The Relative Performance Game

I wrote in a previous post that much of what passes for “investing” is in fact just an exercise in “getting market exposure.” In writing that post, and in the course of many conversations, I have come to realize the investing public is generally ignorant of the game many asset managers are playing (not what they tell you they are doing but what is really going on under the hood). In this post, I want to elaborate on this.

Broadly speaking, there are two types of return objective for an investment portfolio:

Absolute return. For example: “I want to compound capital at a rate of 10% or greater, net of fees.”

Relative return. For example: “I want to outperform the S&P 500.” Or: “I want to outperform the S&P 500, with tracking error of 1-3%.”

We will look at each in turn.

 How Absolute Return Investors Play The Game

The true absolute return investor is concerned only with outperforming his established return hurdle. The return hurdle is his benchmark. When he underwrites an investment, he had better damn well be underwriting it for an IRR well in excess of  the hurdle rate (build in some margin of safety as some stuff will inevitably hit the fan). He will be conscious of sector exposures for risk management purposes but he is not checking himself against the sector weights of any particular index.

I emphasize “true absolute return investor” above because there are a lot of phonies out there. These people claim to be absolute return investors but still market their products funds to relative return oriented investors.

Guess what? The Golden Rule applies. If your investor base is relative return oriented, your fund will be relative return oriented. I don’t care what it says in your investor presentation.

How Relative Return Investors Play The Game

The relative return investor is concerned with outperforming a benchmark such as the S&P 500. Usually managers who cater to relative return investors also have to contend with being benchmarked against a peer group of their competitors. These evaluation criteria have a significant impact on how they play the game.

Say Amazon is 2.50% of the S&P 500 trading on 100x forward earnings and you’re running a long only (no shorting) fund benchmarked to the S&P 500. If you don’t like the stock because of the valuation, you can choose not to own it or you can choose to underweight it versus the benchmark (maybe you make it 2% of your portfolio).

In practice you will almost certainly own the stock. You may underweight it but you will own it at a not-insignificant weight and here’s why: it is a popular momentum stock that is going to drive a not-insignificant portion of the benchmark return in the near term. Many of your competitors will either overweight it (if they are reckless aggressive) or own it near the benchmark weight. Most of them will own it at or very near benchmark weight for the same reasons as you.

Sure, if you don’t own the stock and it sells off you may look like a hero. But if it rips upward you will look like a fool. And the last thing you want to be is the idiot PM defending himself to a bunch of retail channel financial advisors who “knew” Amazon was a winner all along.

The safe way to express your view is to own Amazon a little below the benchmark weight. You will do incrementally better if the name crashes and incrementally worse if the name rips upward but the effects will not be catastrophic. When you are ranked against peers you will be less likely to fall into the dreaded third or (god forbid) fourth quartile of performance.

This is the relative performance game.

Note that the underlying merits of the stock as a business or a long-term investment get little attention. The relative performance game is about maximizing incremental return per unit of career risk (“career risk” meaning “the magnitude of relative underperformance a client will tolerate before shitcanning you”).

If you are thinking, “gee, this is kind of a prisoner’s dilemma scenario” I couldn’t agree more. In the relative performance world, you are playing a game that is rigged against you. You are handcuffed to a benchmark that has no transaction costs or management expenses. And clients expect consistent outperformance. Good luck with that.

I am absolutely not arguing that anyone who manages a strategy geared to relative return investors is a charlatan. In fact I use these types of strategies to get broad market exposure in my own portfolio.

I do, however, argue that the appropriate expectation for such strategies is broad market returns +/-, that the +/- is likely to be statistically indistinguishable from random noise over the long run*, and that this has a lot to do with the popularity of market cap weighted index funds.


Corollary: Don’t Be An Idiot

If you are one of those high net worth individuals who likes to run “horse races” between investment managers based on their absolute performance, the corollary to this is that you are an idiot.

The guys at Ritholtz Wealth Management (see my Recommended Reading page) have written and spoken extensively about the problems with such an incentive system. It is nonetheless worth re-hashing the idiocy inherent in such a system to close out this discussion. It will further illustrate how economic incentives impact portfolio construction.

