This brief book is pithy and full of useful information presented in an understandable manner. Paul Marshall, as well as being the father of one of the members of pop group Mumford and Sons, is also an experienced and successful hedge fund manager. He co-founded Marshall Wace in 1997 with $50m, half of which reportedly came from George Soros, and it now manages more than $60bn. As such, he is well qualified to comment on fund management as a practice and as an industry and does so in an insightful and valuable way.
The book begins by examining the nature of markets and Marshall’s opinions about managing funds in a market environment. He accurately characterises markets as, “highly complex nonlinear systems created by a myriad of half informed or uninformed decisions made by fallible (human) agents with multiple cognitive biases.” (p6)
Lesson 1: Markets are inefficient
Marshall whole-heartedly rejects the efficient market hypothesis (EMH) and uses the following example to illustrate the folly of some of its central assumptions:
“Two economists are walking down the street. One spots a $100 bill on the ground. ‘Hey,’ he says to his friend, ‘there’s a hundred bucks lying on the ground!’ ‘Don’t be silly,’ the other replies, ‘if there were a hundred dollars on the ground, someone would have picked it up already!’ (p12)
He also references the work of highly respected thinkers on markets and the nature of uncertainty to illustrate his belief that psychology, bias and the price action of markets themselves all play a far larger part in price discovery than that allowed to them under the EMH.
Benoit Mandelbrot - work on inefficiency of markets (p15-16)
“Today does, in fact, influence tomorrow. And different price series exhibit different degrees of memory….the obvious explanation…is that market participants are human beings, and humans, driven by fear and greed, are swayed by price movements.” (p16)
George Soros and reflexivity (p16-17)
“Markets not only anticipate economic developments but actually drive them and are in turn driven by them, because, ‘human beings are not merely scientific observers but also active participants in the system.’ With his theory of reflexivity, Soros was demonstrating the limits to understanding and predictability in a self-referential system, a system where an observer is part of what he is observing.” (p17)
Lesson 2: Humans are irrational
One of the main reasons Marshall characterises markets as inefficient is because humans are irrational. This is perfectly captured in the quote, “The heart has reasons which reason does not know.’ Pascal, ‘Pensées’ 1670 (p21).
Marshall also references Soros’s principle of fallibility: “In situations that have thinking participants, the participants’ view of the world never perfectly corresponds to the actual state of affairs. People can gain knowledge of individual facts, but when it comes to formulating theories or forming an overall view, their perspective is bound to be either biassed or inconsistent or both. That is the principle of fallibility.” ‘Fallibility, Reflexivity, and the Human Uncertainty Principle’, ‘Journal of Economic Methodology, 2013’.’ (p23)
Indeed, the recent conditions in any given market can be said to heavily influence the behaviour of its participants as exemplified by a so-called ‘Minsky Moment’ - “His central insight was that long periods of financial stability could ultimately lead to instability because they promoted complacency and excessive leverage and risk-taking.” (p24)
Marshall also posits a ‘Stupidity principle’ saying, ‘there is no such thing as a Stupidity Principle but there should be. Stupidity is a very basic symptom of the human condition.’ (p26). It is also an aspect of the human condition that seems to persist through the ages. Marshall illustrates this point by quoting from Flaubert, “It accompanies poor Emma throughout her days, to her bed of love and to her deathbed. Stupidity does not give way to science, technology, modernity, progress: on the contrary, it progresses right along with progress.” Faubert, ‘Madame Bovary’, 1857 (p27). I was very pleased to find a literary reference in a book about fund management as, like Marshall, I think novels contain the best understanding of human nature rather than economic or financial models.
Marshall references the work of behavioural psychologists Kahneman and Tversky, who could be said to be attempting to ‘prove’ the examples of human fallibility observed in markets and decision making more broadly. He lists the major bias they, and others, have discovered as follows: 1) Optimism bias 2) Gambler’s fallacy / mean reversion 3) Overoptimism - “when someone is doing well their portfolio should be subject to extra scrutiny and their ego deflated.” (p31) cf Fergie and Becks after the World Cup qualifying freekick vs. Greece 2001 4) anchoring bias 5) confirmation bias - “the tendency to interpret new evidence as confirmation of one’s existing beliefs or theories'' (p34) 6) disposition bias - “describes the tendency of investors to sell assets that have increased in value, while keeping assets which have dropped in value.” (p35) 7) sunk cost fallacy - “decision makers were too heavily influenced by the fact they had already ‘sunk costs’ in the project, even though these costs should make no difference to ongoing investment decisions.” (p36/7)
One assertion that gave me pause for thought was, “there is nothing assured about the outperformance of defensive sectors” (p33). I wondered if this is true in the long term given the fact that most of the world’s oldest companies come from defensive sectors. I also think that if a share in a company in a defensive sector trades at the same valuation as one in a cyclical sector, then the defensive share should be preferred as its earnings and cash flow should be more stable across a cycle and its risk of failure lower. Arguably, defensive shares deserve a premium for this reason and should be purchased when the market doesn’t ascribe it to them.
