At various and altogether different moments, I have been both energized and demotivated by the parental colloquialism: you make your own luck. Embarrassingly, I am particularly enthralled by the phrase, even ready to pass it along with a wink and an encouraging pat on the back, when things appear to be going well. Honest reflection lends a needed dosage of sobriety to the most optimistic moments. As much as we would like to believe otherwise, the truth is that often success stories have, my own most certainly included, simple old-fashioned good fortune to thank for a significant portion of a positive result and not our own ability or special genius.
In general, especially in the world of strategy deployment, it is difficult to distinguish skill from luck. Too often human nature assumes that the successful must certainly also be particularly adroit. Society reinforces this tendency, where there is great fortune there is also a slew of parties waiting in line to reflexively heap the successful with a plethora of adulates. Similarly, it is prudent to assign pessimism to the view that failure necessarily represents ineptitude.
Timing, unanticipated developments, right place/right time and the over-arching “luck” factor are several of the terms a layman may use to express the variables at play when identifying skill or a lack thereof. The reality is that the work necessary and a lack of ultimate finality in isolating extenuating variables means the intuitive assignment of skill to success runs rampant and vice versa. Nonetheless, it is the pursuit of the sophisticated allocator not to draw causality or assume repeatability where it does not belong. In the world of investing, even a fraction of helpful information can improve one’s investment decision and sophisticated investors are in the business of trying to accumulate as many data points as possible.
When it comes to how you describe your strategy, how it is deployed and how you intend to continue to develop your approach, the sophisticated investor is looking for clues that will help in determining whether you are truly talented or exceptionally fortunate. This third of twelve articles attempts to diagnose what, exactly, is meant by “strategy” or “style drift.” It turns out that the answer is a delicate balance that has everything to do with determining whether you are truly good at what you do or, well, just lucky.
What is “style” or “strategy drift?”
Strategy drift is cause for concern when a manager decides that how they approached trading in the past is now wrong and how they are thinking about their strategy currently is correct. “Strategy” is not only a reference to the logic behind buy/sell signals but a comprehensive term that encompasses signal deployment, data mining, risk management, ongoing research, trade execution, infrastructure and firm development.
Style drift is not a function of how comprehensively a manager changes their conviction. If a small portion of the program is discussed in a way that flags strategy drift, it is a concern worthy of investigation. If the entire strategy package is being altered it will more than likely be cause for termination or at the least impetus for an investor to request a pause to trading.
Examples of “drift”
- A systematic manager inserting discretion or vice versa without defensible explanation of the development’s evolution;
- Representing an edge (i.e. energy specialist or unique data management) and deploying new strategies that have no relationship to a stated edge;
- Halting previous approaches that were sold as exploiting your unique edge;
- Swapping models, risk management or other differentiating strategy characteristics based on a different philosophical intuitive view of markets.
Using “strategy drift” as an excuse
Perhaps even more concerning than drift in approach, is the manager who defends a lack of advancement as a desire to avoid the red flag of style drift. The reality is that the lucky achiever will invariably be, given a long enough leash and enough time, a recipient of opposing misfortunate. Indeed, what has worked so well in the past will eventually not work as well in the future. The implication is clear, generally speaking, investors expect their selected managers to tirelessly work to consistently improve.
It is imperative that investors have evidence of continual program development and improvement. A manager’s ongoing research process, hiring procedures, deployment approach (etc.), are all critical in ascertaining a strong track record’s reliance on luck or skill. What the investor is looking for is approach improvements that leverage a managers’ unique value proposition to greater affect. If an investor selects a manager that rests on their laurels, they rely on luck for long-term viability. However, inasmuch as the sophisticated allocator succeeds in isolating skill, they can anticipate a greater likelihood of ongoing strategy success.
How to discuss strategy improvement.
The reality is that some strategies (though not all) that once were tremendous alpha generators may simply not work again. There are many potential causes including: liquidity changes, regulatory advancements and new market entrants. Identifying whether a decline in performance is a function of the temporary or permanent is difficult. No one is in a better position to identify the poor performance culprit than managers themselves. If a manager believes their strategy has been victimized, they should return assets to investors. Later, with thought, research and innovation, managers can then re-approach investors with a new offering. Trying to adjust on the fly and tailoring your message accordingly is unacceptable and irreprehensible.
If, however, as should be the case on a relative frequent basis, you have cause to discuss a strategy improvement with investors and prospects, here are thoughts to consider. First, express your advancement as a function of how it extends your core expertise. Second, explain how your innovation fits and betters the overall portfolio. Third, discuss the intuitive justification for why your strategy works relative to a defensible view of the market inefficiencies you aim to exploit.
Investors want to believe they have committed their capital to the very best risk-conscious innovators the alternative investment community has available. It is the manager’s responsibility to justify an investor’s conviction on an ongoing basis.