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Walter Schloss: His rules that beat the market

Walter Schloss and his rules of investing

Anyone cited by Warren Buffett as a super-investor is worth knowing more about. Walter Schloss is one such man.

Walter Schloss was born in 1916. He began working on Wall Street at aged 18, while the stock market was still recovering from the Great Crash.

Schloss took investing classes from Benjamin Graham, who also taught Warren Buffett. He went on to work for Graham’s fund (where he met Buffett) before setting up his own partnership in 1955.

Schloss was an excellent investor:

  • His fund achieved an average compound return of 15.5% a year until he closed it in 2000.
  • The S&P 500 returned 10% a year over the same period.

If you had been able to invest $10,000 in the S&P 500 in 1955, then by 2000 you’d have had:

  • $729,000

Not bad – but $10,000 given to Walter Schloss in 1955 would have grown to:

  • $5,388,000

Nice returns if you can get them!

How Walter Schloss managed money

Most super-successful investors must change their tactics as their funds get larger. Schloss invested for fewer than 100 clients. He was therefore able to invest in small companies and special situations throughout his career.

His investing style was pure Benjamin Graham. In Warren Buffett’s 1984 essay, The Superinvestors of Graham and Doddsville, Buffett wrote:

Walter has diversified enormously, owning well over 100 stocks currently. He knows how to identify securities that sell at considerably less than their value to a private owner. And that’s all he does. He doesn’t worry about whether it it’s January, he doesn’t worry about whether it’s Monday, he doesn’t worry about whether it’s an election year. He simply says, if a business is worth a dollar and I can buy it for 40 cents, something good may happen to me. And he does it over and over and over again.

He owns many more stocks than I do — and is far less interested in the underlying nature of the business.

I don’t seem to have very much influence on Walter. That’s one of his strengths; no one has much influence on him.

By age 80, Schloss hadn’t changed much, according to Buffett’s biography, The Snowball:

Walter Schloss still lived in a tiny apartment and picked stocks the same way he’d always done.

A few chapters on we find Schloss playing tennis at 90. That definitely qualifies him for the Great Old Investor club!

The rules of Walter Schloss

If you’d like to follow in the footsteps of Walter Schloss – to try to beat the market rather than ‘merely’ tracking it – then you’ll want to know how he invested.

As a pupil of Benjamin Graham and a fellow traveller of Warren Buffett, Schloss was obviously a value investor. Your first port of call should therefore be Ben Graham’s The Intelligent Investor.

Like all investors who do achieve the very difficult – but not impossible – and beat the market, Walter Schloss had his own quirks though.

In 1994 Schloss typed them up onto a single sheet of paper. No book, no speaking tour – just 16 bullet point guidelines.

And here they are, near-verbatim.

Factors needed to make money in the stock market: Walter Schloss

  1. Price is the most important factor to use in relation to value.
  2. Try to establish the value of the company. Remember that a share of stock represents a part of a business and is not just a piece of paper.
  3. Use the book value as a starting point to try and establish the value of the enterprise. Be sure that debt does not equal 100% of the equity. (Capital and surplus for the common stock).
  4. Have patience. Stocks don’t go up immediately.
  5. Don’t buy on tips or for a quick move. Let the professionals do that, if they can. Don’t sell on bad news.
  6. Don’t be afraid to be a loner but be sure you are correct in your judgement. You can’t be 100% certain but try to look for weaknesses in your thinking. Buy on a scale and sell on a scale up.
  7. Have the courage of your convictions once you have made a decision.
  8. Have a philosophy of investment and try to follow it. The above is a way that I’ve found successful.
  9. Don’t be in too much of a hurry to sell. If the stock reaches a price that you think is a fair one, then you can sell but often because a stock a goes up say 50%, people say sell it and button up your profit. Before selling try to reevaluate the company again and see where the stock sells in relation to its book value. Be aware of the level of the stock market. Are yields low and P-E ratios high? Is the stock market historically high? Are people very optimistic etc?
  10. When buying a stock, I find it helpful to buy near the low of the past few years. A stock may go as high as 125 and then decline to 60 and you think it attractive. Three years before the stock sold at 20 which shows there is some vulnerability to it.
  11. Try to buy assets at a discount [rather] than to buy earnings. Earnings can change dramatically in a short time. Usually assets change slowly. One has to know much more about a company if one buys earnings.
  12. Listen to suggestions from people you respect. This doesn’t mean you have to accept them. Remember it’s your money and generally it is harder to keep money than to make it. Once you lose a lot of money it is hard to make it back.
  13. Try not to let your emotions affect your judgement. Fear and greed are probably the worst emotions to have in connection with the purchase and sale of stocks.
  14. Remember the work of compounding. For example, if you can make 12% a year and reinvest the money back you will double your money in six years, taxes excluded. Remember the rule of 72. Your rate of return [divided] into 72 will tell you the number of years to double your money.
  15. Prefer stocks over bonds. Bonds will limit your gains and inflation will limit your purchasing power.
  16. Be careful of leverage. It can go against you.