Lesson 3 - Investment skill is measurable and persistent
Marshall argues that investment skill is quantifiable and continuing. He uses the ‘success ratio’ or ‘batting average’ (winners: losers) as a means of measuring this. This ratio also demonstrates how fine the margins between success and failure are in fund management. A good ratio is 52-53% winners, amazing is 55%. Nonetheless, “it is possible to be a consistently good manager with a success ratio below 50% if you have consistent skew towards winning stocks in your position sizing.” (p43) There is also, later on in Lesson 6 - Concentration + Diversification, the ‘slugging ratio’ - realised gains : realised losses aka win / loss ratio (p63)
This Lesson also focuses on the personal characteristics common amongst successful fund managers. People who succeed in fund management are a fairly eclectic bunch, to put it mildly, but Marshall says, ‘perhaps above all they have to be resilient.’ (p46) This reminded me of something one-time star fund manager Paul Woodford said about fund management being the ability to take pain. Unfortunately since his fall from grace and the closure of his shop, it’s difficult to find information online that isn’t related to this recent, high profile failure so I couldn’t locate the quote. Nonetheless, I think it is worth reflecting on what resilience means in this context. Is it resilient to stick to the same idea even when the market disagrees, which is what I interpret Woodford to be saying. Or is it, in fact, the ability to recognise that one’s ideas or hypotheses about the market or individual stocks have been wrong and change one’s mind? The unhelpful answer is that it is both depending on the circumstances! Nonetheless, it’s true that both situations demand severe self-reflection. To use Woodford as an example, while at Invesco he stuck to his defensive, value oriented style through the dotcom bubble and the financial crisis - both periods during which he presumably underperformed in the run up - which meant he avoided the big losses suffered by more aggressive fund managers in the subsequent crash. This secured him a reputation as an extremely successful fund manager. However, when he started his own fund manager he switched to investing a significant portion of his portfolios in unlisted biotech companies, which proved to be his downfall. In this sense, he seems to be a positive example of resilience and also an example of resilience (or attempted resilience) gone wrong! Perhaps something similar might be said of Anthony Bolton, who enjoyed extraordinary success managing the UK Special Situations fund at Fidelity before switching to investing in China and experiencing some very poor performance. Both situations might be seen as ones where initially resilience brings success but then this success turns into arrogance and hubris - more on that in Lesson 10.5. Crucially, Marshall notes the importance of a fund manager's personal circumstances in helping or hindering their professional success, ‘We have found, for example, that the reddest flags for underperformance are problems in people’s personal lives - the three Ds of death, divorce and disease.” (p46) Perhaps because it involves asking intrusive questions, this is rarely mentioned in assessing fund managers but strikes me as extremely important even though it may be difficult to assess.
Lesson 4 - In the short term the market is a voting machine, in the long term it is a weighing machine. (Ben Graham)
‘Successful investing is anticipating the anticipations of others.’ & ‘If farming were to be organised like the stock market, a farmer would sell his farm in the morning when it was raining, only to buy it back in the afternoon when the sun came out.’ JMK (p50)
‘It is not a case of choosing those that, to the best of one’s judgement, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.’ JMK, ‘The General Theory of Employment, Interest and Money’, 1936)
Marshall sees the quant side of the Marshall Wace business as playing the voting machine game and the fundamental side of the business as playing the weighing machine game. (p52)
Lesson 5 - Seek Change
“The greatest opportunities always occur around change. The valuation of a company will not change unless something changes intrinsically about the company (financially, operationally or strategically) or something changes about its economic/financial context (interest rates, growth, volatility, inflation) to create or destroy value.”
This is the first Lesson in which Marshall wags a finger at Julian Robertson and the Tiger Cubs for being ‘narrative investors’ and for ‘ramping’ their stocks. (p56) More detail on this later on in Lesson 10 - Size Matters.
