What poker and fund management have in common
There is nothing worse than attending a fund buyers’ conference where all the fund manager presentations reel through their investment process in their pitch book. A single 40-minute review of a fund manager’s investment process is often enough to send one to despair. A series of these over the course of a day evaporates my will to live as quickly as a pool of water in the Sahara. Just as bad is writing up fund factsheets, and Lord knows I’ve done my fair share. The prospect fills me with all the excitement of a dentist’s waiting room. Why do we focus so much on investment process? Because it is important.
An investment process details the steps that the fund manager takes to select securities and build a portfolio. A good process is consistent with the manager’s underlying investment philosophy and demonstrates the approach is repeatable. A good investment process will often refine the potential universe at the same time as narrowing it. It can either be tight and highly systematic or loose and rather undefined.
One of the UK’s most successful managers, Anthony Bolton, used to operate without a tightly defined investment process and, usually, he introduced his process along the lines of: “I often find interesting opportunities in companies that have one or more of the following characteristics…” This is not to say he had no investment process, but his approach was very loose and necessitated an impressive cycle of company management meetings.
At the other end of the spectrum, quantitative funds employ an entirely systematic investment approach.
The research team at Square Mile has uncovered a number of funds that have no defined investment process or philosophy. This does not necessarily make them bad funds, but the lack of any formalised management approach makes them very difficult to analyse and requires a very long performance track record to provide validation of the manager’s investment expertise.
On the other hand, this is not to say that a well-defined philosophy and process will automatically lead to investment success. It took me some time to appreciate the importance of an investment process, and its value suddenly became much clearer to me while playing online poker.
I have always liked complex games that require skill, combined with management of uncertainty. Unlike games such as chess, poker is one where luck plays a significant part though a small edge in skill can bring significant success over the long term. The stockmarket has some similar attributes and while there are some important differences to poker, interesting parallels can be drawn.
Questions to be considered on a fund’s investment process
- What is the process?
- Is it consistent with the underlying manager philosophy?
How does it refine the investable universe?
By itself, does it identify winning stocks?
How does the process cover selling?
How consistently is the process applied?
Most stockmarket practitioners recognise that not all their ideas will work. Indeed, a success rate for ideas of 55 per cent is generally considered good. In the short term, results can rest heavily upon luck, although over the longer term, skill is more likely to play out.
In poker, it might take upwards of 25,000 hands before skill levels can be determined with confidence just by looking at the results. Much greater insight can be gained examining how individual hands are played. A typical poker competition may involve 100 to 300 hands.
Even playing multiple competitions at once, long periods without significant success should be expected. Emotionally this can be very difficult and there is a great temptation during unsuccessful periods to “try something different”.
However, deviating from a successful process due to short-term difficulties is very dangerous and potentially sacrifices a winning strategy. Portfolio management can also be a numbers game and periods of poor performance should be expected. A manager with a well-considered investment process will be able to lean upon it during difficult periods. An obvious example would be value managers today who have plenty of empirical evidence supporting their approach.
Managers and, just as importantly, fund selectors should be aware of the strengths of the investment process followed. Understanding this underpinning should provide the wherewithal to stay the course even during long periods of disappointing relative performance.
Jason Broomer is head of investment at Square Mile Investment