Investment manager selection is the primary business of most allocator firms. We assess managers across many dimensions but at its core, manager selection is all about the evaluation of investment judgement.
What is Investment Judgement?
“Judgement: The ability to make considered decisions or come to sensible conclusions.” — Oxford Dictionary
Investment judgement is the ability to make sound, considered, and repeatable investment decisions over time. Over the long-term, good decision making should lead to good outcomes. More specifically, it is:
- the ability to find and analyse the facts at hand and make investment decisions that have good probability of success
- the ability to recognise investment patterns
- the ability to understand business models and the key drivers
- the ability to know when a decision must be made despite not having all the information
- the ability to size things appropriately given the level of conviction and range of outcomes
- the ability to ignore irrelevant or misleading information no matter how compelling
- the ability to recognise one's own implicit decisions and to make them explicit
- importantly, it is NOT gut-feel or instinct
Evaluating Investment Judgement
We can evaluate investment judgement in two ways. First, we can look for all those things that lead to good judgement (i.e. the inputs — personal traits, disciplined investment process etc). Second, we can evaluate the decisions themselves (i.e. the outputs) and decide whether they represented good or poor judgement. We can do this second step both quantitatively and qualitatively.
The Inputs of Investment Judgement
"Successful investors tend to be unemotional, allowing the greed and fear of others to play into their hands. By having confidence in their own analysis and judgement, they respond to market forces not with blind emotion but with calculated reason.“ — Seth Klarman
Those with judgement often have certain traits or characteristics in common — see below for examples. Some of these are innate and some of them can be trained. To evaluate investment judgement, we can start by looking for and assessing these traits. Some are not immediately apparent and can be very difficult to see from outside the firm. Take humility for example. The best investors have great humility in that they recognise that they operate in a probabilistic world and that they can and will be wrong. They seek out alternative views and readily change their views when the facts necessitate. They freely admit their mistakes. This investment humility is a different type of humility than we might immediately consider. Someone who is boisterous, confident, and who seeks the limelight would not traditionally be seen as humble. In fact, they might even be considered arrogant. But this does not mean they don’t possess investment humility. The reverse is also true — quiet attention avoiders are often seen as humble but this does not mean they are not dogmatic in their views and readily admit mistakes. When evaluating investment judgement, we must consider the traits that impact investment decision-making and look past the more obvious but sometimes irrelevant impressions.
A well-structured and disciplined investment process is key to having great investment judgement. This will form the topic of several future posts so it is not discussed here. We discuss our own investment process here and outline how certain elements of the process are designed to reduce bias and promote consistency (across the portfolio and over time) to hopefully improve decision-making and judgement.
Decisions: The Outputs of Investment Judgement
We can assess outcomes (i.e. investment returns) and we can assess decisions. The two are not the same though they are correlated. A positive investment outcome is not necessarily the result of a good decision and vice versa. In fact, an analysis of Albourne data on fund returns shows that even 5-year track records were as likely to predict poor performance as they were outperformance. Only over the long-term will good decisions shine through as good outcomes. Sometimes we cannot wait this long before needing to evaluate judgement.
This is not to say we should abandon all track record / outcome-based analyses. We just need to understand their limitations and take statistical significance seriously. We should not use high-level track records if they have zero predictive value on future performance no matter how tempting it may be (admittedly, few agree with us here). We may look for alternative methods such as “hit rates” that may be more appropriate and potential statistically relevant for certain strategies. We may simply use such quantitative tools to help ask the right qualitative questions. This can be particularly helpful when trying to understand the typical portfolio company characteristics an investment manager prefers (e.g. margins, ROICs etc) and how these relate to the manager’s paper investment philosophy.
That said, it is not enough to stop at simply analysing the outcomes. We must also evaluate the investment decisions themselves and decide whether they represent good or poor investment judgement. We must also decide for ourselves whether the companies the manager has invested in fit our own investment philosophy, the manager’s investment philosophy, what kind of business quality they represent, and whether they were bought and held with appropriate margins of safety. Given our conclusions here, we must ask whether the portfolio sizing was also appropriate. As all allocators will attest, nearly any stock pitch can sound impressive and convincing when there is an asymmetry of knowledge about the company. The only way to truly answer these questions for ourselves is to research and understand the company for ourselves. As alluded to in the previous post, this requires the allocator firm to have their own company and industry research process and frameworks. Admittedly, this is a rather controversial topic in the endowment world and not all will agree with me.
It may seem like an overwhelming task for an allocator firm that has tens (sometimes hundreds) of investment managers in the portfolio equating to hundreds if not thousands of individual securities. For sure, it takes significant dedication of time and resources to do this properly. Otherwise it quickly becomes a lip-service task of surface-level research quality and insight. After all, nothing that is easy is a path to outperformance. That said, it is very achievable if done with the right prioritisation. This kind of research does not need to be done on every position — this would defeat the point of allocating capital externally in the first place. Instead, it can be done on the largest positions or the positions that raise the most questions about a manager’s investment judgement or investment philosophy. It can be skewed to the underwriting of new managers. As the process is performed, the conviction and trust in the investment managers that remain in the portfolio will grow and reduce the need to perform this type of work to a monitoring level only. Further, this type of work compounds in value. Over time, as more industries and companies are understood by the allocator firm, the work on new positions becomes more efficient.
As the research and processes underpinning this type of work grow within the allocator firm, it may even be worthwhile considering a shift to a hybrid approach where some of these investments are brought onto the internal balance sheet (to be discussed in a future post). At a bare minimum, it requires team members who are passionate about business models and direct investment research in addition to the standard investment manager diligence.