Manifesto

Introduction

Our investment goal at TwinFocus is to generate superior risk-adjusted returns for our clients. Our investment research process is our key tool supporting this objective.

We believe it is possible to generate superior returns, but it requires a repeatable and repeated investment process, grounded in a deeply held research identity and common-sense decision-making. Even then, there are no guarantees.

Why is it easy to state the what and the how of investing, yet so difficult to consistently realize?

Investing resists reductionism.

Investing balances the quantitative and qualitative. Theory and empiricism. Micro and macro. Science and art. It is a practice that is best learned by doing.

Our team expertise spans these facets. We have written research papers and textbooks, met with thousands of fund managers, and managed portfolios of everything from stocks and bonds to large funds of funds.

Our research identity and process are the synthesis of our decades of experience. Our process provides an ability to execute repeatably and in what we believe to be a thoughtful, unique approach to asset management. The process is designed to evolve over time, with new information, new experiences, new investment opportunities and new people.

At the risk of immediately contradicting ourselves, we have tried to reduce our process to three key beliefs we elaborate on below:

1. It is possible to generate superior investment performance.
2. Superior investment performance requires a repeatable and repeated investment process grounded in common sense.
3. Integrity is non-negotiable.

Beliefs

These beliefs we lay out below are the foundation upon which our investment process is built. They have been formed by our decades of experience, and while there might be slight evolution in the details, the key tenets are unlikely to change.

1. It is possible to generate superior investment performance.

In our experience, most markets are priced efficiently most of the time. But not always. This inconsistency creates challenges—yet also opportunities—to generate superior returns.

Source: freepik.com

Imagine shoppers lined up outside a store.

A crowd suggests the product is desirable. It also signals information — perhaps those waiting have done their research and know the product is worth buying.

Investing follows a similar pattern, but with a key difference. In a store, everyone pays the same price. In markets, each successive buyer often pushes the price higher. An undervalued asset may no longer be a bargain by the time you reach the front of the line. If the goal is to buy low and sell high, you don’t want to be last.

The ideal position? Near the front of a line so that you either get a bargain, or so you can sell it to someone further back in the line.

How do you improve your chances of getting there?

We believe it starts with a different framework — a different way of thinking about markets.

The conventional framework for identifying and measuring inefficiencies is the Capital Asset Pricing Model (CAPM), where expected returns are decomposed into two sources:

1. Beta (b) – A measure of returns explained by broad market exposure.
2. Alpha (a) – Generally interpreted as a measure of returns explained by manager skill.

CAPM is elegant and proffers a simple formula for measuring skill and selecting investments. However, skill is difficult to quantify, and alpha is actually a measure of returns not explained by broad market exposure, which could include pure luck.

While alpha may eventually identify skill, it takes time, and the opportunity may have passed. As a result, we believe this is a largely useless exercise if we seek to be early.

Instead, we reframe CAPM, retaining its simplicity, but revising and expanding the potential return sources:

1. Competitive Edge (a) – The ability to generate excess returns from having a sustainable advantage across a number of potential sources.
2. Market Risk Premiums (b) – The return received for holding exposures across different market risks that other investors choose not to hold, for example, large v. small, growth v. value, domestic v. international stocks. We are not unique here, there are nearly as many factor portfolios as there are fund managers out there.
3. Capital Imbalances (e) – The returns resulting from a mismatch between the demand and supply for capital within a market. Imbalances reflect constraints (discussed further below) that are either imposed on investors or self-imposed by investors. Capital imbalances are easier to identify and represent a more attractive and sustainable source of expected returns.

What are the sources of imbalances and competitive edge?

Information – know something others don’t.

If you only know what others know, it seems unlikely you will consistently be first or near the front of the line. To do that you need to be smarter than nearly everyone else about how to use available information. And in our judgement, there is nearly an infinite number of smart people in our industry.

Otherwise, you need information others do not, and if you can do this reliably, it can be a real advantage. This private information can be gained directly through proprietary sources or by extracting information before others, due to structural or quantitative advantages.

Network – know someone others don’t.

A key proprietary source is networks. A wide and deep network can provide for a broader set of potential investments or an early look at new ideas or opportunities. Wider and more diverse sources improve the odds of identifying unique (front of the line) opportunities.

Outlook / Process – be willing to invest where others aren’t.

Excess returns are compensation in excess of the risk accepted. As noted, we believe capital imbalances provide for attractive and sustainable sources of expected returns. Capital imbalances often arise when market participants are buyers or sellers for non-economic reasons dictated or motivated by underlying constraints.

External constraints are those imposed on investors, typically regulatory and legal restrictions.

Internal constraints are those self-imposed by the investor, typically the result of personal bias, heuristics or misalignment of interests.

Identifying market imbalances requires two key abilities: recognizing constraints that affect others and minimizing your own biases.

External constraints are easier to identify. An example – in 2008-09, changing bank regulations either precluded banks from participating in some markets or made it unprofitable. The departure of bank capital created an imbalance, one of which led to Bloomberg headlines including phrases like The Golden Age of Private Credit.

Internal constraints are more subtle. They stem from behavioral biases, often shaped by the prevailing narratives in the market, and require having differentiated outlook.[1]

• Narratives are the stories told to explain what is happening in the markets.
• If you accept the same narratives as others and respond in the same way as others, you are likely to join the same lines as others.
• To find shorter lines, you need to understand the narratives and respond differently.

Structural – be able to consider a broader or different set of investment opportunities.