Sounds straightforward, doesn’t it?

It’s not! The alchemy of super-rare successful active investing is simple but not easy.

That’s why Schloss’ rules have aged so well. I’d say rule three – to favour book value as a foundation of value – is the only one that’s (arguably) out of date.

Modern companies’ greatest strengths are often intangible assets that aren’t accurately reflected by book value. Think of today’s technology giants, for instance.

Perhaps Schloss would just ignore those. There are still plenty of companies where old-school value investing metrics are relevant. If you’re turning over thousands of stones looking for a few gems – and trading your portfolio rather than aiming to buy and hold the next Microsoft – then valuing hyper-growth tech firms is someone else’s problem.

According to Smart Money, Walter Schloss was still running his own portfolio as of April 2009, aged 95. Schloss passed away on 19 February 2012.

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{ 38 comments… add one }
  • 1 RetirementInvestingToday May 4, 2010, 8:30 pm

    Hi TI

    There’s that name again – Benjamin Graham. So often when you hear of a successful investor there is a link to Graham somewhere. I’ve read The Intelligent Investor and while my version includes the commentary by Zweig which is a little distracting it is a great book.

    I really like the 16 factors. I might pin them to the wall.

  • 2 The Investor May 4, 2010, 9:26 pm

    @RIT – Indeed. The Buffett essay linked to in this piece is well worth reading if you’ve not before, too. (The Superinvestors…)

    I do sometimes wonder if ‘Graham style value’ was a method that just happened to outperform from 1950 to 2000, say. i.e. Though many different practitioners of it did well, they all effectively were lucky to be playing with the right deck of cards.

    Certainly the world isn’t full of Graham-style-value funds (though lots claiming to be) even though it’s all out there in books. Perhaps the edge has been arbitraged away.

  • 3 UK Value Investor May 4, 2010, 9:28 pm

    Walter’s work is the basis for my own investing approach. In fact I think what I do is 90% Walter, 10% me. And that probably overstates my input. However, I’ve never seen this bullet point list before so thanks for that.

    I hope for my sake you’re wrong about the “it’s not” bit, seeing as I’d like to match his compounding record, impressive as it is.

  • 4 Evan May 5, 2010, 1:13 am

    “Don’t buy on tips or for a quick move. Let the professionals do that, if they can. Sell on bad news.”

    What does the sell on bad news mean? How does that work with #9?

  • 5 FinEngr May 5, 2010, 2:30 am

    Intelligent Investor should be mandatory reading….
    Think I may need to refresh my memory on the subject.

    Amazing that he’s still managing his own money even at 95!! Also amazing how often we look to the hottest manager, fund, sector, etc – but those which are most successful are the “tried & true”.

  • 6 George May 5, 2010, 2:37 am

    When a company announces that it is lowering its earnings estimate, that is bad news (some study showed that 80% of companies who revise lower will not have recovered after a year).

