Noise - Chapter 13
Sources Of Noise: Clients
Briefly: Clients
Noise. Your clients are a source of noise, especially when you express non-consensus views.
Expression. You express non-consensus views in your portfolios as a way to generate alpha for your clients.
Consequences. But holding non-consensus views will generate noise from your clients, even if you’re right, and you won’t always be.
You are faced with a paradox:
Views. You have to hold non-consensus views if you are to generate alpha. Consensus views will generate average returns.
Noise. When you hold non-consensus views, your clients will be a source of noise. Noise interferes with your ability to generate alpha.
To resolve this paradox:
Process. You need to be clear with yourself and your clients about their mandate and your process. Confusion amplifies noise.
Conversation. You need to invest in your relationship with your clients. Their patience with your non-consensus view depends on the quality of your relationship.
You need to do two things if you want to deliver above-average returns: you need to be different and you need to be right. As Howard Marks of Oaktree Capital writes, “[To] achieve superior investment results, you have to hold non-consensus views regarding value, and they have to be accurate.”
Non-consensus views are essential for alpha generation, but they are a tough sell to your clients precisely because such views will be dissonant with prevailing orthodoxy. Most of your clients will reflect the average opinion, which means that most of your clients will be intolerant of your non-consensus views. Their comfort with orthodoxy will constrain your ability to generate above average returns on their capital. JM Keynes knew this and wrote, “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” If you have the courage to express a non-consensus view in the funds that you manage, and your call is wrong, there definitely will be pain.
Example: Friess Associates
Foster Friess took an extremely non-consensus position in 1990, when Saddam Hussein invaded Kuwait, and he got his call right. In three days he liquidated 80% of the names in the firm’s main US mutual fund, Brandywine Fund. He exited in time to avoid the equity market decline and reentered to participate in the subsequent recovery. This move attracted the attention of capital allocators. Over the next seven years his firm’s assets under management grew from $1 billion to well over $10 billion. And, at the end of the third quarter of 1997, Brandywine Fund was one of the top-ranked mutual funds in the US, having generated returns of 30% p.a. for the previous three years.
The fund had a major position in the stock of Oracle, which in early December 1997 announced disappointing earnings. Oracle blamed this on the economic crisis that was developing in Asia, and Friess became concerned about the impact of the crisis on other names in the fund.
“Sometimes you make a decision on instinct,” Friess said. He began a rapid liquidation of the fund’s equity positions and one month later the fund was 80% in cash. Unlike the experience in 1990, the equity market kept on rising after he sold, and the fund captured a mere one-tenth of the market’s 40% gain. Brandywine Fund’s performance relative to its peers slipped all the way from top-decile to bottom-quartile, and the investors in the fund made their disappointment known.
“People screamed and hollered,” Friess recalled. Financial advisers and other intermediaries said that they were angry because his move into cash had upset their asset allocation. Other clients were more direct: since they had invested in an equity fund, they refused to pay management fees on the portion of the fund that was in cash. Some clients threatened to withdraw their capital from the fund unless Friess got fully invested in equities, and a few of his largest clients gave him sixty days in which to do it. But many clients simply redeemed their investments. The noise from his clients pushed Friess to breaking point.
Looking back, Friess said, “I’d like to think that all this pressure wasn’t an influence, that I am so tough that come hell or high water - so what that 50 million bucks a week is leaving - I’m going to do what I’m going to do, because the pressure is irrelevant.” But the pressure was relevant and Friess succumbed. He rapidly increased the fund’s equity exposure, as his clients had insisted, and by May 1998 the fund was again fully invested in equities.
Three months later the equity market received twin shocks that sent it into a sharp decline: Russia defaulted on its sovereign debt, and the highly leveraged hedge fund, LTCM, blew up. The now fully invested Brandywine Fund captured about nine-tenths of the 20% market fall. The very clients who had demanded that Friess increase the fund’s equity exposure now withdrew their capital as an expression of their displeasure at the losses. In reaction, Friess said: “My emotions range from anger to hurt to massive disappointment and bewilderment.”
The tensions that are latent in the relationship between you and your clients can suddenly erupt in the form of acute noise, especially when a non-consensus view turns out to be wrong, which can trigger a cascade of negative events: decision error, destruction of alpha, reputational damage, and even business risk.
It seems, then, that if you have the courage to hold a non-consensus view, and you get your call right, then a series of good things should happen: you generate alpha, you please your clients, you enhance your reputation, and your organisation thrives. That’s the theory, but it may not work out like this in practice, because your clients are not guaranteed to be delighted if you generate alpha. This may come as a surprise to you.
