"Seven deadly sins, seven ways to die"

I read a great quote by Zeke Ashton of Centaur Capital on how funds blow up:

“In almost every case of catastrophic failure that we’ve observed, we believe the root cause can ultimately be boiled down to one or a combination of just five factors. The five factors are 1) leverage 2) excessive concentration 3) excessive correlation 4) illiquidity and 5) capital flight.” Zeke Ashton

Most investors start the investment process by looking up. The objective: make money. Identify those stocks which can go up a lot and fill the portfolio with them. They focus on the upside. Very few investors start out by looking down. Instead they should be asking, “What could go wrong? What downside protection do the stocks provide? What happens if the expected scenarios fail to materialise? Are there existential risks?”

Charlie Munger has long advised "inverting" problems. As a portfolio manager, instead of first asking, "How can I make money?", ask, "How can I avoid that which loses money?" By ensuring individual stocks in the portfolio and the portfolio of stocks together minimise the risk of permanent capital impairment [aka the real risk of investing], you’ll be well on your way to investment success.

Below, I’ve outlined my observations of the key factors that blow-up funds, the ‘Seven Deadly Sins of Portfolio Management’ [I've added two more of my own]. Ordinarily it's a combination of these factors that get fund managers into trouble.

Sin 1 - Excessive Leverage

Remember leverage gives someone else the right to say when the game is over. Too much leverage at the portfolio level and/or in the companies that you own can lead to the permanent loss of capital. Within a long/short portfolio, high gross exposure [even when net exposure is low] can impair capital quickly if prices diverge the wrong way. For these reasons, the Investment Masters limit leverage and avoid companies with excessive corporate debt.

Leverage can also come in the form of derivative exposure or shorts. Both can provide unlimited downside, effectively wrong-way asymmetric bets. A telling example were the hedge funds that shorted Volkswagen in 2008. They learnt the hard way the asymmetrical danger of shorting. For a moment Volkswagen became the world’s most valuable company and a new term entered the investment lexicon, ‘getting Volkwagened’. Esoteric strategies using derivative structures can create unintended risks when unexpected circumstances arise. The normal distribution curves assumed in investment models can be upended by tail events.

Sin 2 - Excessive Concentration

Mistakes in investing are inevitable given the magnitude of variables involved and imperfect information. Having too much exposure to one stock or sector can be costly. Large positions can become illiquid and if they become publicly known, may attract predatory activity. The Investment Masters tend to limit their position sizes [even more so for shorts] to minimise this risk.

Sin 3 - Excessive Correlation

On occasion, stocks may become correlated and move in the same direction, offsetting the benefits of diversification. Correlations can "go to 1" in difficult market conditions. Things you expect to be uncorrelated may become correlated due to crowding, index implications, money flows, economic factors or geographic/geopolitical events. There is little protection in a bear market outside of short positions and cash. Investment Masters tend to seek diversification, limit sector exposure, hold cash and constantly consider and manage the potential correlation risks in the portfolio.

Sin 4 - Illiquidity

Illiquidity hurts when an investment thesis changes and/or the portfolio manager needs cash and wishes to exit a position. At times, there may be no market to sell into. If investors can remove capital from a fund at any time this can create a liquidity crunch and a portfolio manager may need to sell assets that are ‘saleable,’ as opposed to those they would prefer to sell. This can lead to further portfolio concentration, further losses, and capital flight. The Investment Masters monitor portfolio liquidity and manage position sizes according to stock liquidity, overall portfolio liquidity and their mandate’s redemption criteria.

Sin 5 - Capital Flight

Capital flight occurs when investors demand their money back at the same time, ordinarily coinciding with weak markets and lower stock prices. Selling a stock at the lows results in the permanent loss of capital. Howard Marks often says ‘the cardinal sin of investing is selling the lows.’ It's even more risky when positions are illiquid. A negative feedback loop can develop where selling stocks to fund redemptions creates further losses and subsequent redemptions. The Investment Masters tend to seek like-minded investors who understand the investment process, have longer time horizons and/or seek more permanent sources of capital.

Sin 6 - High Flyers

When expensive stocks de-rate or a stock market bubble bursts, the result tends to be a permanent impairment of capital. For example, a portfolio loaded with tech stocks at the height of the Nasdaq boom in 2000 or in the ‘Nifty-Fifty’ stocks in the late 1960's ended in significant losses for investors when each bubble burst. The Investment Masters tend to adopt conservative forecasts and avoid paying excessive multiples for stocks unsupported by intrinsic value.

Sin 7 - Fraud

Fraudulent acts by investment managers or a company can be disastrous, a’la Bernie Madoff’s ponzi scheme and Enron’s accounting scandal. Ensuring you really understand how the businesses or funds you own operate and by analysing the long term track record of management will go a long way to avoid these problems. The fact the Investment Masters "eat their own cooking" helps align a managers interest with co-investors.

Summary

Thinking about how a portfolio is structured with regard to the ‘Seven Sins’ is a useful starting point. Almost every fund that has blown-up, and will blow-up in the future, will have one or more of these attributes.

Portfolio management is a skill that requires a broader skillset than picking a bunch of stocks you like. It requires considered thinking. Each and every stock and it's respective size, valuation, riskiness, liquidity, cross-correlation, complexity etc must be considered in the context of the whole portfolio. Furthermore, having like-minded investors who understand your investment process and the nature and volatility of the likely return profile is also critical.

And choosing passive products is no panacea to avoiding these sins. Many index funds and ETF’s have excessive exposure to certain sectors and/or expensive stocks; they won’t be immune to capital flight and illiquidity in weak markets. You don't avoid these risks by being a passive investor.

Remember, successful investing starts by not losing. Indulge in the ‘Seven Sins’ at your peril.