What Makes a Great Portfolio Manager?

The track record gets you into the game. The process decides whether you stay.

In Lesson 8 of my Macro Intern Class, I discussed the characteristics that make a great risk-taker. I want to take this opportunity to expand on those earlier thoughts.

Hard work. Humility. Humble self-confidence. A repeatable investment process. Bayesian updating. Probabilistic decision-making. Resilience. These are the words that most come to my mind.

Markets can manufacture geniuses. Give an ordinary investor the right exposure, some leverage and a lucky year, and they’re on a magazine cover. Luck is a hell of a publicist.

I’ve spent nearly three decades working alongside some of the best risk-takers in the markets and interviewing thousands more. I do not begin with someone’s best trade or best year.  Everyone has one. I focus my inquiry on:

1.     Why do you make money? 

2.     What happens when you’re wrong?

3.     Would I trust you with capital through a full cycle?

Why do you make money?

Most people can’t answer. They describe their positions. They describe what the market did. The polished ones walk me through attribution, which is an autopsy with better graphics.

The strongest investors can identify the mechanism that creates their returns. An edge that puts the odds in their favor: faster information processing and IP, market structure, behavioral discipline, volatility expertise, convex trade structuring, portfolio construction, or real depth in one corner of the world. The great ones can name it. More important, they also know when it stops working.

They have an idea/performance engine rather than a collection of opinions. They can explain how ideas are generated, tested, challenged and discarded. They know what would disprove a thesis. They can tell you how their process is better today than it was a year ago. They also know what they are attempting to create: Are they looking to produce a 0.8 Sharpe, 10% volatility strategy or a 1.5 Sharpe, 5% volatility strategy? It makes a big difference.

Alpha decays. If you can’t explain why the returns exist or what you are attempting to produce, you may be renting beta and calling it skill. And if the returns look too good to be true, ask why before you celebrate. Paranoia is underrated.

The distinction between good and great becomes obvious when you listen to them describe their books. Weaker investors spend most of their time explaining individual positions. Stronger investors talk about concentration, correlation, liquidity, optionality, time horizon and the interaction among positions.

The best books I have observed have often looked very different. Some were directional. Some were relative value. Some were long volatility; others were structurally short it. Some contained many markets, while others revolved around only two or three core themes. But the behaviors were remarkably similar.

The ideas were expressed directly. The risks could be explained without a guided tour through hundreds of line items. Simplicity does not mean unsophisticated thinking. Ten trades resting on the same assumption are one trade in ten outfits. And get the expression right. You can nail the view, pick the wrong instrument and end up with zero P&L. You get style points, and no one gets paid on style points.

What happens when you’re wrong?

Risk management is often described as something that sits beside investing. It does not. Risk management is investing. Three decisions: how much, how long, and what happens if I’m wrong. Everything else is commentary.

A position isn’t an idea. It’s a risk allocation. Size it for the path, not the destination, because a correct trade can still kill you. The margin call doesn’t care about your terminal value. Liquidity is black ice. You normally discover the problem after you have lost traction. Correlations are promises markets make in quiet times and break in a crisis. And when everyone owns the same trade, the door is built for one.

So, before you put it on, ask who else owns it and what forces them out. A decade of cheap money taught investors to behave as if risk had no price. It does.

One of my early bosses asked me the same questions about every position, every day. I thought he was nuts. He was listening for the answer to change, even slightly. Now I think the best risk-takers would be crazy not to do it. Write down what would prove you wrong and what else could explain the facts. Maybe the market is trading rates, not growth. Then separate noise or timing from a thesis that’s actually broken. The best change their minds without drama — and make sure they can get out when they do.

If you’re losing money and can’t say why, cut. There is nothing worse than not understanding why you are losing money.... Don’t average down on confusion. Keep some dry powder. Opportunity does not arrive evenly. And remember: a good outcome doesn’t prove a good decision, just as a bad outcome doesn’t prove a bad one. Math cuts both ways.

Would I trust you with capital through a full cycle?

This is where character comes in. Self-awareness is critically important.

Know yourself. Know what drives you, which biases hurt you and what your last big loss did to your risk appetite. Soros wrote that an acute backache was sometimes his first signal that something in his portfolio was wrong. It did not tell him what was wrong. It told him to look. You don’t need a bad back. You need to notice when you’re no longer thinking clearly. If a trade owns every waking thought, it’s too big. If the PM doesn’t want to talk about it, it’s far too big. The best PMs are emotionally boring. They don’t chase and they don’t panic. The market supplies enough drama.

No surprises. The strongest PMs say more as risk rises, not less. A few clear lines will do: what drove the P&L, what changed, where the risk sits, what’s next. Early communication creates options. Late communication reports the accident. And they welcome the risk team’s view, because no one book sees the whole ecosystem. Deliver any bad news directly and quickly.

Build. The great ones eventually learn to scale: they hire well, give people room and make space for return streams that are truly different. More people putting on the same trade is not scale. The best compliment isn’t “they made a fortune.” It’s “I became a better investor working for them.”

Technology. Access to powerful models will commoditize. The moat will be what you build around them: proprietary data, sound workflows and faster feedback loops. Technology magnifies a good process and doesn’t fix a bad one. A bad decision made faster is still a bad decision.

Failure. I listen to how people describe theirs. Do they own it, name the mistake without rewriting history and say what changed in their sizing or behavior? The best candidates aren’t the best storytellers. They’re the most accurate observers of themselves.

Self-optimization.  More and more I see this as a dynamic within the large multi-managers.  As the “war for talent” has heated up, so has a Portfolio Manager’s ability to find employment elsewhere if they blow up in their current seat. However, I am a believer that “Karma is a bitch.”  Act as a good fiduciary. Don’t be fully deployed when the opportunity set does not justify it. Preserve capital. Show discipline and great risk management. Being a portfolio manager is a privilege. Behind the institutions that invest with you are pensioners, savers and families. Taking risk for a living with other people’s money is borrowed trust. Respect that.

A great portfolio manager isn’t someone who’s always right. It’s someone who knows why they might be right, how much risk the evidence justifies, what would prove them wrong and how the portfolio survives if they are wrong.

Performance opens the door. Process keeps it open. Character decides how long you stay in the room.

Good luck out there!

This website and its content are provided for informational and educational purposes only and do not constitute investment, financial, legal, tax, or other professional advice, nor any offer, recommendation, solicitation, or invitation to buy or sell any security or financial instrument. Any views expressed are solely the author’s own as of the date of publication, are subject to change without notice, and do not necessarily reflect the views, positioning, or risk of Schonfeld.