The Seven Deadly Sins of Portfolio Management

While most funds focus on making money, picking good stocks and finding winners, few focus on avoiding the traps that end in permanent capital loss which is the real risk of investing.  

"Seven deadly sins, seven ways to die"

I read a great piece by Zeke Ashton from Centaur Capital on how funds blow up.  

“In almost every case of catastrophic failure that we’ve observed, we believe the root cause can ultimately be boiled down to one or a combination of just five factors. The five factors are 1) leverage 2) excessive concentration 3) excessive correlation 4) illiquidity and 5) capital flight” Zeke Ashton

As Charlie Munger advises, "invert" the problem.  So instead of asking "How can I make money?", first ask "How can I avoid that which loses money?".  I've outlined below what I see as the seven deadly sins of portfolio management [I've added two more of my own].  

Ordinarily it's a combination of these factors that gets fund managers into trouble.

Sin 1 - Excessive Leverage

Leverage gives someone else the right to say when the game is over.  Too much leverage at the portfolio level and/or in the companies that you own can lead to permanent loss of capital.  High gross exposure [even if net exposure is low] can impair capital quickly if a long and short books prices diverge the wrong way.  The Investment Masters limit leverage.

Sin 2 - Excessive Concentration 

Mistakes in investing are inevitable given the magnitude of variables involved and imperfect information.  Having too much exposure to one stock or sector can be a costly mistake.  Large positions can become illiquid and if publicly known may attract predatory activity.   The Investment Masters tend to limit the position sizes [even more so for shorts if running a short book] to minimise this risk.

Sin 3 - Excessive Correlation 

At times certain stocks may become correlated and all move in the same direction offsetting the benefits of diversification.  Correlations can "go to 1" in difficult market conditions.  Things you expect to be uncorrelated may become correlated due to crowding, index implications, money flows, economic factors or geographic events.  There is little protection in a bear market outside of short positions and cash. The Investment Masters tend to seek diversification, limit sector exposure, hold cash and constantly think of where the correlation risks lie in the portfolio.  

Sin 4 - Illiquidity

Illiquidity hurts when an investment thesis changes or the portfolio manager needs cash and wishes to exit a position.  There may be no market to sell into.  This is particularly dangerous when investors can remove capital from a fund at any time.  This can lead to further portfolio price weakness, further capital flight and so on.

Sin 5 - Capital Flight 

Capital flight occurs when investors want their money back at the same time, usually when markets or stock prices are weak.  Selling a stock at a low point can lead to permanent loss of capital.  It's even more risky when positions are illiquid.  It can lead to a circular loop where selling to fund redemptions creates further poor performance and then further redemptions. The Investment Masters tend to seek like-minded investors who understand the investment process and have longer time horizons and/or seek more permanent sources of investment capital.

Sin 6 - High Flyers 

When expensive stocks get into trouble or a bubble is burst they can be de-rated leading to the permanent loss of capital.  Having all your portfolio in tech stocks at the height of the Nasdaq boom in 2000 or the Nifty-Fifty boom in the late 1960's  is a good example of the risks to capital when stock PE's are significantly de-rated.

Sin 7  - Fraud 

When an investment manager or a company acts fraudulently this can lead to a permanent loss of capital.  Bernie Madoff and Enron are two examples.   Ensuring you really understand how the business operates and analysing the long term track record of management can go a long way to avoid these problems.  The fact the Investment Masters "eat their own cooking" helps align a managers interest with co-investors.

Thinking about how a portfolio is structured in regards to the above is a useful starting point.   Almost every fund blow-up will have suffered one or more of the sins.  Remember successful investing starts by not losing.  Portfolio management is a skill that requires a lot more thinking than just picking a bunch of stocks you like.   Each stock and it's respective size, liquidity, correlations etc must be considered in the context of the whole portfolio.

The risks lie not just with active managers but passive products as well.  Some index funds have excess exposure to certain sectors or expensive stocks.  Many ETF's suffer from capital flight and illiquidity in weak markets.  You don't avoid these risks by being a passive investor.