    When new government regulations or taxes constrain a company, that is bad news. (note that I’m not saying it’s bad for the world, just bad for that company)

    When a small bit of negative news is announced and then followed by another bit of negative news, then that is bad news because it means not all of the cockroaches have been uncovered. (Enron, Washington Mutual, etc.)

  • 7 ermine May 5, 2010, 8:50 am

    Another good article, I must read Benjamin Graham’s book.

    Evan, doesn’t #9 mean don’t be in too much of a hurry to sell when things are rising? That isn’t so incompatible with ‘sell on bad news’ eg BP now, if I’d sold as soon as I heard of the blowout I’d be in a small profit, as opposed to now having sold and eaten a small loss. I took it to mean sell on sudden out of the blue bad news.

  • 8 OldPro May 6, 2010, 2:42 am

    Trading lore is replete with contradictions…such as it’s never wrong to take a profit vs run your winners… or don’t catch a falling knife vs buy on the sound of gunfire… that’s why it’s an art not a science my friends!

  • 9 Andrew Hallam May 18, 2010, 9:33 am

    Monevator,

    I’ve enjoyed reading through your site and I’m adding you to my blogroll. This is a blog with substance, and I really appreciate and enjoy that. Keep up the great work!

    Andrew

  • 10 The Investor May 18, 2010, 9:30 pm

    @Andrew – Many thanks!

  • 11 Andrew August 8, 2010, 1:35 am

    I think rule #5 is a typo. I have seen the original typed version of these rules and rule #5 says “Don’t sell on bad news.” It is also referenced like this in a number of other sites.

    The one thing that Schloss constantly alludes to is not losing money. I figure he hopes that if he buys at or below book value that a company that announces really bad news can always come back to that value either through a takeover, merger, or just winding up if there are enough hard assets (or even a recovery in profits if you wait long enough). i.e. the bad news is only going to make the stock even cheaper than when he bought it so why woud you sell it. If you sell, then you are realising your loss and won’t have that ability to regain capital. This is my interpretation on it and I agree with Oldpro that there are so many so called rules for investing that many contradict each other.

    Great website by the way.

  • 12 The Investor August 8, 2010, 3:11 am

    Ouch! Fixed now. Thanks Andrew, it certainly was a typo. Glad you like the site.

  • 13 D' Intelligent Investor December 29, 2010, 8:00 am

    Wow ! These rules may sound very simple and basic but its full of truths and knowing these principles and applying them to your investing strategy would not doubt do wonder to your portfolio. Certainly these simple rules are a far cry from the useless junk that most market players try to learn today. (beta etc.)

  • 14 The Rhino June 18, 2020, 10:14 am

    Another bit of advice from Graham was not to exceed 75% equity asset allocation. I think about that when I see comments advocating much higher allocations, the 100% crowd. My feeling is Graham’s advice is still sound in that respect.

  • 15 diy investor (uk) June 18, 2020, 10:52 am

    Thanks for this TI.

    That return of 15.5% p.a over 45 years is remarkable. Just looking over those bullet points…I feel the most affinity with 6, 7 & 8 but how you can be sure you are correct in your judgment, I don’t know.

    Maybe it’s not too late to take up tennis!

  • 16 Gentleman's Family Finances June 18, 2020, 2:01 pm

    Some posts are evergreen – especially in these days it’s good to keep a clear head.
    I managed to avoid selling during the panic but missed out on buying thinking i was pmaying it safe.
    I wonder what Walter would’ve made of all this?

  • 17 tom_grlla June 18, 2020, 2:40 pm

    Lots of wisdom from Schloss of course, but yes, I’d say that it’s definitely harder to be a Value investor these days, computer screeners etc. have made things more efficient. Plus intangible assets, as TI says.

    I suspect a good starting point if you want to go down Schloss’s route these days is to be open-minded geographically – I’m sure some will remember Buffett’s flirtation with Korea in the past. These days Japan seems to be a source of Net-nets, and also Hong Kong – sometimes through undervalued land banks.

    There is also the issue of catalysts – the longer the current tech/growth bull market continues, the longer it may take for anyone to show an interest, and get the value realised.