Example: Scion Capital
Mike Burry started Scion Capital in 2000 and quickly gained a reputation as a gifted value investor. His sole objective was to generate above-average returns: “I have a job to do. Make money for my clients. Period.” And he achieved this objective: from inception to mid-2005, while the S&P 500 returned -7%, his fund returned 242%, without him shorting stocks or using leverage.
In mid-2005 Burry bought credit default swaps on subprime mortgage bonds, as a way of creating short exposure to a market that he believed was set to implode. He had noticed that banks were taking advantage of a booming residential property market by lending aggressively to property buyers who had poor credit histories. The banks were charging these borrowers artificially low rates on their loans for an initial period of two years, after which their rates would automatically increase. Burry thought that there would be a wave of defaults starting in 2007 as borrowers failed to make their repayments on loans that were originated in 2005.
By early 2006 he had built up $1.9 billion worth of CDS positions in his $555 million fund. He explained to his investors that they would need to be patient, that the fund would be likely to make money on these positions only in 2007. But most of these clients had invested in his fund because of his ability to buy undervalued stocks, and they were alarmed by the sudden shift away from long-only stock picking to the use of esoteric derivatives to make a huge short bet on a single macroeconomic event.
His clients’ discomfort turned into outright hostility in 2006 when the fund’s performance deteriorated due to unfavourable marks on the subprime exposure. Scion was down almost -20% while the equity markets were up about 10%. Burry said, “I almost think the better the idea, the more iconoclastic the investor, the more likely you will get screamed at by investors.”
Some screamed, others redeemed. Burry wrote, “I do my best to be patient. But I can only be as patient as my investors.” Most of his clients had agreed to a two-year lock-up of their capital in the fund, but more than half of the fund’s $555 million was eligible for redemption at the end of 2006 or mid-2007, and they wanted their money back. To fund the flood of redemptions, Burry was forced to unwind liquid short positions on companies that were exposed to the subprime market. And to keep the business afloat, he was also forced to fire half his team. He wrote to his wife, “It feels like my insides are digesting themselves.”
Burry decided to prevent a run on the fund by placing the redeeming clients’ capital in side-pockets, a mechanism that allowed him not to have to try and sell the illiquid CDSs. His clients would have to wait until the CDSs had run their natural course before they could get their money back. They were enraged. Some clients publicly said that his behavior was unethical, and one went so far as to call him a sociopath. “I think these personal foibles of mine were tolerated among many as long as things were going well”, wrote Burry, referring to his own lack of interpersonal skills, his unconventional dress sense, and his habit of calming himself with loud heavy-metal music. “But when things weren’t going well, they became signs of incompetence or instability on my part - even among employees and business partners.” A long-time shareholder in the Scion business, who also had $100 million in the fund, threatened to sue, and other clients also considered litigation to get their capital back.
Then, early in 2007, just as Burry had predicted, borrowers began to default on their subprime loans at ever faster rates, and the marks on Scion’s CDS positions began to improve. In the first quarter of 2007, the fund was up 18%. In mid-2007 came the news that two Bear Stearns hedge funds that invested in subprime mortgage bonds had blown up, and the subprime market began a very steep decline that would soon take virtually every other asset class with it in what was about to become the Global Financial Crisis.
Burry’s short subprime positions turned out to be very profitable. By mid-2008 Scion had generated net returns of 489% since the fund’s inception in 2000, against the S&P 500’s 2% gain over the same period. Burry had taken a non-consensus view and had been proved spectacularly right. But, even though he had made his investors $750 million in 2007 alone, the firm’s assets under management were only $600m because of all the client redemptions. Burry said, “Nobody came back and said, ‘Yeah, you were right’. It was very quiet. It was extremely quiet.”
In late 2008, with the financial system in peril and global markets in freefall, the US government stepped in with its rescue plan. Burry believed that this represented a great opportunity to go long the equity market, so he started to buy stocks while many of his competitors were still in a state of panic. To Burry’s great distress, his largest remaining investor disagreed vehemently with this non-consensus view and threatened to withdraw his capital.
Finally, all the accumulated noise from his clients had become too much for him. In October 2008 he emailed a friend, “I’m selling off the positions tonight. I think I hit a breaking point. I haven’t eaten today, I’m not sleeping, I’m not talking with my kids, not talking with my wife, I’m broken.” And a month later he wrote his final letter to his remaining investors, informing them of his decision to close his fund after having been pushed repeatedly to the brink by, amongst others, his own clients.