Need to find out more about / read about Philip Fisher - who Buffett credited with 15% of everything he had learned about investment, the other 85% being Ben Graham! (p58)
Lesson 6 - The best portfolio construction combines concentration with diversification
“Diversification is protection against ignorance. It makes little sense if you know what you are doing” (p65) This reminded me of a Charlie Munger quote, ‘the idea of diversification makes sense to a point. If you don’t know what you’re doing and you want the standard result and not be embarrassed why of course you can widely diversify. Nobody is entitled to a lot of money for recognising that because it’s a truism, it’s like knowing 2+2=4 but the investment professionals think that they’re helping you by arranging the diversification - an idiot could diversify a portfolio! Or a computer for that matter. But the whole trick of the game is have a few times when you know that something is better than average and invest only where you have that extra knowledge. And then if you get just a few opportunities that’s enough, what the hell do you care if you own 3 securities and JP Morgan Chase owns 100?’ Daily Journal Shareholder meeting, 2019. Marshall also makes the correct observation, ‘diversified junk is still junk’ (p100) later on in Lesson 9 - Respect Uncertainty but it seems to make more sense to include it here.
Gives a summary in this Lesson of why shorting is more difficult than being long, in his opinion: 1) costs to hold a short, shorts have -ive carry, longs have +ive carry if there is a divvy or stock can be lent out 2) shorting is more competitive - usually dominated by professionals and if a short is popular it will cost more to borrow the stock 3) depends on wider market conditions - ‘in a bull market, poor companies and weak balance sheets are often bailed out by central bank profligacy, asset price inflation or investor animal spirits.’ (p72) 4) unlimited liability 5) says they need to be traded more actively, which I didn’t fully understand? 6) if a short goes against you it becomes a larger % of the portfolio rather than a smaller one, as is the case with a long.
Lesson 8 - A machine beats a man, but a man plus a machine beats a machine
Given his background, Marshall is well placed to talk about hot topics of the day like machine learning and AI. He’s not overly glowing in his praise, ‘machines typically do not fare well in a crisis. They are not good at responding to a new paradigm until the rules of the new paradigm are plugged into them by a human.’ (p83). This made me think that they’re bad at the most important moments, a bit like the picking up pennies in front of a steam roller analogy.
Quantamental investment - using tech and data to help fundamental investment (p84-85) strikes me as where Marshall Wace has really excelled. It seems they have successfully married a predominantly fundamental management style with highly quantitative analysis of this management's performance. I’m a bit hazier on how MarshallWace uses automated trading and modelling alongside this and the book doesn’t go into much detail.
Marshall Wace processes 150 petabytes per month and expects to be doing 20 petabytes per day in 3 years time (written 2020) = 600 petabytes a month - is this very costly and a risk because of energy consumption or does data processing follow a Moore’s law type rule?
Lesson 9 Risk Management - Respect Uncertainty
This was my favourite Lesson, not least because it contains my favourite Keynes quote on p90!
“We have, as a rule, only the vaguest idea of any but the most direct consequences of our acts. Thus the fact that our knowledge of the future is fluctuating, vague and uncertain, renders wealth a peculiarly unsuitable subject for the methods of classical economic theory….By ‘uncertain knowledge’....I do not mean merely to distinguish what is known for certain from what is only probable...The sense in which I am using the term is that in which the prospect of a European War is uncertain, or the price of copper and the rate of interest twenty years hence, or the obsolescence of a new invention, or the position of private wealth holders in the social system in 1970. About these matters there is no scientific basis on which to form any calculable probability whatever” Quarterly Journal for Economics, 1937.
I’m not sure how much is reproduced in the book itself so I’ve copied it from my Skidelsky notes as I lent my copy to someone else. The main gist is certainly in there and, like Keynes, Marshall is keen to emphasise the importance of expectations and their inherent uncertainty in the functioning of markets. Some of this uncertainty might be susceptible to modelling and prediction via probability but much of it will not yield to this analysis and will remain incalculable. This is what I understand Keynes to be saying about the future and markets. Marshall develops this point with a quote from Frank Knight, ‘Risk, Uncertainty and Profit’ 1921, which I hadn’t come across before. He uses the terms ‘risk’ and ‘uncertainty’ to differentiate the two concepts but his broad point is similar:
‘Uncertainty must be taken in a sense radically distinct from the familiar notion of Risk, from which it has never been properly separated…The essential fact is that ‘risk’ means in some cases a quantity susceptible of measurement, while at other times it is something distinctly not of this character; and there are far-reaching and crucial differences in the bearings of the phenomena depending on which of the two is really present and operating…It will appear that a measurable uncertainty, or ‘risk’ proper, as we shall use the term, is so far different from an unmeasurable one that it is not in effect an uncertainty at all.’ (p91)
This Lesson also contained some comments on VaR (value at risk) that reminded me a lot of Marshall’s assessment of machine trading during crises from Lesson 8 - Machine + Man. ‘They are useful in normalised environments. But in stressed environments? Not so much.’ (p93) This made me think that it’s great when you have no need for it and then absolutely useless when you do need it but perhaps this is an oversimplification. Perhaps they turn the machine off during crises and don’t let it trade until more predictable assumptions can be made, thus limiting the amount the model can lose in a ‘volatile’ market. Whatever the case, both comments show some of the limitations of using automation to manage money amidst the ‘multi-agent non-linear complexity’ (p89) displayed by markets.