    As with all things in life, I think it best not to be too partisan either way, i.e. don’t be a hardcore Graham-ite OR a Robinhood-ite – just learn from the smart people and work out a philosophy that works for you and your temperament.

  • 18 ZXSpectrum48k June 18, 2020, 3:22 pm

    As someone who doesn’t trade single stocks, I find these lists often very alien to my thought processes. The idea of “having courage in your convictions” really implies these investors have strong views, something I try to avoid like the plague. “Don’t sell on bad news” seems a very odd rule. If you never cut on bad news i.e. if you’re actually wrong (rather than just some bad headline) how do you maintain risk discipline? Yet these guys are clearly very successful. I’ll stick to rates and fx!

  • 19 Naeclue June 18, 2020, 4:20 pm

    @TI “I do sometimes wonder if ‘Graham style value’ was a method that just happened to outperform from 1950 to 2000, say. i.e. Though many different practitioners of it did well, they all effectively were lucky to be playing with the right deck of cards.”

    Much to be said for that. Fishing in the right pond can go along way to help someone beat the market. Here are the rolling 10 year differences in annual returns between the MSCI World growth and value indexes (Value-Growth).

    1984 5.7%
    1985 5.2%
    1986 3.7%
    1987 3.1%
    1988 3.6%
    1989 4.0%
    1990 3.9%
    1991 1.6%
    1992 1.9%
    1993 2.5%
    1994 2.9%
    1995 2.7%
    1996 2.6%
    1997 2.3%
    1998 0.1%
    1999 -1.5%
    2000 1.9%
    2001 3.3%
    2002 2.8%
    2003 2.2%
    2004 2.7%
    2005 2.7%
    2006 3.5%
    2007 2.4%
    2008 3.9%
    2009 4.7%
    2010 1.2%
    2011 0.7%
    2012 0.7%
    2013 -0.1%
    2014 -1.1%
    2015 -2.0%
    2016 -1.9%
    2017 -1.8%
    2018 -2.4%
    2019 -2.9%

    These are simple index returns as well, not even the “Deep” value “buy below book value” returns that Benjamin Graham and his followers went in for. MSCI only go back to 1974, but if you look at French’s data back to 1926 you will find that value investing gave a significant edge over the market throughout much of the period. 10 year average HML was positive in every year before 2014 except in 1939. Only the last 10 to 15 years have been historically awful for the value factor.

  • 20 Tony June 18, 2020, 5:01 pm

    Thank you for the useful rule of 72. Although I prefer the rule of 115 I then found on looking it up. The only thing to mess up the time aim being the reality of a person’s target return level. Hence the duration then goes up!

  • 21 ZXSpectrum48k June 18, 2020, 5:12 pm

    I’m reminded of this article by Bill Gross from 2013 (https://global.pimco.com/en-gbl/insights/economic-and-market-commentary/investment-outlook/a-man-in-the-mirror). At the time Gross, the co-founder and head of PIMCO, the largest bond fund in the world, was considered a “bond king”. It’s points out that many great investors are possibly great because their investment style happened to fit the investment epoch/paradigm. It’s difficult to know how they would have done in other paradigms since few investment careers are long enough to straddle more than one epoch.

    It’s also interesting because Gross himself, after 40 previously very successful years, has really struggled to make money in the last decade. He found it very hard to adapt to the zero rate, QE infinity type environment.

  • 22 Brod June 18, 2020, 6:14 pm

    @ZX – so just right time, right place?

  • 23 Matthew June 18, 2020, 11:12 pm

    Wrong benchmark:
    “His fund achieved an average compound return of 15.5% a year until he closed it in 2000.
    The S&P 500 returned 10% a year over the same period.”

    Yet;
    “He was therefore able to invest in small companies and special situations throughout his career.”

    So what’s the fairest benchmark/blend of indexes to benchmark him against? Part small index part value index?