The ability to profit from investments that others can’t or don’t want to make, examples include:

• Scale, e.g., the ability to make investments that are too small for larger investors to care about or too large for smaller to make.
• Speed and certainty. The ability to analyze and commit to time-sensitive investments, capturing opportunities that others cannot evaluate in time.
• The ability to increase the value of the investment, e.g., implementing operational improvements that make an investment that is unprofitable for others profitable for you.
• Lower cost structure that allows you to pay a higher price and capture opportunities that are unprofitable for others.
• Alignment with managers – this is different than pure integrity. Managers may not lack integrity, but they may not make optimal decisions if incentives are not aligned.

The challenge in evaluating competitive edge is observability.

We seek to focus on those advantages that we consider meaningful, that we can observe and assess our confidence in their sustainability.

Source: TwinFocus

The challenge lies in the tradeoff between visibility and value. A strong competitive edge is often harder to observe.

Persistent manager skill, for example, can be a significant advantage, but it’s difficult to measure. On the other hand, scale is more transparent, yet it comes with risks —greater competition and the potential for a manager to take on too much capital, diluting returns.

This chart plots our unscientific, highly stylized representation of this relationship.

2. Superior investment performance requires a repeatable and repeated investment process grounded in common sense.

In our experience, most investors claim their investment decisions are disciplined. We generally believe this only when decisions are supported by a rigorous well-defined investment process built to avoid behavioral traps and heuristics.

We believe this is true for all investors; fund managers, individual investors and us. It is not enough to just have an investment process.

“Everybody has a plan until they’re punched in the mouth.” – Mike Tyson.

A repeatable process plans for volatility and unexpected outcomes that can result in emotional responses. Inconsistent decision-making can negate the benefits of a strong framework.

• • Disciplined. A repeatable process requires an adherence to a core set of foundational principles rather than a broad set of specific circumstances. The desire to deviate from an investment process often arises in response to unexpected outcomes, with deviations from the process resulting in inconsistent implementation and likely inconsistent results.
  • Open-minded. Constructing resilient portfolios, ones with the potential to consistently generate superior risk-adjusted returns, requires an awareness of and sensitivity to uncertainty and bad luck that considers multiple potential outcomes, not a singular expected outcome.
    • Financial theory is based on expected outcomes, that is, it assumes a world of risks that you are aware of, i.e., the known unknowns in the vernacular of former Defense Secretary Donald Rumsfeld. Even in this case, unlikely outcomes (bad luck) can still result.
    • Reality is more complex and involves uncertainty, i.e., the risks you are not aware of (unknown unknowns).

Checklists encourage discipline and repeatability.

We have distilled our beliefs and process into an Investment Checklist, the key questions that underpin our investment and due diligence processes.

1. Does the investment capture desired risk premiums or capital imbalances, i.e., fit within a positive thematic view and/or supported by a market dislocation?​
2. Does the manager have a competitive edge that allows them to successfully implement the investment and generate attractive risk-adjusted returns?​
3. Does the investment structure promote alignment and is it appropriate for the investment?

We have to be able to answer “yes” to each question to move forward with an investment.

3. Integrity is Non-Negotiable

Though listed last, perhaps the most important belief. Outperformance requires an alignment of interests, both structural and personal, between the manager and investor.

Incentives drive behavior.

Almost every investment involves an agent-principal relationship and the potential for a misalignment of interests, with the manager acting in their own interests to the detriment of the investor.

There is no perfect alignment between investors and managers, but we want to minimize the gap between interests and incentives. This requires evaluating the structure of the investment and having confidence in the manager’s motivation and character.

• Structural alignment arises from the regulatory and legal environment, as outlined in the investment documents, as well as the limitations placed on the manager by the manager’s investment and operational policies and procedures. The terms of the relationship between the manager and investor are outlined in the investment documents as well as the manager’s written policies and procedures. Considerations include:
  • Does the fee structure align incentives? Too often the manager can make ample money from simply running the investment rather than running the investment well. When possible, manager compensation should be linked more to investment performance.
  • What rights, if any, do investors have to remove the manager if performance is disappointing or the investment is not being managed as expected?
  • Are the manager’s policies and procedures complete and properly implemented to prevent operational errors and fraud?
• Manager compensation should make the investment matter as much or more to the manager as to the investor with the manager only making money if the investor makes money.
  • What are the level and basis of fees?
  • Does the manager earn greater fees from AUM or performance?
  • Does the manager have a meaningful personal investment in the fund and firm?
• While structure and compensation can promote alignment, ultimately how the manager will behave when punched in the mouth.
  • Does the manager’s past performance, behavior and economic interest in the investment align with investors’ interests?
  • Is the manager forthcoming with information, both good and bad, about the fund and firm?
  • Are there examples of clear alignment or integrity issues?

Conclusion

Our beliefs have been developed over decades of experience. They are the foundations of our decision-making framework and investment process which seeks to generate superior risk-adjusted returns for our clients. While easily said, this goal is a challenge to consistently realize.

However, we believe that outperformance is possible. It requires a disciplined, repeatable investment process grounded in common sense that is applied consistently over long time frames and multiple decisions.

While we have committed to paper, this framework is not etched in stone and will evolve over time, with new information, new experiences, new investments and new people. Although the core tenets should remain the same, how we approach investing should be ever improving.
[1] This analogous to Keynes’ Beauty Contest. While the markets may be a weighing machine over the long term (prices reflect fundamentals) they are a voting machine over the near term (prices reflect what investors believe other investors believe).

Memorandum Waivers & Disclaimers

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