Date: 2018-12-30
Takeaway from 2018
2018 was an excellent year for me. This is majorly because perpetual positivity became a core of my coping mechanism against my numerous defeats, but there were some objectively good outcomes as well. I have left Hong Kong; my investment returns were great despite the market turbulence; I have finally narrowed down my focus and started working on my new venture in Vietnam. The process involved lots of setbacks and the challenges continue, but I can still afford to be positive. In this piece, I simply share some thoughts that crossed my mind in recent months – because I already forgot about much of the first half of 2018.
I. Inaccurate statements, humility, and silence
It has already been ten years since I started active portfolio investments of my own. It has been a humbling journey; especially the latter half of it surely has been. Despite the challenges and failures, I feel very happy for myself in that I have been completely focused on investment all along. Such consistency, persistence, and longevity hardly existed in my life, so I find real sense of fulfillment in my investment work. Over the years, I believe I have accumulated substantial knowledge and pretty rich emotional memories about markets in general and I can really feel the maturity, which I am proud of. However such maturity brought about cautiousness which made me much quieter in investment debates than before, in general. When one finally realizes that concept of perfection exists only at a very subjective level – because we all have different ideals – and that certainty hardly exists, it is difficult to make any comments because most statements are likely to turn out to be incorrect. Most words require certain degree of generalization too, which is an added source of inaccuracy. The only way to cope with this issue is taking oneself less seriously and admitting that he or she is almost always imperfect; I believe some forms of perfection can still exist. When one can afford to be silly, he or she has a room to breathe and chat freely. Still, whether the listeners are forgiving or not is another matter, and so the inaccuracy in statements remain problematic.
II. The mindset problem
Those I frequently speak to about investments happen to be investor-entrepreneurs who are in proprietary investments. As much as technology has been empowering for this group, I still find some structural challenges for them. While the managers in big organizations are not completely free of facing the same problem, it is accentuated for the former, and they will be able to perform better after finding a tangible solution to this problem.
Different sort of mindset is ideal for different sort of work. Even within investment management business, the mindset ideal for sales, risk management, analysis of asset fundamentals, analysis of fund flow, and investment execution are pretty different, not to mention the mindset difference among those with different investment styles. When an investment team is too small, it can be difficult to delegate the role and specialize in different mindsets, and I view this as a key vulnerability for one-person-companies and small offices.
1. Sales
I will first pass on the mindset of people in sales, because I find sales’ mindset pretty uniform across different industries. I am of the view that good sales people can sell anything anywhere to anyone at any point of time. While sales is a very important building block of investment managements, I am of the view that the core of any investment company should be the investment analysis and execution rather than sales. This is because skewed focus on sales in investment management runs a high risk of loss of integrity, which is easily observed among shops that engage in volume businesses. I identify herding as something to be extremely wary of in investments, and because strong sales tend to have herding effects and also because it is simply easier to sell the products that are currently popular due to human myopia and lack of foresight, I view this as a structural issue.
2. Risk management
Risk people need to focus on the full range of possibilities. The mindset best suited for this space I believe is a paranoia. I would be worried if risk people in the team have too strong and definitive views on too many matters. The world is actually complex, and so seeming-indecisiveness and hesitance in this area I believe should be taken as a virtue. I would be most relieved if risk people could come up with numerous scenarios both on upside and downside, and especially if they could come up with scenarios most people would call absurd. While not widely celebrated, I believe imagination is a real virtue in this area of work. Only with help of imagination, risk people can come up with a comprehensive assessment of the future.
3. Analysis
(1) Of asset fundamentals
Analysis of asset fundamental tends to be a pretty constructive process. One builds his or her expertise in certain sector or type of assets, and there is certain degree of continuum in this type of analysis. However, prices of good assets can suffer for a long time, and vice versa. While it is easy to say that the prices will eventually converge to a certain level, there is a risk of incurring a significant opportunity cost, too. Because there is a disconnect between the asset fundamentals and the asset prices, analysts of asset fundamentals shouldn’t be overly discouraged or criticized for making ‘money losing’ calls, because ultimately the manager’s call is more at fault. In the same chain of reasoning, when return is made, analysts need to understand why significant credit is given to the manager. That said, I would see some degree of stubbornness and denial as a good quality for analysts for asset fundamentals.
