{"entry":{"title":"Our Approach","heroText":"Industry expertise, investment agility, and disciplined risk management.","heroImage":[{"url":"https://dx8r06tgpzcg1.cloudfront.net/uploads/hero-images/_x1400/hero-approach.jpg","title":"Hero approach"}],"pageTextPhilosophy":[{"paragraph":"We are dedicated to the quality of our products, our people, and our culture."}],"philosophyPhotoBlocks":[{"photoTitle":"Products","photoText":"We build skill-based portfolios intended to diversify traditional holdings.","photo":[{"url":"https://dx8r06tgpzcg1.cloudfront.net/uploads/approach/_x1000/products.jpg"}]},{"photoTitle":"People","photoText":"Our people are among the best in the industry at what they do. We invest a lot in developing them further.","photo":[{"url":"https://dx8r06tgpzcg1.cloudfront.net/uploads/approach/_x1000/people.jpg"}]},{"photoTitle":"Culture","photoText":"Our culture emphasizes collaborative problem solving, personal development, and high expectations.","photo":[{"url":"https://dx8r06tgpzcg1.cloudfront.net/uploads/approach/_x1000/culture.jpg"}]}],"pageTextCapabilities":[{"paragraph":"Why invest in hedge funds? We believe the right hedge-fund portfolio provides access to returns clients won’t find elsewhere, adding valuable diversification to a traditional investment program. But building the right hedge-fund portfolio is increasingly hard: average hedge funds are no longer good enough. Discernment is essential."}],"pageTextCommitment":[{"paragraph":"At Magnitude, we are committed to providing our clients with:"}],"graphIllustrationBlocks":[{"illustrationTitle":"Active Returns","text":"Headline performance numbers don’t sway us. We apply a rigorous approach to differentiate between market exposure, manager skill, and dumb luck.","illustration":[{"url":"https://dx8r06tgpzcg1.cloudfront.net/uploads/approach/active-returns.svg"}]},{"illustrationTitle":"Risk Management","text":"We think risk is much more than just a volatility number. The biggest risks are often hidden. We evaluate market risk in both normal periods and shock periods, when markets are broken. We carefully consider non-market risks, too.","illustration":[{"url":"https://dx8r06tgpzcg1.cloudfront.net/uploads/approach/risk-management.svg"}]},{"illustrationTitle":"Accountability","text":"We strive to earn trust by providing clarity on our investment goals, portfolio actions, and expected results. We offer our clients the transparency they need to hold us accountable.","illustration":[{"url":"https://dx8r06tgpzcg1.cloudfront.net/uploads/approach/transparency.svg"}]}],"insightsText":"Over the years, Magnitude has written about major investing topics. We’ve shared a few of these pieces below with the hope that they provide insights into not only what we believe, but also how we analyze important issues."},"insights":[{"slug":"managing-shock-risk","title":"Managing Shock Risk","postDate":"2019-06-13T12:00:00-04:00","insightsTeaserText":"Shocks don’t happen unless investors are surprised. The winding stair of liquidity suddenly looks much narrower than it seemed going in. Investors generally need to be forced to make uneconomic decisions to create and maintain a shock scenario: they need to sell and buy financial instruments away from what their fair value would be during a normal market. Investors are forced to reduce risk at exactly the moment when they believe that risk offers the most attractive prospective returns.","insightsArticleCredit":[{"title":"Benjamin Appen"},{"title":"James Hall"}],"insightsArticleBody":[{"typeHandle":"copyBlock","copy":"

In February 2007, Magnitude described how market failure can impact hedge fund investors, and how Magnitude thinks about shock risk management through a full market cycle. This essay was recently adapted from that communication.\n

There’s a paradox at the heart of Magnitude’s shock risk management protocol. We say frequently that we’re more focused on managing “shock risk” exposure (risk of loss during periods when markets function badly) than “normal risk” exposure (risk of loss during periods when the markets function more normally). We point to leverage, complexity, and illiquidity as major contributors to shock risk.\n

At the same time, we believe hedge fund investors should focus disproportionately on market-neutral strategies, which are by their nature more likely to be leveraged and often make use of complex securities and illiquid derivatives to construct intricately hedged portfolios. How can this make sense? \n

