Identifying Outperforming Managers

To outperform the market is very tough especially if you are a professional money manger. It is especially tough because you are bound by institutional mandates unlike a retail investor. Famous investor, Charlie Munger, recently said that only 5% of active managers beat the index over the long term which seems to be a very plausible statement (see article image).

To determine which money managers are truly great, we can look to what Howard Marks has said on this topic. According to Marks, outperformance is not just about the raw numbers, an investor's risk posture needs to be taken into account as well. So, for example, you get aggressive investors (taking on more risk) and defensive investors (taking on less risk).

Using Marks framework, we can bucket managers into 5 groups, namely:

1. Poor
2. Below Average 
3. Average 
4. Good
5. Exceptional 

Example:
Let's assume the market returns 10% in year 1, -10% in year 2 and 10% in year 3.

Irrespective of the investor's risk posture, a poor manager is one which generated negative returns in all 3 years e.g., -10% in year 1, -20% in year 2 and -5% in year 3. Similarly, an exceptional managers generate positive returns irrespective of market conditions or risk posture and the returns are market beating e.g., 11% in year 1, 4% in year 2 and 11% in year 3.

A below average aggressive investor will have performance similar to the example below if we assume that the investor is willing to take on "double the risk" (beta of 2):

18% return in year 1, -21% return in year 2 and 18% return in year 3.

In positive years, the investor generates 80% more return than the market eventhough it's twice as risky while in negative years, the investor is down more than double that of the market.

A below average defensive investor will have performance similar to the example below if we assume that the investor is willing to take on "half the risk" (beta of 0.5):

4% return in year 1, -6% return in year 2 and 4% return in year 3.

In positive years, the investor generates less than half the market return while in negative years, the investor is down more than half the market return.

Given the examples above, an average investor will match the market taking into account their risk posture:

Aggressive Investor: 20%, -20%, 20%.
Defensive Investor: 5%, -5%, 5%.

Finally, in our example, an above average investor generates the following returns:

Aggressive Investor: 21%, -19%, 21%.
Defensive Investor: 6%, -4%, 6%.

Ideally, we can use a framework like the one above coupled with a sufficiently long track record (managers with at least 5 years of performance) to identify good money managers.

Potentially Exceptional Managers 

To potentially identify exceptional managers, we can look at hedge fund letters on reddit and scroll through the performance of these hedge funds. 

See here:

https://www.reddit.com/r/SecurityAnalysis/comments/102bzrj/q4_2022_letters_reports/

Doing so, I have identified 2 potential hedge funds with outstanding performance:

1. Fairlight Capital
2. Bireme Capital

Both had positive returns in 2022 and both have outperformed the index by a wide margin. Note, that these hedge funds still need to build up a long track record, but the potential is there.

Websites:
https://www.fairlightcapital.com/
https://www.biremecapital.com/

Resources:

https://www.fairlightcapital.com/_files/ugd/a6cb30_4b516623824544d2b3f9a075da1358e5.pdf

https://m.youtube.com/watch?v=uSUsA6WdPdY&t=5s

https://www.biremecapital.com/blog

https://m.youtube.com/watch?v=6SY16gkPQhc