Traits of the best money managers

Having worked in a fund of hedge funds, I have met with and analysed some of the best long/short equity managers globally. I have compiled a list of what I see as some of the key traits of great money managers as well as, often hard learned, personal lessons. Things to watch out for. While the focus is on equities, they relate to all strategies.

I thought I’d share them in the hope they may be useful to you too. Also, if you have any additional ‘lessons’ to add, pls leave a comment.

While most active managers under-perform and some get lucky, there are a few truly talented managers that consistently outperform. While luck certainly plays some part and initial success may breed later success, in my opinion the great managers demonstrate certain traits some of which I highlight below:

Disciplined Process: The best managers have a very clearly defined process which they stick to thick or thin. They may be value investors or momentum, it doesn’t really matter, they stick to their craft. Value investors do not morph into growth because of market performance – they continue to buy when they consider an asset to be cheap and sell when they consider it expensive. They are not biased by market forces or some vision of what the future may hold.

Patience: They have the patience to wait for their process to work. A value investor will not buy expensive stocks simply because there is nothing else available. Rather they will hold cash and wait for better opportunities or will enter a sold down area of the market that offers value, even if it may take years for performance to emerge.

Manage Risk: They look for trades that are asymmetrical, where the potential for profit is significant while that of loss small. The good managers I have met, tend to spend their time focused on the risks of a trade not on the potential upside. They also try to diversify the risk to mitigate the impact of a single event.

Let winners run and cut the losers: Related to risk, good managers close out of their losing trades early. Soros, one of the greats and not a manager I have met, is reported to have made the following comment ‘My approach works not by making valid predictions but by allowing me to correct false ones’. He sells the losers and holds the winners.

For most of us, it’s human nature to hold onto a position when a position runs against you, perhaps even add to it, in the hope that fortunes will reverse. More often than not though, the position will inevitably continue to work its way down, eventually forcing the trade to be closed at a massive loss. Often just as the market turns. The better managers don’t let the loss develop. If it’s not working to plan and they are not sure why, they close out and add to something that is.

Control Emotions: The good managers don’t get emotional – when a trade is loosing and they see the market moving away from their thesis, they cut the position without any hesitation. They don’t let Ego, Greed and Fear hurt returns – they stick to the process.

Limited trading: A fall out from having a clear strategy and not allowing for emotional bias is that time is spent researching for core trades rather than trading aggressively because of market moves. This relates particularly to value investors but it’s a rule that applies to most strategies. Limiting trading is important as its costly in terms of fees and also on research effort.

Non-consensus: The only way to get ahead of the market is to have non-consensus views at critical reflection points. Value investors will, for example, tend to be sellers just before market tops when consensus is most positive.

If you follow the herd it’s likely you will perform in line with them. Better to make your own mind up on what to own and why and not be afraid to step away from the crowd.

Focussed on generating steady returns: money managers are assessed on their Sharpe ratio – a measure of the return they generate relative to their risk, as measured by standard deviation. A high Sharpe is preferred as it reflects that the manager is able to generate stable returns. They do this by holding diversified portfolios, often with a number of catalysts that are not correlated to each other.

Thus, while one trade may fail, another may do very well and, by maintaining the discipline to cut losing trades, will ensure a positive and steady result. Managers who focus on hitting the ball out of the park, may do well for a time until they don’t…

Diversification of alpha: related to the above, good managers don’t bet their portfolio on one trade. The worst is to bet on one trade which is directional – such as commodities. One well known manager blew up a few years ago as the bulk of what he was doing was focussed on only one trade and the commodity moved in the wrong direction.

Focussed on the long term: The industry is very focussed on quarterly or monthly numbers. Weaker managers and many in the mutual fund industry thus miss the big plays. Better managers are able to manage through periods of weak performance, focussing rather on getting the fat pitch right which may mean sitting on a flat position, waiting for a key catalyst to play out.

For investors in managers, focussing on recent performance is not value add. Better rather to be focussed on understanding what edge, if any, they have and the drivers of performance. When you can identify what manager’s thesis and rationale is, only then can one make a call as to whether or not it’s worth investing.

Valuable lessons, many of which I have learned the hard way:

Don’t bet on the market’s direction or try and time the market: As in the case of managers sticking to their disciplines, few of us know exactly how the economy will play out or which asset classes will outperform another. Most good managers don’t try and guess it right, rather they stick to their process. Macro and multi-strat managers will take a view of the economy and the market’s direction, but will usually be quick to reverse the call if proven wrong.

Be an investor not a speculator…

Watch your leverage: Be a seller when you want to not when you have to. Leverage can help generate outsized returns but when it works against you it can wipe you out. While many professional investors will use leverage, they are very conscious of its risks.

When uncertain move to cash: We all suffer set backs and tough markets. The trick is to keep your capital so that you can reset when the market offers you opportunities.

Use technicals: Assets move in waves, some larger than others and getting the entry price right is critical.

Position sizing: A big mistake is to find a great opportunity with low risk and then not take a large enough position in it.

The market is always right – don’t fight it. Enough said.

Don’t get bogged down: every day is a new start. If unhappy with a position and nothing works CUT and take a break. Don’t add in the hope that things will reverse. This is a tough lesson to learn.

Watch your shorts: A short that pops higher can destroy a portfolio. Witness VW in 2009 when short sellers had no liquidity to close their positions. Many hedge funds suffered significant loss on the back of this but, if you held on throughout, the shorts eventually made money.

Psychology: Track one’s mental state of mind and watch for periods of over negativism or over positiveness.This is related to greed/fear and understanding how to deal with these emotions.

Cut when away from the desk on holiday: there’s nothing worse than trying to fix a trade when sitting on a beach with no internet.

Don’t fall in love:  Always question your positions and the exposures and when the market works against you, enforce strict drawdown controls.

Always be liquid: Ensure you have enough liquidity regardless of what the market does.

Admit and declare your mistakes and move on: The worst thing a trader/investor can do is hide a loss in the hope it will correct itself. Usually this will just lead to an even larger loss. Anybody who has worried about and then cuts a loosing trade, knows how good it feels…

Invest to Live: While you have to enjoy investing you have to see it for what it is. Have fun doing it and don’t sweat it. At the end it’s just numbers.

Only ‘play’ with what you can afford to lose: Only invest once the mortgage/house is paid off, or provisioned for, and you have spare cash in the bank to take care of daily requirements, for at least a few months.

….and lastly, sometimes it’s better to find a good manager than try to be one yourself: managing money can be enormously stressful. Alternatively, find a partner to do it with so that you can discuss and debate views. Not only will that be a lot more fun but you’ll have a good drinking partner when things don’t work out as planned….

If you have any more lessons to share – pls drop a comment.

Good Luck!