The Investor, The Chef, and The Recipe Book

 

I have once again discussed with friends what is proprietary regarding strategy details. Should a manager give up details on how they model and generate returns? I understand that in a competitive market, no one wants to give up their edge or reveal how they generate returns. However, investors still need to understand how returns are derived because backtests and past track records offer only limited insight into the return-generating process. There needs to be a framework for understanding how returns are generated. 

I often use the analogy of a cookbook. There are many great cookbooks available in a bookstore. Great chefs write cookbooks and share their “secrets” in their recipes, often with detailed instructions for preparing the meal. Measurements are given. Ingredients are detailed, and step-by-step instructions are often provided for preparing the meal at home. You may follow all the instructions, yet you will often not get anything close to what you experience in the restaurant. You are frustrated and feel the effort was not worth it. So, what do you do? You go to the fine restaurant and pay the price. You are happy and appreciate all of the work that the chef has done to prepare the meal. All are pleased. Information has been provided with high transparency, resulting in a willingness to pay the price for a great meal. There is transparency, which makes paying the meal’s price more worthwhile.

The core of this story is that there is knowledge from books and theory, and then there is practical knowledge from doing. When you invest with a special strategy, the manager is providing their specialized practical knowledge that cannot be easily learned. The devil is in the details, and that is often the secret sauce. I appreciate the practical wisdom on how to gather the right data, manipulate it, and use specialized techniques to extract signals. That is proprietary, but the overall concept should be discussed. Practical knowledge is contextual and situation-specific, and not easily learned just by being told how something is done.