The High Returns with High Volatility Game

This essay was posted to emergingmanagers.org, please click here to read it there, or read on below.

Perhaps in response to my recent tweet, I have seen some people on Twitter, include some investors that I respect and admire, suggesting that a stock you own being down 50% means you are de facto wrong. I’m going to respectfully disagree with this as a universal statement.

Specifically, based on MIT’s experience investing in long stockpicking funds through several market cycles, I believe the following:

1. It depends on the game you are playing
2. It depends on whether you are actually set up to play that game
3. There are some people in the market playing a very different game, where the ability to be down 50% in something and survive, or even grow stronger, confers a huge competitive advantage

What game are you playing?

I’m not arguing that being down 50% in a stock can be OK in all strategies — far from it. For example, if you are a hedge fund and own positions on a 1–3 year view, and your limited partners (LPs) expect you to earn a return and manage volatility, then yes, being down 50% in a stock is a problem. And probably for the overwhelming majority of the investment world, it is a problem.

However, I have noticed that there is a small corner of the market in which being down 50% in a stock or set of stocks is not necessarily a problem. I find this corner of the market very interesting and very profitable, so I personally spend a lot of my time there. If you own stocks with a 5+ year view, and your LPs truly buy into that, having stocks that go down a lot isn’t actually that big a deal. Everyone around the table wants exceptional long-term returns and is willing to pay the price of volatility. You see, it really depends on the game that you are playing. The game I just described, we can call the “high returns with high volatility” game. (For more on the concept of playing different games in markets, please see Morgan Housel’s excellent essay on this topic.)

Are you really set up to play that game?

One very important thing we have learned: setting out to play this game without being set up to play this game is likely to end in disaster. Tolerating volatility is not a natural state (for humans and investment firms at least) — this capability must be deliberately and carefully engineered. The unadjusted price of high volatility can be extreme pain, and can be fatal for your portfolio and/or investment business. There is a rare set of things that have to come together to be able to play the high returns with high volatility game.

I won’t list out everything we’ve learned about how to play the high returns and high volatility game — which would take up many pages because so much has to be just right. (If you’re interested in playing this game, make sure you spend a lot of time studying others who have successfully and unsuccessfully played it, and spend time thinking from first principles about how to create a firm that is robust to volatility. I will say, it is humbling just how much has to go right). As just one example of what has to come together, as portfolio manager, you have to be able to stay rational and not “mark your emotions to market.” Importantly, rationality includes allowing for the potential that you could be wrong. You must avoid being one of those people who is completely sure they are right, and the market is a bunch of short-term focused fools, and so they reflexively double down over and over again and turn out to be flat wrong. Yet you also have to be someone who has conviction in their work and is willing to stand up and be a contrarian when the circumstances warrant. That is a tough needle to thread.

By the way, you are probably more likely to be able to tolerate high volatility later if you start testing it out early on in your career. Though you can’t exactly simulate the feeling of being down 50% with a large amount of other people’s money, perhaps you can at least start to approximate it. You can own stocks personally and see how you feel when they go down 50%, for example. Part of what you are trying to do is practice experiencing drawdowns, but I think at least equally much you are trying to discover whether this is a game you can safely play — does your temperament allow it? Many people are simply not wired this way and finding this out sooner rather than later is far better.

Are your LPs playing that exact game? Are they set up to play that game?

I have also learned that it doesn’t matter if you play the game well if your limited partners are not also playing the same game. Actually, not just playing it, but set up to play it. Even better, not just set up to play it, but enthusiastic to play it! Such LPs can be comfortable with you being down 50% in a name or set of names (You know you’re really set up to play the game when your LPs are not just comfortable, but excited that you’re down, because they want to add capital). On top of that, playing the game requires a strong balance sheet at the fund level and at the LP level to avoid being forced out of positions early or at the wrong time. At MITIMCo, we spend a lot of time thinking about our role in allowing our partners to play the high returns with high volatility game. We have seen LP quality make or break highly volatile funds so we take our role seriously, and we also spend time to understand the quality of all the other LPs around the table beside us. We always make sure to ask questions like, “the last time you were down 20% in a month, how many angry or upset phone calls did you get from LPs? Did you get any new subscriptions?”

Essentially, every link in the chain must be highly secure, because high volatility will put huge strain on it.

How can you identify LPs who are really able to play the high returns with high volatility game?

If you want to play this game and need LPs who can withstand volatility, they don’t grow on trees but they do exist. Here are some ideas for how to identify them: First, you should spend a lot of time getting to know them and be completely transparent about the game you are playing. Make the conversation a two-way street — you should be asking them questions, not just answering their questions. Be extremely upfront about what you do and see how they react. Second, make sure you check out not just what they say but what they actually do. It’s far easier to say the right things than to do them. Ask them for references of other GPs they invested with. Ask them the last time they added to a manager that was down 50%, or had 2 years of bad performance. Ask them about their actions during March 2020 and March 2009. Ask them about why they have parted ways with managers in the past. Third, ask them about how they make decisions — if talking to an institution or family office, are the key decision makers the ones that you are talking to, or someone else who is getting relayed information? Ideally, the people who you have a direct relationship with should also be key decision makers — otherwise, you aren’t actually building trust with the right parties.

Conclusion

So, to sum it up: make sure you know the game you’re playing, make sure you’re truly set up to play that game, and make sure your LPs are too.

If you are one of the few able to play the high returns with high volatility game, you can create a powerful competitive advantage. As just one example of how this advantage can be put to good use, think back to March 2020 or March 2009 — there were plentiful bargains, but there was no way to be sure they wouldn’t go down another 50% based on intense pessimistic market sentiment. With hindsight, the market rallied. But you had to underwrite and be comfortable being down another 50%. There was no way to be sure where the bottom was. Those who bought heavily, with margin of safety but without a care to being marked down temporarily, made huge profits. In effect, being properly set up gives you an ability to make decisions that your competitors can’t make.