This respect for uncertainty is also expressed as a dislike for doctrine and dogma. Marshall uses the example of Colonel John Boyd, a US pilot. ‘At a 1992 address to the Air War College he warned of the dangers of rigidity: ‘The Air Force has got a doctrine, the Army’s got a doctrine, Navy’s got a doctrine, everybody’s got a doctrine.’ But of his own work he said, ‘doctrine doesn’t appear in there even once. You can’t find it. You know why I don’t have it in there? Because it’s doctrine on day one, and every day after it becomes dogma.’...’if you got one doctrine, you’re a dinosaur. Period.’ (p96) I wondered about the semantics here because Marshall certainly has some beliefs about fund management that appear to be dogmatic, for example, his views on liquidity later on in this Lesson and in Lesson 10 Size Matters. I suspect that the difference lies in the relative complexity of the situation; the more complexity the less doctrine / dogma are useful but in simpler situations they can be useful.
The Lesson also contains some information on the funds at MarshallWace. For example, the maximum leverage of any Marshall Wace fund is 400%, Citadel and Millenium are apparently 600-700%, but it still seemed quite high to me. I suppose it all depends on how reliable and correlated the funds underlying holdings are. Marshall says, ‘most of our investment funds are built on a model of diversified low-correlated alpha streams.’ (p100-101). I wondered if this was a hubristic statement after such a successful run for MarshallWace. Sometimes undiversified, low-correlated assets turn out to be far more correlated than historical data suggests, e.g. CDOs during the financial crisis of 2008. I’m also unsure what an ‘alpha stream’ means in the context of a fund - is this a fund manager managing a % of the portfolio? Or is it an automated trading strategy? Or could it just be a single stock or derivative position? I would have liked more information on how the funds are structured at MarshallWace but the book is more of a general overview and some of the information is probably proprietary given it’s a hedge fund.
Marshall has very clear views on concentration in portfolio construction. Some might call them doctrinal or dogmatic! In his view, a fund should be able to meet client withdrawals in all but the most extreme instances and should never resort to gating funds and preventing clients from redeeming their holdings. ‘Clients should never be asked to pay such a price [gating of funds, because it shows the manager has not been prudential about liquidity]. In some cases, clients literally had to pay the price, continuing to pay the management fee while the fund was gated. This may have been legal but it was a disgrace to the fund management industry.’ (p104) I couldn’t agree more! It reminded me of Neil Woodford’s woes investing in unlisted (aka illiquid) biotech stocks I mentioned earlier in Lesson 3 - Skill is measurable + persistent. He counsels investors, ‘never be in a position where the stock owns you.’ (p104) This reminded me of Sam Zell’s famous, ‘liquidity is value’ soundbite. I wondered what specific rules Marshall used in the funds. For example, at the long only fund manager I used to work at, there were rules to forbid owning more than 10% of a company, 20% of the free float and owning a position larger than 30/90 days at 30% of average daily trading.
Lesson 10 Size Matters
Marshall talks about his experience at Mercury Asset Management where it simply grew too big and then blew up, performance-wise, in 1998. (p106) Now that MarshallWace manages more than >$60bn, I wondered when he felt it would be too big.
