Hedge Fund Job Interviews: Applicant #1

Applicant #1 is an extreme case.  He has a PhD, a JD, has written nine books and 1200 articles, and has been hired for important positions by the most prestigious Wall Street Firms.  So the paper credentials are excellent!

The price is also right.  He is revealing to me an easy method for investing that would have beaten the S&P by 50% over the last ten years.  First, let’s explain that he means that his system would have gotten average gains of 13.4% versus the S&P return of 8.9%.  That is 50% better all right, but people sometimes get confused by these comparisons.

This is a pretty impressive record.  Any applicant that could add that much value is worth his weight in gold.

The System (as described by the applicant)

Here are the four steps you need to follow, once a year:

1. Scan
   Morningstar’s database and pick the top no-load equities in each of the
   nine "style box" categories, from large-cap growth to small-cap value
   funds.
2. Invest an equal amount in each of the nine funds.
3. Save regularly, add new money and stay close to your allocations.
4. Then
   next year scan Morningstar’s database again: If the nine funds you
   already own aren’t still near the top, replace them. Otherwise, hang
   onto your winners.

Characteristics

Frequency of trading — low
Turnover — low
Ease of use — excellent
Risk/Reward — NA from stats offered
Drawdowns — NA from stats offered

Evaluation

So we get into the issue of backtesting.  We will see several applicants who use sophisticated backtesting software, and we shall explore the issues involved.

For now, it is simple.  This applicant simply looks at the funds that did well last year in nine different groupings and pretends that he bought them ten years ago.  I have the race results from yesterday’s running at Arlington Park available, but they won’t let me bet on that race today, drat it!!

Briefly put, this applicant did not do a real backtest — going back to a given point in time and using the information then available to choose the fund.  The reported results do not show what would have happened by this method.  And, as we will see, this is the most rudimentary form of backtesting, still fraught with peril.

Chasing performance from prior years is how the average investor manages to make half of the market returns over time.  It is sad that people do this, but looking backward is all that most investors know how to do.  They are encouraged to do this by the media and financial reporting.

I choose not to hire applicant #1.  In fact, I bet him a dinner that this strategy underperforms the market for the next year.