If you say to three guys, “I will give each of you 33% of my net worth and whoever has the best performance one year from now gets all the money to manage,” you will end up with a big winner, a big loser and one middle of the road performer. You will choose the the big winner who will go on to be a loser in a year or two. Except the losses will be extra painful because now he is managing all your money.

Here’s why. You have created an incentive system that encourages the prospective managers to bet as aggressively as possible. This is exacerbated by the fact that your selection process is biased toward aggressive managers to begin with. No self-respecting fiduciary would waste his time with you. People like you make for terrible clients and anyway a self-respecting fiduciary’s portfolio is not likely to win your ill-conceived contest. Your prospect pool will self-select for gamblers and charlatans.

In Closing

Incentive systems matter. Knowing what game you are playing matters. There is a name for people who play games without really understanding the nature of the games.

They’re called suckers.


*Yes, I know it is trivial to cherry pick someone ex post who has generated statistically significant levels of alpha. I can point to plenty of examples of this myself. Whether it is possible to do this reliably ex ante is what I care about and I have yet to see evidence such a thing is possible. Also defining an appropriate threshold for “statistical significance” is a dicey proposition at best. If you feel differently, please email me as I would love to compare notes.

Case Study: Embraer Investment Post Mortem

One of the most vexing problems in the world of investing is that of distinguishing luck from skill (spoiler alert: it is nigh on impossible). This is an issue of paramount importance. It is, in a sense, the whole ball game. Morgan Housel calls luck “the flip side of risk:”

[E]xperiencing risk makes you recognize that some stuff is out of your control, which is accurate feedback that helps you adjust your strategy. Experiencing luck doesn’t. It generates the opposite feedback: A false feeling that you are in control, because you did something and then got the outcome you wanted. Which is terrible feedback if you’re trying to make good, repeatable long-term decisions.

In investing, a huge amount of effort goes into identifying and managing risk. But so little effort goes into doing the same for luck. Investors hire risk managers; no one wants a luck consultant. Companies are required to disclose risks in their annual reports; they’re not required to disclose lucky breaks that may have led to previous success. There are risk-adjusted returns, never luck-adjusted returns.

As someone who evaluates investment managers for a living, I am acutely aware of this issue. Particularly as it relates to repeatable, long-term decisions. The hedge fund graveyard is littered with the remains of dudes who got one big bet right then proceeded to nuke their fund with the next one.

The way I deal with this in my personal portfolio is to keep an investing journal. The purpose of the investing journal is to document key decisions and conclusions: research; trade and position sizing rationales; emotional triggers and strategies for dealing with them. All this is documented for later review so I can at least attempt to understand the role of luck and skill in the outcome.

You may recall my old post on trading Embraer (ERJ) using a mix of technicals and fundamentals. On 04/03 I sold the remnants of my ERJ position for a decent gain. Below is my investment post mortem. You will have to forgive me the rough edges as this is only lightly edited from the investing journal itself for grammar and clarity.

ERJ Investment Post Mortem

Below is my original model for ERJ. This would have been done in Fall 2017 (I am lazy about the dates). Obviously the numbers are rough. I am not one of those people who agonizes over precision in a DCF model where a couple basis points on the discount rate will move the valuation by $500 million. My format is blatantly ripped off of Professor Aswath Damodaran’s DCF template. Knowing his philosophy on teaching I trust he’ll take that as a compliment.

The point of the exercise is to get an idea of the upper and lower bounds on the business’s value so a position can be sized. ERJ is subject to a high degree of uncertainty due to the capital intensive and cyclical nature of the business. Even though the model produced a point estimate of the per share value I think of a range of possible outcomes. For ERJ playing around with the numbers led me to believe the base case business value would fall somewhere between $24 and $30 per share. So decent upside appeared to be on offer from an entry price in the mid-18s.

Source: Demonetized Calculations

My initial experience with the name is laid out in the trading post linked above. So we will pick up later in 2017. In 3Q17 I wrote:

The theme of the 3Q17 call could perhaps best be described as “under promise and over deliver.” See the above graphic from the presentation slide deck for all the summary you need. They are guiding down in 2018 due to all the factors highlighted in gray bubbles. This more or less holds 2017 results flat and has no impact on the investment thesis. In fact, today the shares traded down further.

The 190-E2 program looks to be on track with the first delivery set for April 2018. They expect about 10% of 2018 deliveries to be 190 E-2 jets.