In short, it makes sense because we believe the market pays investors for carefully managing shock risk exposures. We think excess returns (over a full market cycle, including a shock period, and excluding beta returns that can more sensibly be earned in lower fee vehicles) earned by portfolios with such exposures are much more attractive than by hypothetical portfolios that have been immunized against shock exposures. \n

Broadly speaking, investors either can bet on the returns of broad markets (by investing in passive index-type products) or can try to extract value from inefficiencies in these markets. The reason hedge funds exist is to take advantage of inefficiencies. The fees are just too high for investing in hedge funds to make sense otherwise. \n

Inefficiencies occur disproportionately in markets that work less well. The most efficient sectors of markets are the spaces accessible to everyone, where millions of professional and amateur eyes track every new development, and vote with their dollars on its impact. The least efficient sectors are those where it’s hard to invest: illiquid markets, markets where special expertise is needed to evaluate opportunities, markets where information is scarce. As long as investors remain risk-averse, assets that are hard to trade, complex, and opaque will tend to be cheaper than liquid, simple, transparent assets. When risk aversion goes up (generally when markets go down, and always when markets are shocked), these hard-to-price assets usually get cheaper faster. Many of the best opportunities are found when inefficient markets leave assets so much cheaper that they compensate investors more than fairly for the additional risk. As a result, even the best investors in the inefficiency business expect to lose money during periods when markets are shocked. \n

This essay will explore Magnitude’s views on shock risk management in more detail. We’ll touch briefly on normal risk management, but our goal is to try to clarify the more complex questions of what shocks are and how we believe investors should try to manage their exposure to them.

"},{"typeHandle":"sectionHeadline","headline":"Bimodal Risk Management"},{"typeHandle":"copyBlock","copy":"

For an investor, risk management is the attempt to understand and control the distribution of possible return paths for a portfolio. The standard approach to risk management for modern investment institutions is primarily data-driven. Investors use historical information to try to evaluate prospective exposures, working under the assumption that the future will be more or less like the past. Most of the time, this assumption works just fine. Fundamentally similar instruments tend to behave in similar ways; riskiness metrics (volatility, correlation, and their various complicated children, such as skew and kurtosis) generally persist over time. \n

Infrequently, though, this assumption is turned on its head by periods of anomalous market action. Magnitude refers to these as “shock periods.” Shock periods aren’t necessarily triggered by negative performance for markets, even though most assets do go down during shocks. From March 2000 through February 2003, the NASDAQ Index declined from more than 5,000 to less than 1,500. During this period, global markets generally functioned as effectively as they had the previous three years. Borrowers found lenders, sellers found buyers, and similar instruments behaved similarly while different instruments behaved differently. Cheaper assets drew interest from buyers (and more expensive assets drew sellers), creating a negative feedback loop to help correct market mispricings. This combination of normal credit, liquidity, and correlation patterns with stabilizing feedback processes defines for us normal market function. \n

By contrast, shock periods are defined by market failure: credit and liquidity are scarce, technical factors outweigh fundamental data, and the financial system displays positive feedback behavior (as where selling drives prices down, and falling prices generate more selling pressure).

"},{"typeHandle":"pullQuote","quote":"Shocks are generally relatively short, extremely painful, and very poorly understood by traditional empirical risk management techniques."},{"typeHandle":"copyBlock","copy":"

The 1998 hedge fund crisis highlighted by the failure of Long Term Capital Management (among others) is a classic example.

"},{"typeHandle":"sectionHeadline","headline":"Normal Risk"},{"typeHandle":"copyBlock","copy":"

Risk managers often focus their attention on normal periods because the data are better. Statistical tests show greater validity for observations derived from large data sets than from small data sets. Data sampled from normal periods are more predictive of out-of-sample outcomes than data derived from shock periods. And, perhaps most important on Wall Street, investors who focus their risk management efforts on normal markets typically make more money than people who focus on shock exposures. Until they don’t.\n

Nevertheless, we believe that risk management in normal periods is by a large margin the easiest, and least important, risk management task for investors. Much of this is the happy result of our investing in the hedge fund space. The rich returns to successful hedge fund managers have given rise to a spectacular diversity of investment strategies among which an investor can choose. By being careful to select managers who do different things, an investor can eat as much of diversification’s free lunch as its appetite allows. The second benefit of investing in hedge funds is the opportunity to find managers who hedge out exposure to major market risk factors. The chance to get paid well for delivering a skill-based return whether markets go up or down is attractive enough to encourage many skilled managers to forego the riskier model of depending on gross market movements to determine the bulk of their annual performance. Sadly, though, focusing investments on managers who seem market neutral in normal markets should give investors little real comfort that they have properly understood (much less managed) their shock risk exposure. Shocks are, by definition, periods when markets behave abnormally. Accordingly, a good understanding of shock risk dynamics requires us to turn to a less empirical, more theoretical, approach to risk mitigation.

