Thursday, October 13, 2016
The Weatherstone approach to hedge fund investing
Dennis Weatherstone, the former CEO and Chairman of JP Morgan had a special approach for deciding on the riskiness of new products. He would give the developers three 15 minutes slots (45 minutes) to explain the product. His rule for approval would be simple. If the product could not be explained in the allotted time, it was too complex and risky; consequently, the bank should not undertake the product risk.
I am not arguing for all due diligence to be done within 45 minutes, but the basic principle is sound. If a manager cannot explain what he does and his edge in 45 minutes, you should not invest. The storytelling should include when the strategy will make money and when it will underperform as well as any hidden or less obvious risks. A good story should also explain why the investment should be held in a portfolio. If the manager can explain this simply, then it is worth a deeper dive. There is power with good storytelling that is often missing from marketing.
Weatherstone was also the father of VaR when he asked analysts at JP Morgan to determine how to get a single end of day measure of risk for the bank. His vision of getting condensed information on daily risk was the driver for modern risk management. Of course, others may view his desire for simplicity should make him the father of all financial crashes based on poor risk analysis. Perhaps he was a parent to both.
A Weatherstone approach would reduce hedge fund analysis to as few numbers as possible. While we know there are limitations, our number one statistic is the return to risk ratio. It answers the simple question whether you are being paid enough to take on a particular amount of risk. Measures of downside which account for non-normality are even better, but the basic statistic is still the same. Start with payment for risk and then work deeper into the numbers.
Finally, Weatherstone was also known for having some good quotes:
"If you're not confused, you don't understand the business."
"I don't think you're wrong. I just disagree with you."