheaper to own than rent. On face, these companies provide a compelling statement - they effectively arbitrage low mortgage rates with the fed with tight credit standards for mortgages and have an implicit put in stabilizing housing prices.

But how much does this translate to company profits? Rental yields are usually < 10% to begin with pre-leverage (RESI presentation, slide 13) and mortgage/upkeep are ongoing while renters may leave and so profits depend on 1) maintaining a steady stream of renters while 2) keeping costs low.


The first might not be so easy, given that nationwide supply has increased by over a third since 2005 (the housing peak). Early players have amassed large holdings, leading to downward rental yield pressures even as new entrants, such as SBY/RESI, try to capitalize on the new trend. The result? Silver Bay Realty, one of the larger (new) public companies, is so far unprofitable with a 81% occupancy rate even on homes owned for 6 months. 81% might not sound so bad, but then why is SBY unprofitable?

This leads to the second point - just how much economies of scale does one get from managing thousands of houses? Does owning two lawns mean you only have to mow one of them? There may be the usual pricing power that comes with size, but such services to have to be applied to each individual house in different locations etc. If these costs are actually too high, how does one monetize/exit gracefully or at least protect downside? How about an IPO/spinoff?


So, given an industry that has low barriers to entry (only need plentiful capital), revenue that is not consistent, and costs that do scale with size, how well can we expect the institutional herd/interest in such companies to do?

Disclosure: no position in SBY/RESI

Shibor - Canary in the Coal Mine?

I'm surprised that the recent Shibor spike hasn't (Shibor is the Chinese version of LIBOR) sparked more concern. After staying at less than 4% for the last year, the 3-month rate has surged to above 5%. The overnight rate has spiked even further to 13%. To put things in perspective, 2011's top five banks by profits included four chinese banks. What is happening?

One major explanation being posited is that this is the just the next step in the Chinese government's attempt reduce credit expansion/leverage in the system. However, what if this is a different signal - that of a funding crisis? Such a crisis was prelude to the US-led recession of 2008.

On face, China's metrics are fine (gdp growth of over 7%, large fx reserves, small deficit), the soft landing scenario from rapid growth. However, how much of this growth was economical and indeed sustainable? The overall china argument has been debated ad nauseum centering on non-economical commercial real estate backed by a levered shadow banking system, but could this funding crisis be catalyst for the bears? After all, this is not just restricting lending, it is choking China' banking system.

More specifically the strongest point that is related to this is China's own "Ponzi Scheme" (central bank governor's works) fundamentals in its wealth management products and in others' opinions (see: Chanos) more generally the China's shadow banking system. These products essentially allow yet another layer of borrowing short to lend long. However, what happens when funding disappears (a la Lehman 2008) given the vast proliferation of these products?

As a result, what if the funding pop is not by choice? A large flood of liquidity would push the rmb lower, usually okay, but given Fed tapering could push the rmb lower than even what the government/economy wants? Furthermore, fear of this could unfortunately be self-fulfilling because a push to buy usd could lead to more conversion into usd (or non-rmb currencies) ahead of a banking/currency crisis.

Pricing Power of the TI-83 Plus

For many of us in United States, the TI-83 Plus is the quintessential (pre-college) calculator. It was required for many classes (e.g. AP Calculus) and the $100+ price tag 10+ years ago did not do wonders for the wallet. Still, the multi-line interface, matrix operation capabilities and games such as snake made it a versatile instrument pre-iphone. 

Yet, as an electronic system in a highly competitive field, why is the same TI-83 Plus still almost as pricey as a decade ago?? Keep in mind that with the same money, one can buy a 4th gen ipod touch with a Color screen, gigabytes of ram and streaming video+wifi and that the same smartphones a year from now are probably worth far less (try selling the older motorola razr's now). This extends beyond phones to vcrs (remember those?), stereos etc.

John Herrman from Buzzfeed gives us a reasonable explanation - captive customers:

This is a list of CollegeBoard-approved calculators for the AP exams (college-level high school courses) which includes the TI-83 Plus. The TI-83 Plus has remained on this list for at least a decade, requiring each new batch of customers/students to either buy from the year above (which may or may not happen depending on the older students' needs) or buy a new set of the same product.

This is only the beginning, however - teachers get used to these approved calculators (specifically) TI-83 Plus and learn to teach with them. Study guides, manuals etc. for calculus come directly with TI-83 Plus-specific instructions, further strengthening the stickiness of the the product. Given that the underlying topics (high-school/early college mathematics) do not change much, the product does not need to improve much. 

As a result, for these certain products (especially the TI-83 Plus) there is an institutionally-mandated and sticky demand for these.


Unfortunately, it is harder to translate this into an investment because calculators as a whole is only 3% of revenues for the producer (page 6), Texas Instruments (TXN). Calculators revenues are lumped into an "other" segment that includes other products - but it is interesting to note that this other segment has the highest operating margin of the company:

When an Investment Goes Awry, Politely Ignore?

Paulson and Co. made an interesting decision last week:

"At the request of clients and consultants, we will be reporting the performance of our Gold Funds separately to investors in those funds and interested parties," Paulson wrote to clients. The firm's gold investments "have received a disproportionate amount of attention over recent months"—as gold prices plummeted—"and have detracted attention from the performance and positive developments of our other funds."

They key instigation is that despite being only 2% of the firms assets, the Gold Fund's -47% performance (not a typo) is getting all the attention. This would make sense, except that most of his fund is gold-denominated (e.g. gold-share classes). 


This means that even the funds that are doing well, such as the credit funds (up 16.7% ytd) are often overwhelmed by the gold losses. Roughly 85% of Paulson's aum is in gold share classes so that the best fund's 16.7% is usually realized as -30.3 = 16.7%-47%. In other words, gold does matter greatly to the Paulson & Co. as a whole.

I do believe this is a unique situation and opportunity to learn (and possibly profit) as it is a purely marketing and psychological move meant to soothe investors' and consultants' fears. Like a many trader when a large position moves against him/her, the natural instinct is to ignore and hope it comes back. This phenomenon is well-known and is inherent to us as humans.

(source: http://sophlylaughing.blogspot.com/2012/03/home-cognitive-dissonance-kit.html)

In this case, it is Paulson & Co.'s unwillingness to truly consider a fundamental misunderstanding of gold. Indeed, the below statement shows the fallpack to general statements:

“Federal governments have been printing money at an unprecedented rate creating demand for gold as an alternative currency for individual and institutional savers and central banks alike,” John Reade, a partner and gold strategist at Paulson & Co., said yesterday in an e-mailed statement. “While gold can be volatile in the short term and is going through one of its periodic adjustments, we believe the long-term trend of increasing demand for gold in lieu of paper is intact.”

As the the largest holder of GLD at 6.7%, it is not stretch to say that the first represents a large part of the gold bull arguments and crowd. What happens if the crowd realizes it can't take the pain?

Disclosure: I am short GDX.