Hedge Fund Investment Process: Portfolio Management, The BILLIONAIRE's skillset, Success Formula

Now, at the end of the day, portfolio management is about allocating the firm's resources to minimize risk while optimizing return. There are really two portfolios that a PM manages. The investment portfolio and the team portfolio. That's human resource that we talked about. We already discussed some of the PR processes necessary, but I'm going to go a little deeper things that are more specific to the portfolio manager's process. The research process is what the analysts execute, but the PM that designs the firm's process and holds the analyst accountable to adhere to it. The portfolio manager has sole discretion over the timing and sizing of the position of the portfolio based on the research and conviction level provided by the firm's analysts. The PM doesn't trade but does direct to trading desk to execute orders within certain parameters or guidelines. So the PM designs and reviews the management reporting to allow for efficient and effective measurement. We're going to go through all of these areas in some detail right now. As previously discussed, the PM is responsible for the design and makeup for the investment team over the life of the fund. This means continually looking for and closing gaps in the skill sets of the team. Performance measures of the analyst team is a key responsibility of the portfolio manager. This is a process that the PM not only should be a part of designing, but also executing because the results are crucial to many areas of the success of the firm. The review process assists the manager with understanding an analyst strengths and areas of development. It also informs a PM how to compensate and appropriately incentivize an analyst. If analysts superior in skill, there's always a risk that they'll leave to start their own fund. In this instance, a potential retention strategy is for the PM to reward such analysts with their own portfolio to keep them from leaving the firm and starting their own fund. Process is key to alpha generation. There's direct correlation between the quality of the process and the resulting decisions and outcomes. The PM must ensure that for repeatable functions, the team has a process and that process is counted on to be done and improved on all along the way. Communication amongst team managers with the PM is paramount to the success of the firm. Included here is identifying what modes of communication are appropriate and for what purpose. Encouraging the team to be clear and concise in its communication regardless of the form it takes. Collaboration tools like Slack should be part of any discussion on communication. The culture of the team is crucial to the investment manager's success. The PM is the culture bearer of the firm and must make it clear what the values and principles are for the team. For Instance, building a culture of trust is a crucial element for any team as it spurs creativity. As we discussed, the PM must also infuse accountability into the team's cultural fabric. Team members should be accountable to themselves, their teammates, their manager, their direct reports, and most importantly, to the limited partners of the firm. Intellectual curiosity is another great cultural trait to have that's often the lifeblood of the firm. Without this, the firm won't grow. Humility is also a crucial trait. Successful firm is always challenging their own ideas and the ideas of their colleagues. A good analyst should spend the resources to build conviction but won't be wedded to any position if proven wrong. We have a saying at our firm firm strong opinions weakly held meaning. Build a conviction, but don't let your ego hold onto it if proven wrong by the facts. It's the PM's role to make the final decision on both timing and sizing of positions in that portfolio based on the research information, importantly the level of conviction provided by the analysts. The analysts will provide fundamental analysis which evaluates the intrinsic value of security. This can help the sizing of positions. They will also provide technical analysis which provide information on the entry and exit points from a security based on trends in the stock's price, the volume or other factors. Exit points for security depends on the firm philosophy. Many times there are predetermined exits where target price is determined in advance. These can even be automatically set to execute, for instance as a stop loss order. Sometimes firms will have a check in price to reevaluate the hypothesis to see if the conviction level on the stock's future performance has changed. If not, PM will continue to hold the hypothesis has changed. The PM will either exit or add to the position. In the latter case, that means that the hypothesis is even better than it initially was. Now, with respect to timing on the long side of the portfolio, and a portfolio with a long term investment horizon, the timing of entry is generally as soon as an analyst has a level of conviction in the security. If the firm has a long term investment horizon, timing on the long security isn't as important, say as a short term investment horizon such as a day trading firm might have. The exit will occur once the hypothesis has played out or the hypothesis has changed. On the short side of the portfolio, timing can be a little more tricky. There's generally more volatility on the short side, so timing does make a bigger difference. There are also different types of shorting scenarios, each with their own strategy and also having different stages of exit and entry. For instance, in a fraud scenario. On the short side, if you uncover a fraud through legitimate value added research, the ideal price to get in is before others figure it out and drive the price down. Another ideal entry point for a struggling company is a trigger point such as when the metrics of the company start to fail, such as a debt offering coming due or debt that can't be paid or another better product that's being introduced or a competitor coming into the market. The ideal exit price for short is zero. That's the ultimate feather in the cap for short sellers. Sizing of positions largely depends on the level of conviction of the pm, right? That comes from the research analyst. While key conviction isn't the whole answer though, if it was the sole determining factor, the position with the largest conviction would be the only position in the portfolio. Risk factors such as diversification, correlation with other positions, and other factors play a role inside the timing of positions for a portfolio manager. Now, as mentioned in our discussion on timing, the importance of trade execution depends on the duration of the investment style. For an investor with a long term investment horizon, the impact of trading isn't as important because over time, theoretically there will be large moves in the stock. Short term trading firms, on the other hand, depend on taking advantage of smaller moves in the price because they earn their returns on volume over time. The PM the trader is Best execution trader is going to look for guidance from the PM as to how to execute the order. If there's a trigger that's expected, then the PM may have some time sensitivity as we discussed, to get the order on quickly. This is rarely the case for a longer term fund and the order will usually go slowly. The PM would tell the trader, for instance, to be a percentage of the volume so the order itself doesn't move the stock price up or down. On the short side, as we discussed, there may be a trigger that the fund thinks will drive the price down. Like debt coming