"},{"typeHandle":"sectionHeadline","headline":"Shock Risk"},{"typeHandle":"copyBlock","copy":"

“Will you walk into my parlor?” said the spider to the fly; \n
“‘Tis the prettiest little parlor that ever you may spy. \n
The way into my parlor is up a winding stair, \n
And I have many curious things to show when you are there.” \n
“Oh no, no,” said the little fly; “to ask me is in vain, \n
For who goes up your winding stair can ne’er come down again.” \n
\n– Mary Howitt, \"The Spider and The Fly\"\n

Shocks don’t happen unless investors are surprised. The winding stair of liquidity suddenly looks much narrower than it seemed going in. Investors generally need to be forced to make uneconomic decisions to create and maintain a shock scenario: they need to sell and buy financial instruments away from what their fair value would be during a normal market. Investors are forced to reduce risk at exactly the moment when they believe that risk offers the most attractive prospective returns. This may happen because lenders have issued margin calls, or because the ultimate owners of capital have requested its return from agents. It may also happen because market participants fear these factors will manifest themselves in the future. In any case the dominant factor driving these anomalous price movements is generally not a change in fundamental economic data. Instead, the technical factors of short-term supply and demand are the crucial drivers of market action. Risk management based on historical data is of less utility at such times. \n

Investors seeking to mitigate shock risk are left in a difficult place, then. Their primary risk control worry is the least susceptible to empirical analysis. Over the years, we’ve worked with faculty members of Columbia Business School to get a sense for whether there are more sophisticated empirical tools for understanding, forecasting, and managing shock exposures. The more time we spend on such data-driven approaches, the greater our confidence that resources expended in that domain will have limited returns. Instead, we believe investors should structure portfolios based on a broad understanding of how markets behave under stress, rather than by looking at historical market data. There are four key elements to this approach.\n

First, we think investors should drive capital to spaces with rich opportunity sets, and remove capital from spaces with poor opportunity sets. In 2002, there was a tremendous amount of uncertainty about the carnage in the distressed debt marketplace in the wake of unprecedented default behavior from U.S. corporates. In the wake of these losses, there was substantial uncertainty about the returns to be expected in corporate credit. From our perspective, this sort of hyperawareness of risk shifts latent shock exposures into the more manageable normal world. Nobody is surprised by credit losses in an environment when people talk of nothing else. Without the prospect of surprise, you don’t find shock risk. \n

Second, we think investors should focus on selecting managers who think about and manage shock risk in a very proactive way. People who suffered through previous shocks tend to be very happy giving up returns today to increase portfolio stability tomorrow. They will agree to pay higher fees for less leverage, but will have multiple prime brokers, term financing agreements, long notice provisions, and they will protect their reserves of unencumbered cash. \n

Third, we think investors should try to build portfolios that explicitly offer an inferior risk-adjusted return in normal periods in the belief that these portfolios will do better in the shock periods that come eventually. For example, investors can add managers from strategies without built-in shock exposures, even where these managers will degrade the portfolios’ risk-adjusted returns in normal periods. Quantitative macro funds often have Sharpe Ratios little better than 1 but can offer portfolios with as much liquidity and market risk on the long side as on the short side. While these managers are sub-optimal most months, the reduced structural shock exposure relative to a distressed fund (for example) is likely to benefit investors’ portfolios during the worst times. \n

Finally, investors should prepare their portfolio and management firm for post-crisis response. For long-term investors, it’s just as important how they come out of a shock as how they go into it. Historically, prospective returns for shock risk-exposed strategies go up substantially after shock periods. So investors should select managers who will be able to increase risk in very uncertain environments and maintain these risky positions as conditions return to normal. Effective post-shock allocations can mitigate the pain suffered during the shock period. \n