  • 24 ZXSpectrum48k June 19, 2020, 11:30 am

    @Brod. Not just right time and right place. But in my mind, there is little doubt that certain market regimes suit certain investment styles. So while you need to have some ability, being in the right place at the right time can lever that ability, leading to outsize returns.

    Even in my own career (16 years trading/portfolio management, and another 7 as a quant investment strategist), it’s obvious that certain periods were more productive than others. One part of my own strategy is long convexity/long volatility, so volatile years like 2008, 2009, 2013 or 2020 produce outsize returns. Low vol years like 2005, 2010 or 2017 were harder work. Staying in the black was the aim. There’s a clear correlation.

    Moreover, while it’s nice to believe that you’re smart and talented, the reality seems to be that other factors are at work. Pretty much everyone who was on the same desk as me, at the same bank, in the same time period, has been successful: the same strategy, the same anomalously high Sharpe ratio. Perhaps it was being there at that time, the strategies that were developed, the exposure to the right people, that gave me any edge at all. In fact those who started half a decade earlier on that desk include the UK’s most successful hedge fund manager. He had first mover advantage and a bucket load more risk tolerance. Relative to him, I wasted 7 years in research and I’m still a dismal failure. At least I invested in his fund!

  • 25 Naeclue June 19, 2020, 11:50 am

    @Matthew, good point about small caps. I cannot construct an index from French’s data on US markets, but from his analysis small value has been by far the best strategy to follow for decades. Of the 84 rolling 10 year periods from 1936 to 2019, small value was the best strategy (compared with small neutral, small growth, large value, large neutral, large growth) 81 times.

    The distribution of returns from investors will be naturally skewed towards value investors and small value in particular. Across history it would be highly unlikely for there not to be investors with long term track records like those of Walter Schloss.

    To what extent Schloss’s guidelines contributed to his success is hard ascertain given the sample size of 1. I am sure there are lottery winners out there who will claim the secret to their success also lies in following a set of guidelines. Should we believe them?

  • 26 JohnG June 19, 2020, 7:02 pm

    @Matthew: The article doesn’t say it is a benchmark, and doesn’t say he beat it or that the two are directly comparitive. It’s just a handy marker to put the otherwise hard to visualise rate of return in perspective.

  • 27 Matthew June 19, 2020, 11:19 pm

    @naclue – I cant unfortunately find index data for small value far back enough and probably back then there was no passive option for it, but going forward someone would have to prove that they can beat that index, more than just select the sector. Perhaps though we should consider his choice of sector to be the smart thing (aside from luck or survirorship bias), but even if his overall return was greater, on a risk adjusted basis could we really say that? – of course safer allocations may grow less, and avoiding risk isnt wrong in itself

    @johng – it doesn’t say its an official benchmark, but ones an apple and the other’s an orange – right marker then?

  • 28 The Investor June 19, 2020, 11:35 pm

    …but going forward someone would have to prove that they can beat that index, more than just select the sector.

    I think if I enjoyed these sorts of debates (I don’t 🙂 ) then at this point I would note that we might consider that someone with genuine alpha could use their skill to *pick the best sector*. 🙂

    E.g. Would a Warren Buffett born in 1973 — but just as interested in the markets from age 8, just as able to add up strings of six/seven digits in his head, just as able to pour through 1,000 word documents without getting bored, just as voraciously interested in all industries, and just as socially differently-adjusted — might have looked at the market as he came of age in the mid-1990s, saw value was dead and that tech was where it’s at, and chose growth investing as his metier over value.

    Of course we don’t really have much chance of exploring such counterfactuals… 🙂

    Also, Buffett himself hasn’t really pivoted to tech (though he did buy Apple). That might shoot down the theory.

    On the other hand I think very few saw tech really getting this big from the vantage point of the 1990s, it had a long history behind it of booming and busting (especially at the company level).

    Also Buffett *has* changed his investing style several times, albeit at least as much driven by the growing size of his assets under management as by his changing investment perspectives.

