People often remark that “AUM is the enemy of performance.” But is this truly always the case? Here’s another thought-provoking excerpt from Stephen Duneier of Bija Capital Management that explores the nuances of the AUM-Performance relationship. AUM, Expected Return, Sizing, Selectivity, Liquidity

“Since becoming a portfolio manager more than ten years ago, I have managed as little as $8 million and as much as $910 million. What did I do differently at each extreme? Nothing. On average, I had the same number of trades in the portfolio, structured the positions the same, analyzed the markets the same, generated trade write-ups the same, and in proportion to the overall portfolio, I sized the positions the same. Those are the relevant factors that investors should be asking about when it comes to AuM and here is why. With a minimal amount in AuM, you are clearly not confronted with capacity constraints, therefore you can be highly selective when choosing among opportunities, allowing for optimal portfolio composition. While operating below your capacity constraint, the portfolio composition runs within a fairly steady range. So how do you identify the limits of a PM's capacity?

Well there are two determinants of capacity. One is internal (mental) and the other is external (market). For those trained as prop traders and PMs within large organizations, you are typically allocated risk rather than capital, which means you think of gains and losses in notional terms. That makes for a difficult adjustment to the world of proportional returns, and particularly shifts in AuM, thereby prematurely capping either AuM growth, or the risk and returns on it. The external constraint is market liquidity per trade or structure. So long as I can maintain the same proportional exposure to a given position, I remain under my capacity limit. Once I have to increase the number of trades in order to maintain the same overall proportional risk exposure, I have breached max capacity for my style. You see, before you reach capacity, you are selecting only the best ideas and expressing them via the optimal structures. You could do more, but you choose not to. When your overall risk budget gets to a point where you cannot maintain the same overall exposure with the same number of trades, you must begin adding less optimal structures and even ideas of lesser conviction. That is the true signal of having breached your maximum capacity.”

There’s something in the Santa Barbara water (or wine) that produces some extremely thoughtful investors/writers. Some of you already know that I’m a fan of Eric Peters of Weekend Notes (who resides in Santa Barbara). A friend recently told me about Stephen Duneier of Bija Capital Management (another Santa Barbara resident) who also has been writing thought provoking letters. Below are excerpts from a piece written a few weeks ago on risk management, titled “The Managing vs. Marketing of Risk.” For those of you who appreciate differentiated opinions, it’s a worthwhile read. Risk

“ 'You can take risk. Just don't lose money.' - A Former Boss

Risk management seems like a simple endeavor. It’s not. It requires a deep understanding of what risk is and how it can be managed. Some think that simply being strong is the answer. It’s not. Many think of risk as something you deal with after the fact, and it shows in their pitch. “I will force positions to be shut down.” “I will step in and close positions myself.” “We will cut risk...” All of these statements reflect a reactive risk management process. While they sound tough and disciplined, they are really just impulsive behaviors attempting to clean up impulsive behaviors, after the damage has already been inflicted. Fact is, the biggest hedge fund disasters don’t occur when funds are doing poorly. They come about when they are doing well, and risk management has been sidelined. That’s why every loss and every gain attracts my interest in exactly the same way, for the most effective risk management is both proactive and consistent execution.”

“The speed bump is a generally accepted risk management tool. Essentially it serves as a line in the sand which triggers a specific reaction. As an example, if a portfolio manager is down 5% from the high water mark (HWM; peak profit), then her risk is halved. If it happens again, risk is halved again, and so on. It's one of those things that sound good in a marketing presentation, allowing a fund manager to masquerade as a disciplined risk manager. The problem is that its mere existence creates an impediment to thinking deeper about and implementing more effective, proactive risk management procedures. Worse yet, speed bumps ultimately serve two distinct purposes. They reduce the returns of a good investment manager and they extend the life of a poor one. The better the manager, the more dramatic the negative impact, and vice-versa…in every case where the PM is a positive performer, your returns will be better without a speed bump. What about the poor performer? Simply stated, you should fire him.”