Lessons from Jim Leitner - Part 3 of 3

Here is Part 3 on the wonderfully insightful interview in Steve Drobny's book The Invisible Hands with Jim Leitner, who runs Falcon Investment Management, and was previously a member of Yale Endowment's Investment Committee. Leitner is an investor who has spent considerable time contemplating the science and art of investing, making money opportunistically across all asset classes, unconstrained, focused on finding the right price and structure, not losing money...and remaining humble (an increasingly rare quality in our industry).

His very clearly articulated thoughts about hedging, risk management, cash, and a number of other topics are profound. Below is Part 3 of a summary of those thoughts (please also see Part 1 and Part 2). I would highly recommend the reading of the actual chapter in its entirety.

Definition of Investing

“Investing is the art and science of extracting risk premia from financial markets over time.”

Risk, Preservation of Capital, Volatility

The risk management process starts with what you buy and how you structure those “themes and trades.” Jim manages his portfolio with a particular focus on the downside, where he “never wants to lose more than 20 percent and structures his portfolio to make sure that under no possible scenario can he ever exceed this loss threshold.”

People have a tendency to spend “more time thinking about returns than about how to manage downside risk. The investment process seems to be driven by a need to generate certain returns rather than a need to avoid absolute levels of loss on deployed capital.”

Jim gives a number of reasons why it’s important to preserve capital and limit downside volatility.

1. Psychological – the emotional damage and potential impact on decision making, associated with large losses even if they’re unrealized or not permanent. He talks about not being willing to lose more than 10% in any given month, no more than 20% in any given year – these figures were determined based on personal “psychological recognition.”
2. Career Risk – investors and bosses may not care that your losses are unrealized or not permanent
3. Negative Compounding – After a drawdown, the law of mathematics makes it an uphill battle to get back to even. For example, when an investor is down 40%, it means he/she would need to make 67% to breakeven. This doesn’t account for any cash outflows/redemptions, which makes it even more difficult to get back to breakeven $ wise.

“While I am not sure what my focus on truncating downside risk has cost me over time in terms of lost opportunity, I am certain that I have not maximized return. But at least I can be sure that I will be around for future opportunities.”

Diversification

As a part of his process, he tries to identify crowded trades, securities, assets, “even portfolio approaches” because “…diversification only works when you have assets which are valued differently…If everything is expensive, everything will go down, so it doesn’t really matter if you own different things for diversification’s sake.”

Lesson from 2007-2008: “At the beginning of this period, all risk assets were no longer cheap. There was no real diversification in owning a portfolio of overvalued assets. This is the true lesson. Overvaluation becomes a risk factor that must be addressed directly in portfolio construction.”

Lessons from Jim Leitner - Part 2 of 3

Here is Part 2 on the wonderfully insightful interview in Steve Drobny's book The Invisible Hands with Jim Leitner, who runs Falcon Investment Management, and was previously a member of Yale Endowment's Investment Committee. Leitner is an investor who has spent considerable time contemplating the science and art of investing, making money opportunistically across all asset classes, unconstrained, focused on finding the right price and structure, not losing money...and remaining humble (an increasingly rare quality in our industry).

His very clearly articulated thoughts about hedging, risk management, cash, and a number of other topics are profound. Below is Part 2 of a summary of those thoughts (please also see Part 1 and Part 3). I would highly recommend the reading of the actual chapter in its entirety.

Hedging, Leverage, Creativity

Summarized below is a wonderful example of Jim’s differentiated and creative thought process.

Conventional wisdom cautions investors to avoid leverage because it is considered more “risky.” This is generally true if you’re employing leverage to purchase additional positions that have similar correlation/volatility profiles to existing positions.

But what if you used leverage “to purchase only those assets which, at least historically, have had negative correlations” to the existing portfolio holdings? Theoretically, this additional leverage should not increase the “riskiness” of the total portfolio because in the event of a market drawdown, the asset purchased on leverage will increase in value thus avoiding the margin call and downward spiral generally associated with leveraged portfolios in bear markets.

One example Jim gives is a levered (via the repo market) position long government bonds, an asset class that tends to rally when equity markets hiccup.

Usually, hedges and insurance protection cost money to purchase which in turn causes number of problematic issues (for more on this topic, please see a whitepaper published by AQR). But what if we could find a hedge that pays us instead? Although rare, it’s possible. In the example above, “bonds can be repo’d at the cash rate and have a risk premium over cash, over time the cost of such insurance should actually be a positive to the fund.” In other words, the interest received from the bonds purchased is greater than the interest paid on cash borrowed to purchase those bonds.

Lessons from Jim Leitner - Part 1 of 3

In Steve Drobny’s book The Invisible Hands, there’s a wonderfully insightful interview with Jim Leitner, who heads up Falcon Investment Management, and was previously a member of Yale Endowment's Investment Committee. Leitner is an investor who has spent considerable time contemplating the science and art of investing, making money opportunistically across all asset classes, unconstrained, focused on finding the right price and structure, not losing money...and remaining humble (an increasingly rare quality in our industry).

His very clearly articulated thoughts about hedging, risk management, cash, and a number of other topics are profound. Below is Part 1 (please also see Part 2 and Part 3) of a summary of those thoughts. I would highly recommend the reading of the actual chapter in its entirety.

Cash, Opportunity Cost, Liquidity, Derivatives

“Cash always gives the lowest return when modeling on a backward-looking basis.” This is why endowments, etc. tend to hold very little cash, because they construct their portfolio allocations looking backwards, based on historical returns.

But if we construct our portfolio allocations on a forward looking basis, “…cash is the essential asset. When other assets have negative return forecast…there is no reason to not hold a low return cash portfolio.”

Also, by looking backward, we tend to ignore the “inherent opportunity costs associated with a lack of cash…cash affords you flexibility…can allocate that cash when attractive opportunities arise.”

“The correct way to measure the return on cash is more dynamic: cash is bound on the lower side by its actual return, whereas, the upper side possesses an additional element of positive return received from having the ability to take advantage of unique opportunities.”

“Holding cash when markets are cheap is expensive, and holding cash when markets are expensive is cheap.” As equity or other assets get more expensive, it’s important to hold more “cash and cash-like assets” because it decreases the potential for downside volatility.

It’s important to have cash on hand in case assets or securities become cheap because redeeming from existing allocations or selling existing positions takes time.

Hedge funds and some investors that use derivatives and swaps have the ability to gain large notional exposures (via these derivatives) while holding cash in reserve – a nice luxury.