Meanwhile order activity continues in the legacy book. 12 Super Tucanos were ordered (6 by the US for Afghanistan and 6 by an undisclosed customer). The Super Tucano also passed the initial qualifications required for the US OA-X light attack plane evaluation program. 45 E-175 jets were ordered by SkyWest which is a nice bridge order.

For the time being I like this as a 5% position. I would add opportunistically again below $18/share, assuming no fundamental challenges to the thesis. Need to keep an eye on the order book (they didn’t break out the order book in the presentation material).

On December 21, after ERJ-BA merger talks were announced, I wrote:

ERJ closed up about 22% of the day on the back of news that it and Boeing were in merger talks. This was confirmed by both companies a couple hours after WSJ broke the news. WSJ said the discussions involved a significant premium for ERJ but the sticking point is that the Brazilian government has to bless the deal.

This is a huge validation of the investment thesis and argues for sizing up the position. Considerations:

Analysts think the deal is likely to break. Of course, no one saw it coming anyway so not sure how good their read really is. Skepticism seems to center on the fact that Boeing had been dismissive of Airbus’s move with Bombardier’s regional jet business (although, when you think about it, why would Boeing give public props to its competitor?)

I actually think the deal makes more sense than the analysts. Airbus has clearly gone out of its way to validate the regional jet market. These deal talks do the same. Plus, Boeing and Embraer already have cooperation agreements in place related to the KC-390 tanker.

However, the Brazilian government is a total X factor and I have no desire to try and handicap its actions.

Given the uncertainty, I think it makes sense to hold at current levels and size up opportunistically. If the deal talks stall, ERJ will drift back down toward $18-20 and present an opportunity to add incrementally to the position. The validation of the deal talks clearly is a tremendous boost to the ERJ investment thesis. If the deal breaks, on the other hand, the price will fall quickly back to $18-$19.

I do not think it makes sense to sell out of the position now and bank gains. That would be a short-sighted trade versus what I am really trying to accomplish with core positions. I would rather have Boeing take me out at a higher price (I think this deal gets done between $25 and $35 if it goes through) OR size the position up after the talks collapse and wait for value creation according to the original investment thesis.

No trades placed today but need to keep a weather eye on ERJ’s price.

On 1/5/18 I trimmed the position:

Sold shares of ERJ today @ $26.17. This reduces the position to about 3.3% of the portfolio. The cash on cash return for these shares is about 30% with an IRR in excess of 70%.


Negotiations between Boeing and the Brazilian government are ongoing. Brazil doesn’t want to give up control. Boeing wants control. Allegedly Boeing will not settle for a JV (this process has been leaky and I suspect both sides are strategically leaking info in an attempt to enhance their negotiating position).

This is more or less impossible to handicap. The Brazilian government is not operating purely on economic considerations.

What changed today was that it was leaked that Boeing’s offer for Embraer was $28/share on an informal basis. This is smack in the middle of what I think the likely value of the equity is today (about $25-$30/share). At $26/share the risk-reward skew just isn’t that great anymore.

But why not sell the whole position?

It is possible a deal goes through at $28/share or even higher.

If a deal does not go through, it is possible the shares sell off but to a level well above cost. If this occurs, there is an option to accumulate a bigger position. I am not sold that Boeing won’t accept a JV if it is the only option. It seems stupid for them to walk away all together given the Airbus/Bombardier arrangement. A Boeing JV would be a tailwind for the business and in any event this arrangement validates the long-term investment thesis for Embraer which should enhance conviction.

If a deal does not go through, and there is no JV, the shares should sell off back to around $20 or so. In this case I would accumulate back to a 5-6% position and add opportunistically over time. With 2018 a transition year there is a good chance for an earnings or guidance disappointment that will create further opportunity to accumulate additional shares.

In sum, I feel good about this trade. It feels like a balance of offense and defense. This is a perfect example of why I like to retain the flexibility to actively size positions to  manage risk and return. The key is not to be “trading scared” based on loss aversion. The focus has to be on the business fundamentals and the risk/reward skew.

On 4/03/18 I closed out the position with the following rationale:

Sold the remainder of my ERJ position.

I had intended to wait longer to exit this position in hopes of eking out a little more performance. However, in reviewing the overall portfolio it seems clear there are better opportunities on offer.