due. There might be some time sensitivity there. The hedge fund has a fiduciary obligation to get best execution for the fund, which means that the fund is an obligation to make a good faith effort to get the best price either at entry or exit of a position. The most common way to test best execution is to compare the actual execution of the trade with a benchmark such as vwap, which is the value weighted average price of a given security over the course of the day. Slippage is when the order is done at less than a favorable price compared to the benchmark can occur if the trade is done too quickly or during the day where there's a lot of volatility or maybe some news came out. The fund usually has a trading oversight committee to review the trading performance of the desk. Trading costs such as commissions are also reviewed as part of the trading oversight committee's role. Another cost that is more difficult to measure is the change in price from when an analyst has arrived at a conviction level for security to the price at execution. Theoretically, the longer this period, the higher the cost is. Doesn't really have a name, but I think you get the idea. The PM might provide guidance to the traders in the form of execution conditions and restrictions. A stop loss order is an example of that that specifies that a stock is sold when it reaches a specified price below the current price. Or a limit buy order instructs the trader to only buy at or below a certain price. Those are some examples of some firm restrict so risk management. So while some funds have risk management, many do not really. That's the responsibility of the PM. PM's the sole risk manager for the fund on the portfolio side. Most important risk that a hedge fund faces the degree of leverage that it employs. Leverage is in essence a line of credit that can be drawn down upon. It's collateralized by the securities of the portfolio. The objective is for the fund to magnify its gains by putting on more exposure. But it can also magnify its losses by doing that right. In other words, more risk, more return. If the bets go south against the hedge fund, prime brokers can sell the collateral which can magnify the losses. When this happens, basically game over funds out of business. We'll talk a little bit about that later. The intention of derivatives exposure is asymmetric risk, which means that the maximum loss is much less than the maximum gain. There are many risk management tools, but over the years I've found that the one that works the best usually is requiring the hedge fund portfolio manager to keep a percentage of his or her net worth in the fund alongside the LPs. The higher the better. True alignment of interest Again, even that doesn't always work right. CR takeouts Here are some exposures to risk that a PM must manage right Liquidity risk Liquidity risk not having the cash when you need it. This is the famous economist Peter Bernstein's quote. It basically means that you can't sell at what you feel is a fair market value because there's not enough demand. Macroeconomic risk Think interest rate risk, for example. Sector industry risk. PM may be overexposed in a sector and industry concentration risk. The portfolio may have too much exposure in any given area needs to diversify correlation risk. Different investments may react the same way to other investments. There are some common portfolio risk managements that can be viewed at the fund level. Determine the level of risk that a fund has. Gross exposure is the total exposure of the portfolio to the market. So for example, the fund has 120 million of long exposure 80 million of short exposure. The gross exposure of the fund is 200 million the net exposure, the long exposure less the short exposure. In our example 120/80 the fund has a net exposure of 40 million. By the way, these two levers, gross and net exposure, are the most important tools that the portfolio manager has in its toolbox to manage risk, both leverage and risk to the market. Beta is a measure of a fund's returns relative to the industry of an index. The index being compared is assigned a beta of one fund with a beta of 1.5 therefore will tend to have a return of 1.5% for every 1% of movement in the market or the index. Var or the value at risk is the highest amount that can be lost in the portfolio over a period of time with a specific confidence level. Doesn't always work. Sharpe Ratio is a popular hedge fund risk measurement tool. It measures the risk of a performance of a fund compared to a risk free investment after adjusting for its risk. It basically represents the additional amount of return per unit of additional risk. Quality PM decisions are only as good as the information he or she has to make the decisions. Therefore, the reporting that a PM gets measuring performance not only the portfolio and the analyst, is crucial to measure the processes that led to the results as well as the results. Really important reports must have the highest amount of quality information with the least amount of words and numbers, right? In other words, the PM is really busy. He or she needs to get it right away. High quality concise reporting I call this principle the Billionaire's Mindset. How to break the complex down into the simple now to routine. In addition to teaching all the technical information in the presentation, we go a lot deeper into the cognitive and development side of building leadership skills. All important for managing a portfolio. We help people, executives and businesses to raise their standards to become the best versions of themselves. Along those lines are a few relevant, relevant themes that we talk about. We talk about mindset. Understand the mind. Understand cognitive biases. Understand the great mindsets too. Grit, Curiosity, Crisitunity Understand process. Find out what works, Keep doing it. Find out what doesn't work. Stop doing that. Learn how to manage your Resources, your intrinsic resources especially. Right? That's what a leader does. A leader can manage their time, their energy, their discipline, their focus. Learn how to manage your extrinsic resources. Capital dollars, human capital, technology, service providers. The key to all of this is waiting and prioritization. We also teach decision making processes, nothing more important. Communication skills, learning skills, listening skills. That's Covey, right? Influence skills. That's Carnegie brevity skills. Turn the complex into the simple. The billionaires mindset. Goals that focus you in on your mission. Crucial to have plans to achieve the goals. The key is to prioritize the actions within your plans. Accountability strategies. Right? Keep you on track with your plan. That's why I love coaching so much. Why it's the focus of my new business measurement. You can't focus on what you don't measure. Right. Finally, you need outside forces to help you get there. Your professors, mentors. Yes, again, coaches. This is our success formula. It's basically the framework for, you know, what we teach. Basically, start with your mission. You move to a gap analysis. Where am I? Where do I want to be? Set goals to close the gaps. Design plans to achieve the goals. Prioritize both the goals and the action items within your plans. Schedule in your actions, execute on your actions. Have an accountability strategy like a coach. Measure your result along the way. Make sure you're making progress. Revise your approach. If the measurement's not where you want it to be, right. Call a timeout. Score is going against you. Revise your approach in the process. Is it not working? And then you achieve your mission. Right. And celebrate.