    Personally I believe edge exists. However I think it’s very rare, and ‘an edge at spotting others with edge’ is the unlikeliest edge of all, unless perhaps you’re someone like a David Swensen (Yale Portfolio) who can in addition grill the best fund managers in the world for hours over many years (as opposed to reading puff pieces in the FT and thinking “he sounds smart”.)

    So most people should index. But we knew that. 🙂

  • 29 TheIFA June 20, 2020, 10:48 am

    What was once considered alpha is now widespread knowledge and can be purchased cheaply.
    https://www.aqr.com/Insights/Research/Alternative-Thinking/Superstar-Investors

    Who knows if factors that worked in the past will continue to work in the future if enough people choose to crowd into them? If you are taking a tilt (such as small cap value), are you really being sufficiently rewarded (both in terms of risk-reward) AND that you will may have to accept long periods of broad market underperformance? You only have to read the numerous publications questioning whether the value premium is dead. It’s tough!

    Some interesting research on factors:
    https://alphaarchitect.com/2020/06/11/5-surprising-things-we-learned-from-a-factor-investing-expert/

  • 30 Matthew June 20, 2020, 12:50 pm

    @TI – a problem here is that there are good reasons why small & value should outperform anyway (in general)- more risk is taken – selecting small/value is in itself like selecting equities over bonds – just scaling up the risk

    An ‘edge’ would be a definable thing – a strategy or a difference in process, no hocus pocus

    -Having a higher risk tolerance / flexibility is an edge – one achieved at asset allocation or your patience in life
    -personal tax advantages are an edge – one persons situation is different to another so equities/bonds/income/foreign assets have different value between people
    – Insider trading us an edge. Zodiac cards are an edge
    -Reading through long reports and filtering like Buffet used to be an edge before people had computers
    -indexes are essentially a long term momentum trading strategy – momentum over time is up!
    -narrowing your selection of stocks might give a portfolio with very different risk than an index (like dart throwing)- so it shouldn’t be surprising when these strategies outperform – again there is a reason for it when you test it
    -people like Woodford tried to increase the portfolio risk without it looking like he was doing that, so he was still compared to normal benchmarks, when maybe he shouldn’t have been

    I think like you say you’re more likely to see a different animal with fund size – smaller ones can have riskier holdings – but these are riskier portfolios and I wouldn’t say the risk adjusted return was better

  • 31 The Investor June 20, 2020, 1:55 pm

    An ‘edge’ would be a definable thing – a strategy or a difference in process, no hocus pocus

    I think what you call hocus pocus is all that’s left, apart from perhaps time arbitrage or, as you say, risk tolerance.

    Anything clearly defined can be quant-ed away. 🙂

  • 32 tom_grlla June 20, 2020, 2:10 pm

    Re: Edge: Smaller investors can have the advantage of accessing certain ‘special situations’ e.g. illiquid stocks which any commercial fund would not be able to hold.

    And perhaps there is the edge of time – there is the idea that if you have confidence in the sustainability of a company’s earnings, you can to your DCF out further and see things that investors with a shorter time horizon might not.

    It’s not always that difficult to spot exceptional managers. Going back a bit, Angus Tulloch would have done you proud and wasn’t exactly a secret. Ditto with Harry Nimmo, Anthony Bolton etc. Lindsell Train.

    Of course you can counter-argue Woodford, but it was pretty clear that he was over when the governance issues (e.g. offshore listings etc.) emerged. And Darwall… well, the jury’s still out – does one trust him to have learnt from Wirecard. Otherwise he’s been pretty impressive.

    Have a good weekend!

  • 33 TheIFA June 20, 2020, 3:00 pm

    tom_grlla Would love to know how to spot exceptional managers or even an example of an exceptional manager. Once you adjust for factors etc, all alpha tends to disappear, certainly all the analysis I’ve seen. Very hard for humans to compete against the computers.

  • 34 The Investor June 20, 2020, 3:11 pm

    It’s not always that difficult to spot exceptional managers. Going back a bit, Angus Tulloch would have done you proud and wasn’t exactly a secret. Ditto with Harry Nimmo, Anthony Bolton etc. Lindsell Train.