We think these four steps are sensible and intuitive for investors seeking to manage shock exposure. They move in the right direction, anyway. But investors can have very limited confidence whether they have moved far enough. Unfortunately, there’s no real way to know. Until we see a shock, we won’t have the data. \n

Which brings us back to our opening paragraphs. We made the argument that we believe the markets pay investors well to manage these risks, but we dodged the question of how we could make that assessment going forward. After all, we don’t think investors can know with any degree of precision when the next shock will happen, or how painful it will be. While the historical returns of arbitrage strategies through full market cycles have, in many cases, added very substantial value to portfolios, our confidence in using such data to forecast future returns is minimal. \n

In the end, our view is more philosophical than empirical. It’s hard for us to believe that we live in a world where the least efficient markets don’t offer, in aggregate, better investment opportunities than the most efficient markets. Of course, we know for certain that one of the costs of investing in less efficient markets is exposure to shock risk. At the same time, we believe that shock periods offer the best opportunities for skilled investors to set themselves apart. Indeed, that may be the best definition of what defines a skilled investor.

"},{"typeHandle":"articleDisclaimer","disclaimerHeadline":"IMPORTANT INFORMATION ABOUT THIS ESSAY","disclaimerText":"

This essay reflects the opinions and views of the authors and is not intended to describe any strategy, product, or services provided by Magnitude Capital, LLC (“Magnitude”). This essay is for informational purposes only, does not constitute investment advice or an offer to buy or sell securities, and should not be deemed to be a recommendation to make any investment. This essay, insofar as it discusses investment strategies, portfolio construction, and/or other investment-related themes, is general in nature and does not address any individual investor circumstances or risk-tolerances, which may vary significantly. The reader is reminded that an investment in any security is subject to a number of risks, including the risk of a total loss of capital, and that the discussion herein does not contain a list or description of relevant risks. The reader should make an independent investigation of the information described herein, including consulting the reader’s own tax, legal, accounting and other advisors about the matters discussed herein.

The factual information set forth herein has been obtained or derived from sources believed by the authors and Magnitude to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness. Certain of the information in this essay may include estimates, opinions, forward-looking statements, and unverified information. Such information may be generated by Magnitude or obtained from third-party sources. Such information and analytic tools employed by Magnitude in generating such information may be subjective in nature, subject to substantial uncertainty, subject to flaws, and unreliable. Neither Magnitude nor any of its officers, partners, employees, or affiliates, will bear any liability for reliance on such information. Approaches used by Magnitude in the past and those used in the future may be made with a different view of markets, may utilize different strategies, may not have similar characteristics, and may produce different results. Much of the material contained in this essay is subject to change and Magnitude has no obligation to amend or update the information. As always, past performance is no guarantee of future results.\n

No part of this essay may be reproduced in any form, or referred to in any other publication, without express written permission from Magnitude. Some of the images, logos or other material used in this essay may be protected by copyright and/or trademark. If so, such copyrights and/or trademarks are most likely owned by the entity that created the material and are used purely for identification and comment as fair use under international copyright and/or trademark laws. Use of such image, copyright or trademark does not imply any association with such organization (or endorsement of such organization) by Magnitude, or vice versa.\n

"}],"insightsPdf":[]},{"slug":"culture-and-investing","title":"Culture and Investing","postDate":"2019-06-13T12:00:00-04:00","insightsTeaserText":"The more difficult part of investing in hedge funds is making subjective judgments about people and the cultures they create. Making great decisions requires a good understanding of which cultures predict persistent investment success… Certain firms seem to incubate cultures that maximize the probability of such success; others do not. It’s our job to try to tell the difference.","insightsArticleCredit":[{"title":"Benjamin Appen"},{"title":"James Hall"}],"insightsArticleBody":[{"typeHandle":"copyBlock","copy":"

In December 2007, Magnitude outlined its commitment to assessing the culture of investment firms (and managing its own investment culture). This essay was recently adapted from that communication.\n

Most of the time, when we write about how Magnitude selects managers, we focus on the easier part. Magnitude tries to find unusually attractive opportunities in the markets and managers with a tangible edge in exploiting them. We carefully evaluate the risks taken by managers in our portfolios, limiting passive exposures and searching for diversifying shock risks. This sort of analysis is our wheelhouse. Our backgrounds help us be confident that we can make good decisions once we have good information. So we focus our attention on areas where the bulk of the investment decision is driven by data we can evaluate concretely.

