Quoted so we can remember it forever.
Exhibit A as to why so many funds underperform their benchmarks.
Frank,
The problem is that undergraduate textbook CAPM and portfolio construction is ridiculously terrible. No one should rely on that to construct portfolios. Your managers take the connection between returns and betas far too seriously.
The view that you want to express is two-fold: 1) You think the stock will outperform, 2) You think it has low downside risk. It is possible to express traditional value views quantitatively and perform a portfolio optimization. Instead of the benchmark weight, it may tell to invest twice the benchmark weight. However, the output (if you’re using some advanced techniques, rather than simple MVO) will likely not be a concentrated portfolio.
It really comes down to who your client is. If we’re talking about your own personal account, and you’re trying to minimize factor bets to reduce unintended consequences…well, good luck to you. I bet you’re a blast at parties.
However, for institutionally managed money, my clients demand a predictable performance contour. They’re buying our funds to play a specific role within a larger product. While I love the gunslinging fund manager, that style doesn’t play well with others. So long as our funds perform as advertised - momentum based funds do well when momentum is working, for example - our clients are generally happy.
Frank,
I can see where you’re coming from but you’re either not managing money or you’re a star stockpicker. Unfortunately, most of us live in-between those two extremes. As such, risk management is important for at least two reasons.
If you claim to be a long term investor, then paying attention to risk and correlation helps you to remove volatility drag, arguably the most important concept in generating long term performance. In an ideal world where you run an “unconstrained” mandate (i.e. star stockpicker scenario), your approach works. Again, most of us are somewhere in-between. There’s set position limit, drawdown limit etc. High conviction portfolio without proper hedging is almost not going to work. You will be force to liquidiate for the wrong reason e.g. your investors need liquidity.
The second reason relates to your point about “hedging ignorance” - career risk. You’re damn right that we’re trying to smooth the return not for the abovementioned but to keep our jobs. Investors have memory like goldfish. They send you an e-mail with “LOL” when you lose 2%, they call you when you lose 5%, they set up a meeting when you lose 10%, they renegotiatie IMA when you lost 20% (precisely what they shouldn’t do), they sue you when you lose 50%. You get the idea…
what is volatility drag?
i pay a lot of attention to risk, but its not the risk that the stock price will go down over a short period of time…all these risk concepts ppl mention are market price based…imagine if you got a chance to get in on a private investment…is the correlation of the business to other business and what other people think of it what you would be thinking about? or would you question the durability of the business and the people running it?
i understand a lot of ppl use concepts like correlation, volatility because its their job for the reasons you mentioned…i’m just saying they’re not condusive to good returns over time…
you actually don’t have to be a “star stockpicker” to do decent…you can do quite well just avoiding big lossess…or losses in general…
Frank is like a dog with a stick on this issue.
I would lean towards to say everyone has different views on risk management and I happen to be on the numerical camp. Frank comes from an angle that everyone can incorporate risk in their stock picking process. Using correlation, volatility and etc is a way to avoid losses - that is what RISK MANAGEMENT is… Lastly, I guess I didn’t get the idea through across properly… In an institutional money managing business, you NEED to be a star stock picker to run an “unconstrained” mandate (i.e. your approach, all in or nothing…). It’s kinda like Carmelo Anthony made D’Antonio resigned…
my portfolio construction process is this…
100% AAPL