(2) Of fund flows
Depending on the investment style and what the topic of analysis is, mindset can differ significantly. For instance, analysis of fund flows require pretty different sort of mindset from what is necessary for the analysis of asset fundamentals. How current buyers and sellers are feeling about whatever is currently going on (and what their actions are) is the focus of the analysis, and this work can appear a lot less constructive than the analysis of asset fundamentals. Because they engage in guessing others’ incentives and emotion, the conclusion is most likely speculative, however still very useful for the investment execution. Due to these differences, I find it understandable when analysts of fund flows change their views much more frequently than those of asset fundamentals do. So I would view humility and flexibility as a good quality for the analysts of fund flows.
4. Execution
Within execution, there is a number of different mindsets simultaneously at work.
(1) Per risk consideration, focus need to be on the portfolio itself. ‘How much of what to own, owe, long, or short’ is a very difficult question to answer, and external factors’ net impact on the portfolio is a main consideration.
(2) Per monitoring of investment universe, focus needs to be on the horizontal comprehensiveness of the world. Conceptual and true sense of comprehensive is important at this stage, and any indices or price signals are useful as variables at this stage. The mindset needed in this stage is that of an economist.
(3) At the trade design stage, focus needs to be on the availability of vehicles, and the consideration of how much hassle it is to monitor certain vehicles is important. The mindset needed in this stage is that of a practitioner, and the focus needs to be on the constraints.
(4) When utilizing macro views on investments, I believe it should end at the asset allocation stage, and the executions at a more micro level (for instance which securities to buy and sell) should be quite independent from the macro view. This may sound like an oxymoron, but I have personally found this approach very useful in practice, especially when the macro and micro stories have discrepancies and both stories seem completely valid.
(5) When finally executing trades, I am of the view that the manager must forget about the portfolio’s pnl altogether. This is because one’s portfolio’s pnl has no causal link to the future movement of different assets’ prices, direction nor magnitude. I view pnl as a distraction at this stage.
Reconciliation of all these different mindsets in one body at one point of time is extremely difficult, and I expect this weakness to persist especially among one-person- or small- investment offices. I’ve been trying to divide my time and adopt different kind of mindset at different point of time, but it is of course hardly perfect. I don’t have a very good answer to this problem just yet.
III. Portfolio construction framework
I find similarities between the way I construct portfolio and how a chef pick a menu and cook. The chef would go to the market to check which ingredients are fresh. Likewise, I constantly assess the short and long term market condition. Depending on which ingredients are particularly good or reasonably priced, the chef pick the main menu of the day. Sometimes it would be chicken, but some other times it would be fish or shrimps. Likewise, I pick a few positions that become anchors of the portfolio. Then the chef buys miscellaneous ingredients that can make the key ingredient most tasty; I make some side positions that can make the expression of my view purer. In the end, the chef considers what other dishes can complement the main dish well, and pick some other dishes, possibly paying attention to the nutrition balance. Likewise, I make some positions that could be good hedges, unrelated to the core theme of the investments of the time. Some degree of diversification is achieved this way.
IV. Diversification
It helps to diversify in as many dimensions as possible. Different strategies work better in different circumstances, so it is silly to seek to identify one superior strategy. Understanding the pros and cons of varied strategies is more helpful for the return itself. Theory is very important because major assessment criteria for including and excluding varied investment strategies all boils down to the soundness of the respective strategies’ theory, because we have not yet lived future.
V. View on 2019 onwards
I am of the view that we have already seen the peak of this bull market. UST’s domestic Issuance-subscription imbalance is most likely to dictate the USD trade narrative in 2019. I am curious to see what additional bond issuances will do to the USTs. The situation in Aussie housing market has been slowly unwinding and it is most likely to continue; I find Aussie government pretty impressive on this regard. Hong Kong gets a very lucky break thanks to prematurely weakening USD. I like high yield HK equities as a weak USD trade. Even as HK property market remains weak, the wage gap between HK and mainland seems sustainable for a while more, which is a savior for HK economy. I like MLPs and energy utility companies which are adversely affected by the oil prices. The PRC is most likely to accommodate US’s key demands in trade negotiations at least on surface, because the US surely has an upper-hand. Despite the need for a serious amount of UST subscription from overseas going forward, I still see the US certainly leading this negotiation, ultimately thanks to its military might. In fact, the PRC does not really have any good arguments to make. Even as the US knows that the PRC is not likely to follow through with the promises, a declaration of triumph from this end will come in very handy for the next election, so it works. Gold and JPY are probably best currencies to hold for now. There is a high chance we will see a stagflation within few years, and the inflation data remains as useful timing gauge for gold trades. I foresee gold rising by double digit percentages in its price for at least 2-3 years in the next 5 years, as long as the Fed does not turn too hawkish, which I view as a relatively low probability event given the recent rout.