"},{"typeHandle":"copyBlock","copy":"

Unfortunately, that’s never enough, and sometimes it’s not much at all. The more difficult part of investing in hedge funds is making subjective judgments about people and the cultures they create. Making great decisions requires a good understanding of which cultures predict persistent investment success. By success, we mean generating substantial risk-adjusted value for clients in aggregate over a long period of time.

"},{"typeHandle":"pullQuote","quote":"Certain firms seem to incubate cultures that maximize the probability of such success; others do not. It’s our job to try to tell the difference."},{"typeHandle":"copyBlock","copy":"

Instinct, intuition, hunches: these all strike immediate negative reactions from us at Magnitude. Reliance on such vague terms impairs the analytical process essential to good decision-making. They make teamwork more difficult because they’re so challenging to communicate precisely. They can’t be easily weighed against other factors or clearly tested with concrete data. But it can’t be denied that subjective assessments of character traits like discipline, ethics, intelligence, originality, and passion are crucial. Because markets, managers, and strategies are guaranteed to change, a clear understanding of character can be a better guide to a manager’s success over the long run than even the best evaluation of current market opportunities and firm infrastructure.\n

We need to make these subjective evaluations concrete enough that they are subject to an analytical process. In this essay we try to outline how we do this (and in doing so, to make this process more concrete than it was before). We also hope to give you a flavor for how Magnitude has developed its own culture. The things we like to see in good investment managers are of course the things we try to live every day.

"},{"typeHandle":"sectionHeadline","headline":"Investing Culture: Values"},{"typeHandle":"copyBlock","copy":"

Culture is what people believe and what they do. To understand the culture of the people and firms we invest with, we try to assess their values and the institutions they create to reinforce their values. Obviously, there’s no finite list of values that is sufficient to explain observed patterns of investment success. Nevertheless, we’ve identified five values which we think matter most (while acknowledging that any such list is a bit arbitrary). We’ve never come up with any consensus ranking of their importance, so don’t read anything into their order below. We’ll initially discuss the importance of these values as personal characteristics, and then discuss some norms and institutions which embody these values for a hedge fund management company.

"},{"typeHandle":"subheader","headline":"Intelligence"},{"typeHandle":"copyBlock","copy":"

Because of the difficulty of adding value in modern markets, we believe that investors capable of extraordinary levels of analytical precision are most likely to offer sustainable success. While intelligence isn’t remotely sufficient for investment results, its opposite definitely makes persistent success improbable.

"},{"typeHandle":"subheader","headline":"Originality"},{"typeHandle":"copyBlock","copy":"

Investing well requires the ability to see something that is not obvious to others. In general, security prices discount forward the consensus distribution of possible outcomes, leaving approximately equal amounts of expected risk on both sides of the current market. Seeing where such consensus distribution estimates err requires the skepticism to reject what’s visible and false combined with the creativity to envision what’s invisible and true.

"},{"typeHandle":"subheader","headline":"Passion"},{"typeHandle":"copyBlock","copy":"

At the end of the day, good investing requires good people. Only human beings have the sophisticated pattern recognition capability that builds good judgment over time, and judgment is the keystone of investing. Without it, the edifice is unstable—it may stand for a while, but not forever. Because people matter, motivation matters. People not only need skills, they need the drive to get the best results from the skills they have. And in our experience, the most successful investors are incredibly passionate about what they do, generating results much better than individuals endowed with similar talents who may not be similarly driven.

"},{"typeHandle":"subheader","headline":"Discipline"},{"typeHandle":"copyBlock","copy":"

By discipline, we mean the same things meant in ordinary speech: the setting of high standards and the application of rigor and effort to achieve these standards. It encompasses a commitment whenever possible to clarity rather than ambiguity; measurement rather than estimation; attention to detail in thought, speech, and writing; hard work; and reliability. In hedge fund management, we believe it also encompasses patience and prudence. Disciplined managers don’t risk capital where they don’t have an edge, and are careful to make decisions that maximize risk-adjusted economic value for clients.

"},{"typeHandle":"subheader","headline":"Ethics"},{"typeHandle":"copyBlock","copy":"

We believe that unethical behavior is wrong for us as people and uneconomic for us and our clients. We try to select hedge funds that not only follow the letter of the law, but act in a way that would not harm society if it were generalized. At the same time, we do not view hedge funds as mechanisms to act for social good, but as entities in pursuit of economic gain. In other words, funds engaged in socially positive activities don’t get extra points, but we don’t want to work with firms and people we don’t trust.

