On Position Sizing and Hedge Funds
Consider the casino business: The casino enjoys a small statistical edge over the punter, and uses it ruthlessly. While the outcome of any single game could easily be a win or a loss, that statistical edge becomes overwhelming when a large number of games is played. The punters, in aggregate will inevitably lose.
If you find yourself playing the role of the punter, you have a couple of options. If you want to maximise your chances of walking away a winner, you need to prevent the statistics from working their one-sided magic. You can do this by minimising the number of bets you make: if you chance everything on a single spin of the wheel or a single hand of cards, you have almost a 50 per cent chance of winning the day. With a little bit of luck, you can walk away with a large profit and a great story.
If, on the other hand, you want to be entertained, your optimal strategy is very different. In this case you should draw the experience out by placing many small bets. The more you do this, the more likely you are to ultimately lose, but if you’re having fun and can afford the losses, that can make perfect sense. The casino will also love you for it; this is how they make their money.
There are some parallels here in investing. However, with investing it’s normally assumed that:
- Your goal is to win, rather than be entertained; and
- Part of winning means having an edge – ie. the odds are on your side.
In other words, when you invest, you are aiming to be the casino, not the punter, and this flows through into how you want the game to be played.
Just like the casino, you want to play the game many times, so that your edge becomes overwhelming. You will win some and lose some, but with enough repetitions you can ensure a good result. This means that you want to spread your investments over a good number of companies, and you want to stay in the game for a good number of years.
One thing you don’t want to do is place large single bets that have the potential to clean you out. That strategy made sense when the odds were against you, but when the odds are on your side, it’s the last thing you want.
Why then, do some of the biggest names in global investment markets seem to favour outsized bets on their highest conviction ideas? Valeant Pharmaceuticals is a recent example: its share price has fallen from over $250 to under $100 since the start of August, and it appears that no less than three titans of the hedge fund industry had more than 20 per cent of their funds invested in Valeant. That is a serious amount of risk to take on a single stock.
Call me cynical, but I keep going back to the punter at the casino. If the odds aren’t on your side, it makes sense to bet big, and put your faith in lady luck. If luck smiles, you may well walk away with a big payoff and a great story.
If there are enough players doing this, a few will enjoy repeated success, and perhaps even acquire a reputation among the titans of the casino betting business. We won’t ever hear much about the ones whose luck ran out early.
Many of the leaders in the hedge fund industry are certainly highly skilled and thoughtful investors, who can expect to do very well over long stretches of time. However, whenever I see large single bets being taken with investor capital, by a hedge fund manager or anyone else, I do wonder which side of the table the investor is really sitting on.
Tim Kelley is Montgomery’s Head of Research and the Portfolio Manager of The Montgomery Fund. To invest with Montgomery domestically and globally, find out more.
Tim joined Montgomery in July 2012 and is a senior member of the investment team. Prior to this, Tim was an Executive Director in the corporate advisory division of Gresham Partners, where he worked for 17 years. Tim focuses on quant investing and market-neutral strategies.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
Justin Carroll
:
Personally, I don’t think that there is anything wrong with putting 20%, 30% or even 50% or more into a single stock. If the value is there and it is on sale, you should really go for it. Those opportunities are too rare to take advantage only half-heartedly. Cases in point are: the young Warren Buffett and the salad oil scandal of the early 1960s and George Soros and Stanley Druckenmiller with the British Pound in 1992.
The problem with Valeant is that at no stage of its existence as a listed company has it been a high conviction investment. It is leveraged to the max and its business model has always been highly questionable. I think Charlie Munger really got to the essence of Valeant when he characterised its growth as “phoney”.
That a number of very experienced investors were seduced by Valeant’s story, nonetheless, and ended up putting a substantial amount of their clients’ capital into it is merely further confirmation, if further confirmation were needed, that smart people can do dumb things.
Roger Montgomery
:
Thanks for sharing your thoughts Justin.
Peter Abela
:
If you have your money invested in five managers, then one manager’s 20% position becomes 4% of the investor’s portfolio, which might just be tolerable (unless, of course, all the managers hold the same stock!). Although I suspect the average investor would not do this level of analysis for concentration risk.
Andrew Mckenzie
:
Hi Tim,
Roger has stated before that if he were managing his own money he would probably only have 6 or 7 stocks with a largest holding of around 20%. A fund manager having over 20% in one stock seems terrible for the investor as it just increases the portfolio variance and reaps massive rewards in the way of fees if they are right with downside risk absorbed by the investor. Touching on your analogy, their are strong punters out their who actually beat certain games, blackjack for example. They will usually use kelly criterion method or something similar to ensure they are increasing their bets on the individual plays where their statistical edge is higher (risk adjusted). With stocks of course knowing how much better an idea is than another as not quite as tangible and all you have is your ‘perceived’ value and higher conviction. So while saying 20% is too high, how about helping us by guiding us into what is an appropriate maximum and why. Given the example of a invested fully portfolio of 15 stocks and cash, of which your favourite is a super high conviction idea, is the same Valeant stock. What would be the maxiumum percent the team at Montgomery would be prepared to allocate and why? And what amount would you recommend to an individual investor with a reasonable grasp on the market in the same situation?
Cheers,
Andrew
Tim Kelley
:
Hi Andrew,
The question ‘what is the right maximum position size’ is a difficult one to answer in a general sense, but in simple terms it will be driven by how many good investment ideas you can identify. A quantitative process that can cover every stock in its universe should usually have a lot of small positions, on the other hand a very high conviction manager who only has the ability to cover a handful of stocks in sufficient detail will have few. For the Montgomery Fund, maximum possible position size is 11%, but in practice we don’t go much above 6%. At that level we are still considered ‘high conviction’. For individual investors doing their own stock picks, the picture can be different: if you know you have a very long time frame and a high tolerance for year-to-year risk (and don’t want to spend all your time analysing stocks), you can run a very concentrated portfolio. I don’t think its necessarily a good idea for fund managers to assume that their clients fit that description.