    I think it’s really hard. Normally by the time the likes of us have heard of them and their record is in the books, they are at least a decade into their career and usually more. Again, if you’re a Swensen you might be offered a chance to put initial money into the first hedge fund of a rising star who leaves an investment bank and starts a fund, but, well, I don’t believe Swensen reads Monevator. 😉

    Take me for instance. I’ve been chatting with a hedge fund adjacent friend for five or six years now about starting a fund, though I believe it’s effectively impossible (/too high risk) for the likes of me, given my relatively small own capital, very limited institutional connections, unaudited track record (though I have my own that could be verified by say a weirdly willing family office looking to cross check with my various brokers records, even if just by sampling a few).

    I have a record that all else equal people might invest in, though arguably not a process. Even if I could scare up, say, £50m (I can’t, and I think £100m is the minimum really) it’d be at least three years before it became ‘marketable’ to institutional investors. Probably five years. At that point I’m decidedly into my 50s!

    Okay, I’m an edge case but the point is skill in manager selection doesn’t come from looking at a 20-year record, seeing it’s a good record, and then investing and hoping it doesn’t mean revert (which academic literature suggests it will).

    It comes from finding someone young, identifying them before their 20-year record is established, and so on.

    In practice what e.g. institutions do is give a load of different bright insiders a book to run and then employ a survival of the fittest strategy, allowing the best performers to have more assets (/run what they grow) and weeding out the rest. (@ZX could speak to all this much better than me). (I don’t want to work for anyone so it’s moot for me, before you ask! 🙂 ) This way they select the young star early, but at the cost of investing a little in a bunch of also-rans. It’s like VC model.

    Once someone is very well-established they gather massive assets — fewer managers run more active money (there was a graph/story showing this in Weekend Reading a few weeks ago). As we all know, these hedge fund returns have massively lagged simple portfolios on average, although industry defenders will always come along and argue their special case is different or we’re not taking into account risk or lowered volatility or some other supposedly beneficial client mandate (which could often have been fulfilled equally for the majority of mediocre funds by owning a bunch of bonds).

    Personally I think the order should be invest passive in index funds, invest in stocks if you think you have edge, invest in managers if you think you have that edge. Cost increase as you move through that list so your edge needs increase as you go!

    And in reality, unless you’re a weirdo like me, if you truly do have edge you should get a job and use it probably, rather than trying to earn an extra 2% on what’s almost certainly a small non-life-changing portfolio (versus running eight/nine figures for an institution with your edge.) 🙂

    But who knows. It could all be hocus pocus anyway. 😉

  • 35 TheIFA June 20, 2020, 5:21 pm

    @The Investor
    “Okay, I’m an edge case but the point is skill in manager selection doesn’t come from looking at a 20-year record, seeing it’s a good record, and then investing and hoping it doesn’t mean revert (which academic literature suggests it will).

    It comes from finding someone young, identifying them before their 20-year record is established, and so on.”

    Personally I really struggle with the concept of a star fund manager in 2020. Even back pre-2000 DE Shaw, for example, were trading up to 5% of US stock markets using quant models, exploiting (and therefore removing) inefficiencies.
    https://thehedgefundjournal.com/the-waxing-and-waning-of-demand/

    Fast forward to today, computing power is still the limiting factor (according to someone I recently spoke to) with more power allowing ever more complex strategies to be analysed. The edges, even with all this data (quant funds could be considered as tech shops) are tiny (hence leverage) and positions are held for a few days.

    If you look at the relative success of Rentech’s REIF (longer term holdings I believe) vs Medallion, even the very best brains struggle to buy outperforming shares over the longer term.

    How does anyone think a fund manager can compete? It perplexes me, but maybe I’m missing an angle…?

    “As we all know, these hedge fund returns have massively lagged simple portfolios on average, although industry defenders will always come along and argue their special case is different”

    And my argument extends to the non-computer/data/quant driven hedge funds as well. 🙂

  • 36 ZXSpectrum48k June 20, 2020, 11:19 pm

    @theIFA. I think you are missing something. You seem focussed on equities which is dominated by participants who are trying to make investment returns.