"},{"typeHandle":"sectionHeadline","headline":"Investing Culture: Behavior and Institutions"},{"typeHandle":"copyBlock","copy":"

While human values are one part of the investment culture equation, it’s also important to observe how those values are embedded in the processes and structures of the management company. When a company spends resources to achieve cultural goals with remote financial payoffs, it is a strong signal that the company assigns high values to these cultural goals.

"},{"typeHandle":"subheader","headline":"Cultures of Excellence"},{"typeHandle":"copyBlock","copy":"

One of the most frequently observed elements of the most successful investment firms is the explicit creation of a culture of excellence. Great investors make themselves better by surrounding themselves with people who are smart, creative, and excited about what they do. Great investment firms devote substantial sums to make this possible. They work hard to attract the most talented and skillful potential employees. They are diligent in selecting the best from among these prospects. They take great care to develop and train employees. Finally, great firms work tirelessly to create an environment which incentivizes their most productive people to stay at the firm, by enabling them to grow professionally and by sharing the rewards of success widely. \n

The investment business makes this easier than many other businesses. First, because the business offers unusually attractive financial rewards, there is plenty to share. Second, because there are more concrete metrics that can be used to assess the productivity of individual employees than are typical, so there’s less ambiguity about where value is added. Finally, because the flexibility of the business allows individual growth to be more easily balanced with growth in responsibility than is normal. (Try to set up a new semiconductor fab for each of your best ten managers, and you will wish you were in the fund management business where you can assign them each a VaR limit and let them go.) Unfortunately, those same factors (large potential for financial gain, value created by individuals is relatively separable from value created by the franchise, and low barriers to entry in many parts of a business) also create attractive opportunities for people to leave. So again, culture enters the equation, as a non-financial element of employee retention. Great people want to work with other great people, and recognize how hard it is to find situations where one is surrounded by them. Great cultures make people reluctant to leave, even when the economic payoff from leaving appears highly attractive.

"},{"typeHandle":"subheader","headline":"Investing with Edge"},{"typeHandle":"copyBlock","copy":"

Investment has always been an interesting marriage of art and science. The art part is the spark of genius that allows a manager to see something with a clarity his/her peers can’t approach. Maximizing the potential genius in an organization is accomplished by attracting and retaining people who are intelligent, original, and passionate. The science part is making sure that the firm gets paid properly for the art part. This is where discipline comes in. Great investment firms assemble a culture of discipline in investment decision-making. They build decision tools that minimize the probability of loss and extract the maximum return from core insights. \n

Analysts at disciplined investment firms focus on sourcing better opportunities, obtaining more valuable information, and understanding it more deeply than their competitors. Disciplined firms are more likely to make consistent investments in infrastructure (human, technological, and informational) to maintain their culture and success. Such out-of-pocket expenditures by management companies are positive signals of the firm’s culture. \n

Discipline also manifests itself in risk management, but not always in the way commonly assumed. A volatile track record is not by itself an indication of an undisciplined investor. Disciplined investors can target any level of risk that isn’t inherently self-destructive but will always make risk management decisions backed by economic logic. Sometimes, managers admit to us that they have implemented risk management rules (maximum position sizes at cost, drawdown controls that are insensitive to market context, e.g.) that don’t make economic sense because their investors pressured them for more risk management, and the managers were unwilling to reject irrational decision rules. This is a warning sign; it suggests a culture of ad hoc decisions rather than disciplined investing. Portfolio risk should be tilted so that the greatest risk is taken where there is greatest edge. This has always been one of the primary reasons why a persistent passive exposure in a manager’s performance is a negative signal for us. Any money manager willing to take his largest risk position (being 40% net long the market, e.g.) where he has least edge relative to competitors strikes us as undisciplined. For us, disciplined investing means minimizing exposure to risk where the manager’s analysis adds least value. \n

Finally, disciplined investing includes a commitment to protect against risks that can’t be accurately measured or predicted in advance. Managers with disciplined investment cultures are more likely to recognize that the risk of severe loss is as great or greater from these unlikely scenarios as it is from more normal scenarios. As a result, they are more likely to take substantial pains to mitigate these risks.