This is the Lesson where Marshall really gives a stern telling off to Tiger Management and its founder Julian Robertson, having mildly scolded them as ‘narrative investors’ in Lesson 5 - Seek Change. He writes, ‘Julian Robertson was the almost legendary manager of the Tiger Fund. He annualised circa 25% per annum during the 20 year life of his fund from 1980 and became a billionaire. But this would not have been your investor experience, especially if you were late to the party. The money-weighted return on the fund since inception was relatively modest. Robertson allowed the fund to grow to $13bn but did not adapt the way he ran money, which was through a concentrated high conviction portfolio. In its last three years the fund lost 4% (1998), 19% (1999) and 13% before it was decided to close it down in 2000. Some of the positions were so large and unwieldy that Robertson decided to distribute them in specie to clients rather than unwind in the market, most famously his 22.4% stake in US Airways.’ (p107). This is certainly quite different from the usual narrative that surrounds Robertson and his ‘tiger cub’ proteges. Marshall is obviously a bit upset that he enjoys such a great reputation in spite of his irresponsible management of his fund's liquidity. Against that, averaging 25% over 20 years is fantastic performance in anyone’s eyes. Of course, he will have taken most of that money towards the end of the fund’s life and returns would have obviously suffered given the performance in the fund’s last three years. However, I wondered how much responsibility lies with Robertson and how much lies with his investors. It’s undeniable that liquidity was not a key concern for him but presumably his investors knew this about his management style, especially those who invested later and could analyse his track record. As such, I feel that his later investors were greedy and should share the blame even though I also think Marshall is right about Robertson’s irresponsible management . It seems a bit rich to expect a fund manager to turn away clients, especially if your fund manages >$60bn! Marshall’s response to this would be that some automated trading strategies are more scalable than simple equity investments. He writes, ‘from our experience, execution costs typically lead to a fundamental equity strategy being capped anywhere from $1-3bn in capital. Most good managers can deliver strong alpha on up to $1bn of capital. Very few can deliver the same persistently above $3bn. For systematic strategies it is possible to scale much higher.” (p108) I wondered how they came to these conclusions, besides the ‘experience’ mentioned, as I would have imagined there are many funds >$1-3bn with significant, sustained outperformance. Nonetheless, the point that size matters, makes outperformance more difficult and can cause big problems depending on the management style.
Lesson 10 ½
The final lesson is best summarised by the quote, ‘all political lives, unless they are cut off in midstream at a happy juncture, end in failure, because that is the nature of politics and of human affairs.’ Enoch Powell, ‘Joseph Chamberlain’ 1977 (p111). Marshall says this is also true of fund management.
The advice is to always be aware of the prospect of failure and to beware of hubris at all costs. He cites the intriguing example of fund manager Tony Dye in 1999 at the peak of the internet bubble (p113) who had been calling the bubble since 1995 but was sacked a few days before the crash after years of ‘failure’. Sometimes failure is forced on a fund manager by clients or employers!
Marshall already mentioned hubris as a significant source of bias in Lesson 2 - Humans are Irrational - point 3 ‘overoptimism’. Here he cites a classical example, ‘The Ancient Romans had a good approach to this [hubris]. When a general would return home they were typically granted a ‘triumph’ - it was technically illegal for an army or a general with imperium to enter the city other than at this event - which was effectively a big parade in which the general displayed all of the plunder and captives from the campaign…At the end of the parade, the general would ride in a chariot to be lauded by the crowds lining the streets and to offer a sacrifice at the Temple of Jupiter on Capitoline Hill in the centre of Rome. The general would be accompanied in the chariot by an ‘auriga’ (a slave with gladiator status). The auriga would continuously whisper in the general’s ear ‘memento mori’ - ‘remember that you are mortal’. At the peak of his triumph, the general was reminded of his mortality.’ (p115) I wondered how this might play out in Marshall’s hedge fund world. After a big win or a period of huge outperformance would he gather up his employees and march on the homes and offices of his rich clients brandishing thick wads of cash while the cleaner whispered in his ear, ‘remember past performance is no guarantee of future results, these clients will turn on you and cause a redemption crisis’? Of course, Marshall would take issue with them as he believes investment skill is measurable and persistent (Lesson 3 - Skill is measurable + persistent) and that he is a prudent manager of liquidity (Lesson 10 Size Matters)!
Conclusion
I thought this was a pithy and understandable introduction to markets and the fund management industry from a successful market practitioner. There’s lots to think about and plenty of opportunities to delve deeper from the quotes and books mentioned, which are of an eclectic and high quality. I would certainly recommend it to others and have already lent my copy to someone else.
Quotes
“In theory there is no difference between theory and practice. In practice there is.” Yogi Berra (p1)
‘In the past 50 years there have been six bull markets and six bear markets…the average bull market has lasted 6.9 years, the average bear market 1.5 years.’ (p73)
‘The definition of a stock which falls 90% is a stock that falls 80% and then halves.’ (p74)
‘As Bill Gates said, we always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next ten.’ (p76)
‘There are old soldiers and there are bold soldiers but there are no old, bold soldiers.’ David Hackworth, US Army Colonel, ‘About Face’ (p87)
Markets are ‘a near-perfect example of multi-agent non-linear complexity.’ (p89)