    In other markets that isn’t the case. I do mainly interest rate and fx derivatives. Now the interest rate swap market, for example, is huge but it’s also a closed system – a perfect zero net sum game. But the players aren’t all risk-neutral types trying to earn returns, we also have very large risk transfer players. Corporates paying swaps to hedge liabilities, assets managers paying swaps to net duration, DB pensions lending swaps to meet LDI targets, banks doing swaption collars to hedge mortgage books etc.

    These players aren’t aiming to make money, they are aiming to obtain certainty or lock in margins. They aren’t that sophisticated. They don’t do the optimal trade but they are very big players so they causes distortions. Moreover, the bank market-makers who intermediate between the buyside players are very constrained. They aren’t allowed to take much risk. They also aren’t that experienced. Pay is poor so the good ones tend either to move to the hedge fund buyside or are promoted into bank management. I find I have a clear advantage in terms of product knowledge over many of them. I have a better understanding of yield curve or vol surface dynamics.

    I think you also overrate what quantitative strategies can do. I’m fairly quantitative (PhD quantum field theory, previously head of fixed income quant strategy for US investment bank) and I use large amounts of data and some quite cutting edge analytics. Nonetheless, I’m still fundamentally a discretionary portfolio manager. Building algorithmic models does work but it simply can’t generate the necessary Sharpe ratio alone. That still needs the additional discretionary layer. So a hybrid approach works better.

    Like I said in a prior post, I’d like to believe that my 16 years of consecutive positive returns and a career Sharpe of 4 are due to my talent, intellect and good looks (ok not the last one). The only problem is that everyone I started with, at the same bank, on the same desk, doing the same thing, seems to able to produce the same results. Some a bit worse, some a lot better. So I’m doubtful that I’m special. Instead, there seems to be a persistent opportunity. It ebbs and flows but it hasn’t been eliminated yet.

    The fundamental limitation is not market efficiency. The problem is liquidity and scaling. The opportunities are a USD amount, not a % return. My original head of desk started a hedge fund in 2000 with just $100mm. It initially produced great returns of 20-50%/year. But by the time it was $30bn, it was producing more like 3% returns. He returned investor capital, went private with his own money (plus some early investors like me) taking AUM back to around $3bn. In the last 4 years, it’s produced 50%, 45%, 25% and 50%. A tenth of the AUM gives 10x the return.

    That’s where quant has the real edge. Quant can be scaled better, it can be industrialized, it doesn’t need to sleep and it’s doesn’t retire or lose ambition. You lose Sharpe but you make more USD.

  • 37 TheIFA June 21, 2020, 8:49 am

    @ZXSpectrum48k
    “I think you are missing something. You seem focussed on equities which is dominated by participants who are trying to make investment returns. In other markets that isn’t the case. ”

    Yep, accept that, partly due to my background, and partly due to the discussion around star fund managers operating in the equity space. So the question is do the same “inefficiencies” exist in the equity space allowing fund managers/private investors to exploit them?

    “I have a better understanding of yield curve or vol surface dynamics. ”

    That to me is an edge which could/might explain your performance

    “The fundamental limitation is not market efficiency. The problem is liquidity and scaling.
    That’s where quant has the real edge. Quant can be scaled better, ”

    I think scaling is the limiting factor whether quant or not. My contact (pure quant shop) had a similar journey – returning money to investors due to scalability cap.

    But this to me is market efficiency in the sense that the markets at any moment in time are not efficient, but there is only so much “inefficiency” to be removed by one or more players, which makes it efficient for the rest of the “competition”

  • 38 Phil Coder June 21, 2020, 1:08 pm

    15% CAGR is indeed remarkable. But is this a true period return performance calculation, including fees, expenses and all other cash flows, beginning 6 months after inception to avoid the initial ‘pop’? If not, it is difficult to say what his actual performance was.

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