"},{"typeHandle":"subheader","headline":"Client Focus"},{"typeHandle":"copyBlock","copy":"

The institutionalization of ethics is a space where it’s difficult to draw fine gradations from the outside, because one sees relatively few instances where people behave unethically. Every manager claims to be clean, tries to look clean, and knows the clean responses to the standard questions. Nevertheless, we look for all kinds of hints that managers put ethics first, and they come through in a thousand ways. \n

The most fundamental principle of ethical business is honesty. Each manager owes investors honest communication about the firm’s strengths and weaknesses and the fund’s realistic prospects. This means admitting to mistakes and committing to rectifying them. It means minimizing spin: a marketer has the obligation not only to persuade but to inform fully. Sometimes that means telling difficult truths.\n

An additional ethical practice is building the business seeking to avoid conflicts of interest. This means reducing incentives for favoritism in allocating resources or opportunities; for example, different investment vehicles managed by the same manager under the same strategy should offer similar payoffs to management. It means sensible limits on personal investing activity by front office personnel. It means generally taking risk with client money as one would like one’s own money managed. \n

Finally, ethical investing requires treating clients fairly. Ethical managers don’t raise more money than can be prudently invested with existing infrastructure with existing strategies. Ethical managers provide investors with sufficient information about each investment opportunity to allow them to make reasonably well-informed decisions. And ethical managers take a long-term approach to building a relationship of trust with clients by not exploiting changes in relative power situations to clients’ detriment.

"},{"typeHandle":"sectionHeadline","headline":"Impact of Culture on Magnitude’s Investment Decisions"},{"typeHandle":"copyBlock","copy":"

In general, Magnitude seeks to invest when everything adds up cleanly. We want the opportunity set to be unusually attractive, the manager to have a tangible edge, the passive risk to be minimal, and the shock exposure to be diversifying. We like to find managers who exemplify each of our important values and have built businesses to match. Unfortunately, not only does it not always happen—we can’t think of a single example where the investment has been extraordinary in every one of these dimensions. Investing has always been a business of trade-offs, weighing one thing against another and trying to figure out what’s most important at a given time. \n

That said, our biggest investment errors (both positive, where we did something that ended badly, and negative, where we failed to do something that turned out well without us) have resulted from an insufficient understanding of a management firm’s culture. Although there’s a chance we’re fooling ourselves, we don’t believe this is because we’re bad at understanding culture. We believe that we made these errors because understanding culture is the most difficult part of hedge fund investing. \n

Unfortunately, there’s only so much we can do to improve. We can’t read culture more accurately just by deciding to do so, or by identifying the one key factor that will drive everything else, or by hiring a team of culture due diligence experts. All we can do is keep analyzing investment cultures that succeed, understanding how managers can create and nurture them, and trying to evaluate how our managers stack up.

"},{"typeHandle":"subheader","headline":"Magnitude Culture"},{"typeHandle":"copyBlock","copy":"

We look forward to being held accountable by our clients to the standards we set forth here. If we can’t keep hiring sharp, creative, careful, honest people who are happy to come in to work each day, it’s a problem. If we lose our track record of retaining them, it’s a problem. If we don’t inspire them to work with discipline in an ethical manner, it’s a problem. And if we ever have these problems and somehow fail to notice that we’ve fallen short, we will be truly grateful to the person who wakes us up.

"},{"typeHandle":"articleDisclaimer","disclaimerHeadline":"IMPORTANT INFORMATION ABOUT THIS ESSAY","disclaimerText":"

"}],"insightsPdf":[]},{"slug":"the-secret-to-smart-hedge-fund-investing","title":"The Secret to Smart Hedge Fund Investing","postDate":"2018-09-20T17:11:00-04:00","insightsTeaserText":"A more competitive and efficient market is good for the world, but it’s a tougher environment in which to add value as an investment manager. So should we all just pack up our tents and head back to the land of the 60-40 portfolio? Probably not – or at least, not all of us.","insightsArticleCredit":[{"title":"Benjamin Appen"},{"title":"James Hall"}],"insightsArticleBody":[],"insightsPdf":[{"url":"https://dx8r06tgpzcg1.cloudfront.net/uploads/insights/Smart-Hedge-Fund-Investing.pdf"}]}]}