This is the first example of me liquidating a position to redeploy the capital into a better idea. Really what appears to be on offer from ERJ in the shorter-term is a merger-arb type return–a fairly small bump (maybe another 10%) with deal break risk. As a residual position it just can’t contribute that much relative to what it would detract in a deal break scenario. This is more of a value pattern investment even though ERJ has a good track record of capital allocation. So ultimately in looking at the risk/reward seems prudent to take the win and move that capital into a better opportunity.

I used the proceeds from the ERJ sale to build my CBOE position above the 10% threshold to bring it to Core Weight.

What Worked

  • Modeling appears to have been validated by subsequent market action and alleged Boeing negotiating position.
  • Trading around this position worked well (85% IRR vs. 43.3% cash return).
  • Disciplined exit.

What Didn’t Work

  • Position was sized too small. However, I can’t really knock myself too hard for this as the Boeing takeout clearly surprised the entire market. I suppose it might have been possible to foresee a deal after Airbus and Bombardier announced their partnership. But that is subject to significant hindsight bias. And anyway, I don’t want to leave myself in a position where I am relying on someone else to take me out for an investment to work. These aren’t supposed to be merger-arb trades.

Luck vs. Skill

  • The Boeing merger talks served as a catalyst which was not underwritten at all in the original investment case. So I get no credit for that.
  • From a risk management POV I think I can take credit for prudent position sizing. Remember that at the time the Bombardier-Airbus partnership was seen as a significant threat. Also the business performance outlined in the 3Q17 presentation was in line with my expectations for a rocky transition to the E2 Series.
  • Luck did not “save me,” but it certainly got me paid on an accelerated time horizon.
  • I do give myself some credit for thinking of the whole portfolio and not just this name in deciding to exit the position.


  • Not too much to take away from this one. Looking back I don’t think there is anything I could have done different without the benefit of hindsight. Probably the biggest takeaway from this position is not to attribute the quick payday to my own analysis. The position was properly sized but my actual investment case did not play out (the investment was underwritten for a much different time horizon).
  • I will keep an eye on things with ERJ to see how they play out. For one thing it could make for a good investment again in the future. For another, it will allow me to compare my investment case to what actually plays out, and assess whether redeploying the capital into CBOE was really the right decision.


I hope you enjoy reading this. Feedback is always appreciated. I will share more of these in the future.


Getting While The Getting’s Good

Woodcut depicting the deadly sin of Gluttony, by Sebastian Brandt; Source: Wikipedia

Lately, investors have been gorging themselves on private equity. The Financial Times reports:

“The current speed of fundraising is in my experience unprecedented,” said Jason Glover, a London partner at Simpson Thacher, the law firm. “[Private equity groups] are keen to take advantage of the unusually benign conditions, particularly in anticipation of a change in market conditions when fundraisings may become significantly more difficult.”

But Mr Glover, who has been involved in private equity fundraising for more than 25 years, said investors are eager to park their cash in top-performing funds. “Investors are keen to deploy increasing amounts to private equity and with many of the top funds massively oversubscribed, their only way to secure a commitment is to act quickly before those funds are sold out,” he said.

Private equity funds have also gained traction with investors as other asset classes, like hedge funds, have underperformed, said Warren Hibbert at Asante Capital Group. He said: “The private equity market today provides a unique product which is very difficult to kill, unlike hedge funds. It’s very difficult to lose money in a private equity fund.”

Part of the public service I attempt to provide on this blog is drawing attention to screaming red flags when I see them. As far as screaming red flags go this is a pretty good one.

Private equity is simple in principle and is first and foremost an exercise in financial engineering:

Step 1: Buy cheap company.

Step 2: Add gobs of debt.

Step 3 (optional, if desired): Cut expenses to boost free cash flow.

Step 4: Flip the levered entity at a higher valuation.

The problem private equity investors face today is that they are buying into funds based on past performance that is not likely to persist. The reason? Valuations.

Remember, per the above steps private equity works the same as flipping houses. You need a cheap entry price, low financing costs and stupid willing buyers on the other side. As entry valuations rise, the bar rises on the back end. You need to find progressively dumber more optimistic buyers to exit the investment and earn an attractive return.