Alpha Is Not Enough
You will not be spared turmoil even if you deliver above average returns for your clients. It is essential that you generate alpha, but it’s not enough. The piece that is frequently neglected is your relationship with your clients. Markets can withhold their rewards for longer than your clients can remain patient. During your inevitable periods of underperformance, everything will depend on the quality of relationship that you have with your clients. If you have not built and maintained these relationships, your clients will take away the capital that you need to express your non-consensus view. You can hedge the volatility of your investment performance with the quality of your client relationships. By doing this, you will better serve your clients’ interests, you will derisk your firm’s business, and you will improve your career prospects.
In both the cases of Friess Associates and Scion Capital, the fund managers took non-consensus views in their quest for alpha, and they needed their clients to remain patient for these views to play out. In both cases, their clients experienced discomfort as a result of the non-consensus views and a period of underperformance. And in both cases, their clients’ patience was severely tested by the fact that the non-consensus views also represented style drift. The clients of Friess Associates understood that the mandate of the fund was to be fully invested with equity exposure of 95%-plus, so equity exposure of 20% was a radical departure from their expectations. The clients of Scion Capital understood the mandate of the fund was to have long exposure to a variety of value-type stocks, so a single massive short position via complex derivatives was a radical departure from their expectations.
Talk About Change
The conflicts and tensions that exist between you and your client at the outset of your relationship tend to worsen over time because both of you will experience change. When your client’s situation changes, and your own situation changes, and these changes are not adequately communicated, the potential for noise only increases.
Your clients’ commitment to you is constantly being tested, even when you deliver alpha. They too are subject to multiple sources of noise that interfere with their commitment, such as the attractions of competing managers, strategies, and products. Your periodic underperformance increases the relative attractiveness of alternatives. Their own susceptibility to market-related noise means that your clients can amplify the noise that you experience, which can pressurise you to diverge from your investment process. The noise that you inflict on your clients through underperformance, style drift, and message dissonance reverberates back on you. Their noise becomes your noise in a number of ways:
Emotional Contagion. Their hopes and fears infect your thinking. This will drive you either to take consensus views or to abandon your process.
Resource Diversion. You spend more time hand-holding and reassuring. This will make you more prone to emotional contagion through exposure to clients or to being wedded to your positions through repetition of your views.
Fund Flows. Clients invest and redeem at the worst times. This will force you to buy high and sell low.
Your commitment to your clients is also being tested, even when they are committed to you, because you are subject to change. The underlying structure of the market changes over time, sometimes abruptly, and makes it more difficult for you to generate alpha. Other factors are also in flux: your team changes; your assets grow; or your firm merges. And you change: your baseline risk aversion changes as you accumulate battle scars, and your confidence waxes and wanes over time.
If you and your clients are not talking to one another about the changes that each of you is undergoing, someone is in for a nasty surprise. But, while communication can serve to reduce noise, it can also be a source of noise. It can divert your scarce resources away from alpha-generation; it can reduce the flexibility of your decision-making; and it can erode your competitive advantage. So you need to take great care over the quantity and quality of your communication.
At the very least, you want to reduce the chances of a negative surprise, so you need to communicate material changes quickly. If you lose a key member of your team, you need to pick up the phone and tell your clients so that they are not surprised or embarrassed. On top of that, and in the absence of material change, you want to develop a person-to-person relationship where your clients get to know you a little better, which allows you to get to know them a little better. Knowing each other is a massive competitive advantage. When the doors are closed and the board of trustees are deciding whether to fire you over poor performance, you need someone in the room to stick their neck out for you, and they will only do that if they know you.
References
Marks, H. (2013) The most important thing illuminated: uncommon sense for the thoughtful investor. New York: Columbia University Press.
Keynes, J.M. (1936) The general theory of employment, interest and money. London: Macmillan.
Tanous, P.J. (1997) Investment gurus. New Jersey: New York Institute of Finance.
Article in The New York Times on 9 November 1997 by Carole Gould: ‘Investing with Foster F. Friess; Brandywine Fund.’
Article in The Wall Street Journal on 15 October 1998 by Charles Gasparino: ‘Top fund manager is humbled when he makes ill-timed moves.’
Lewis, M. (2011) The big short: inside the doomsday machine. London: Penguin Books.