Dan Rasmussen of Verdad Capital has written and spoken extensively about his firm’s in-depth research into private equity returns. In a piece written for American Affairs, he discussed the negative impact of higher entry valuations at some length:

This is more troubling than most market observers understand. Private equity is price sensitive because of the use of debt. Higher prices require more debt, leading to higher interest costs and higher risk of bankruptcy. The importance of valuation to returns is controversial but key to understanding the asset class, so it is worth looking at the issue from a few different angles.

The first approach is to look at PE deals and compare returns to purchase price. One PE firm did just such an analysis and found that over 50 percent of deals done at valuations of more than 10x ebitda lost money and that the aggregate multiple of money was barely over 1.0x (i.e., for every dollar invested, only slightly more than one dollar was returned to investors).

The second is to compare the average purchase multiple in a given year to the returns of the funds from that vintage year. There is a –69 percent correlation between purchase price and vintage year return, a strong inverse relationship.

The third is to look at PE-backed companies that IPO. My firm, Verdad, looked at every company taken public in the United States and Canada by a top-100 PE firm since the financial crisis, a data set of 195 IPOs with an aggregate ebitda of $66 billion and an aggregate market capitalization of $728 billion. The average company in this data set went public with $4 billion in market capitalization, traded for 17x ebitda, and was 21 percent leveraged on a net debt/enterprise value basis at IPO. We segmented these IPOs by valuation at IPO. We divided the universe into three buckets: companies that went public at less than 10x ebitda (about 20 percent of companies), 10–15x ebitda (about 20 percent of companies), and more than 15x ebitda (about 60 percent of companies). According to our research, the cheaper IPOs dramatically outperformed the Russell 2000, the moderately priced IPOs matched the Russell 2000’s return, and the expensive IPOs underperformed.

Included in the article is this chart comparing historical valuation multiples:

Source: Verdad Capital via American Affairs

As for Mr. Glover’s assertion that “it’s very difficult to lose money in a private equity fund,” here is a list (not comprehensive) of assets and strategies that wore that mantle at one time or another:

  • Tulips
  • Railroad stocks
  • The Nifty Fifty
  • Tech stocks
  • Hedge funds
  • Mortgage bonds
  • Florida real estate
  • Energy stocks
  • Bitcoin
  • Beanie Babies
  • Tesla stock

1Q18 US Factor Performance

This is a wonkish post updating my US factor performance graphs. I use the data from Ken French’s Data Library for the following:

  • US Market
  • US Size
  • US Value (Book-to-Market)
  • North American Momentum
  • US Investment (Conservative Reinvestment Policy Premium)
  • US Operating Profitability

(Note that this data is produced on a lag so my “quarter” is always a month behind the calendar quarter. This update adds 12/17 through 02/18)

First chart out of the gate is our rolling 3-year factor returns. The Market factor continues to lead the pack in terms of performance since the global financial crisis. This is one of those data points that has led me to conclude Something Changed in the markets post-2008.

Longtime readers know my view is that quantitative easing by central banks pushed up cross asset class valuations, effectively lifting all boats to the detriment of many asset managers (hardly a unique perspective). This has been a significant tailwind contributing to the popularity of market cap weighted index funds. However, when and to what extent this trend reverses remains to be seen.

As the chart shows, factor performance tends to move in cycles. So I feel it is unlikely that Market factor performance will dominate forever. That said, it is basically impossible to time these things.

Source: Demonetized Calculations; Ken French’s Data Library

The single factor charts below more or less tell the same story.

If you could go back in time a few years and buy one of these factors, Market would be the clear winner. Again, if you’re Vanguard, this has served as a massive tailwind for your index products.

Much ink has been spilled about the recent weakness of the Value factor and this data shows a continuation of that trend. Likewise Value’s cousin, Conservative Reinvestment, has performed poorly.

I am not going to belabor the point here. I will simply reiterate that the tidal wave of interest in market cap weighted index funds is not likely to abate until the trends in cross factor performance shift in a meaningful way.

Source: Demonetized Calculations; Ken French’s Data Library
Source: Demonetized Calculations; Ken French’s Data Library
Source: Demonetized Calculations; Ken French’s Data Library
Source: Demonetized Calculations; Ken French’s Data Library
Source: Demonetized Calculations; Ken French’s Data Library
Source: Demonetized Calculations; Ken French’s Data Library