A return to Middle Earth

Randeep Grewal (pictured) returns to Middle Earth, using a little magic to reveal Elven investment tricks, via John Maynard Keynes.

A hush descended on Cloister Court as the tall cloaked figure stepped out from behind the gnarled, antediluvian oak door. The pale, narrow, ghostly face was barely visible and the penetrating eyes were completely hidden by the thick fur hood. The figure strode determinedly across the ancient cobbles. He passed through archways and along corridors with easy familiarity till he reached the slightly ajar study door of the Professor.

The Professor had clearly been expecting his visitor and had a warm tankard of the finest mead ready next to the worn leather armchair. The visitor took off his heavy cloak and eased himself into position in front of the glowing fire. Its warmth was only exceeded by that of the Professor’s greeting.

As he briefly glanced into the coals, Elrand cast his mind back to the first time he had left the comforting embrace of Middle Earth to enter the world of Man. On the site of the College had stood a nunnery. Being young he had been fearful of contact with Man; thus he had observed from a distance. He remembered the piety and tenderness of the nuns as they cared for the sick and poor. And how times had changed. He remembered the last two nuns – one was said to be a woman of ill-repute and the other was rumoured to be a man.

After the nuns, the site had become a Cambridge college – indeed it often claimed to have the oldest buildings in town; though Elrand wondered if many appreciated precisely how old some of the buildings really were.

Elrand himself had also changed over the years, for now he was none other than Chief Academician to the Court of King Elros, Lord of All Elvenkind. He had dedicated himself to the study of Man himself and hence regularly ascended from Middle Earth to consult with the Professor, and before him, with many of his predecessors. Indeed there were many academic papers and books in the human world where, if one tilted the front page just so, then one might see Elrand’s name, written in Tengwar, shimmer briefly in gold before vanishing.

The Professor had recently been appointed Bursar of the College. As they settled he began to explain the predicament he faced. Over the years his predecessors had built up an endowment fund. It had been invested with apparently the finest advice available at the time. Sometimes they had used active managers and other times passive funds. Sometimes they had external advisors who organised a beauty parade of fund managers and sometimes the College had selected managers itself. Sometimes the portfolios had been benchmarked and at other times they had been unconstrained. 

Sometimes they had invested in ‘long duration assets’ and accepted illiquidity (for instance in forests and venture capital) and other times they had sought entirely liquid investments. Sometimes they had sought growth stocks and at other times defensives; sometimes value and at other times quality. Sometimes the investments were in emerging markets and at other times solely in developed markets. Sometimes the College would use a large investment firm and other times a small firm. Sometimes they would diversify and other times they would run concentrated portfolios. Sometimes the College had used discretionary managers and systematic managers, macro managers and fundamental investors. Sometimes the College invested in equities, and then in fixed income, and in forex, and sometimes in derivatives and sometimes in credit. Sometimes it owned assets directly and sometimes it owned synthetics.

The Professor/Bursar felt exhausted just describing the various permutations and combinations of investments the college had invested in. Traditionally the Bursar chaired the College Investment Committee. Having recently taken over the role he had diligently read through the notes of previous committees over generations. Each time the committee set out with lofty ideals and high hopes. As time progressed, the tone of the notes would become despondent and disappointment would sink in. The port consumption of the committee would increase as the performance of the endowment portfolio deteriorated and eventually a new committee would take over and the cycle would start again.

Desperate not to be remembered as the Bursar who finally lost the remaining endowment and having no delusions that he had any expertise in the field of investing, he had desperately sought advice throughout the university. Whilst wandering through the Department of Economics he had been struck by a portrait of John Maynard Keynes – and how from an angle he looked of Elvenkind. This had started a chain of thought which had culminated in the present meeting. Elrand smiled for he remembered Keynes well – and perhaps some magic had indeed passed between them as they had debated long and hard.

Elvenkind have an ability to become invisible should they choose to; Elrand had used this ability over the years to study men and had particularly enjoyed watching investment committees of family offices and endowments in action. Furthermore he had put his insights into practice advising how to invest the wealth of the Court of King Elros in the world of Men. Having been forewarned on the topic of discussion, Elrand pulled out a scroll with his notes. A little magic has allowed AlphaQ to bring the list and supporting notes to its readership…

Write down the objectives of the endowment

An investment committee should write down its investment objectives and test every investment decision against that. And a well-organised and experienced secretary needs to administer and manage the paperwork and execute on decisions.

Avoid 'sometimes' portfolios (and also avoid `everything' portfolios)

Investment ideas come and go – do not keep on switching. And there is no obligation or need to be in every style, strategy, asset class or type of investment (ie. avoid an ‘everything’ portfolio) – indeed too many strategies increases the probability that strategies will be correlated. Thus both excessive diversification and frequent switching have costs.

Equally one should be aware of ‘sometimes’ and ‘everything’ fund managers – consistency of approach has much to commend it.

Keynes did not believe in an efficient market 

Keynes himself was an active investor and commented that markets are ‘governed by doubt rather than conviction, by fear more than forecast, by memories of last time and not by foreknowledge of next time’. 

Even Nobel Prize winner Paul Samuelson himself invested in both Commodities Corporation and Berkshire Hathaway. And Warren Buffett has spoken out against the Efficient Market Hypothesis in his presentation of ‘The Superinvestors of Graham-and-Doddsville’.

It is interesting to observe that some fund managers and investors’ mental makeup compels them to seek out and find market inefficiencies – but such managers are few and far between – seek out such fund managers.

Keynes performed badly as a macro/top-down manager but well as a value investor

Keynes’ performance in the early part of his investment career was based on top-down investing – in which he did badly. However by 1932 he changed his approach to being a fundamental value investor. His returns subsequently considerably beat the market. Each investor’s expertise, skill and temperament have a market niche where it works well – and many niches where it works poorly.

Skin in the game: does the fund manager invest his or her money in the same way? 

The best investment managers are those who invest their own money – ideally in the fund they manage or in a similar way. Keynes personal investments mirrored those of the Kings’ College Endowment. (Chambers, Dimson and Foo note that 81 per cent by value of the funds Keynes managed in the Kings College Discretionary Portfolio reflected positions he held in his own personal holdings). So seek out those funds where the manager is willing to invest a substantive part of his own wealth in the fund and to reinvest a significant part of any future bonus back into the fund. A performance fee is an incentive but not skin in the game per se – fund managers with both skin in the game and with appropriate incentives are likely to be more focused on attractive risk adjusted returns. 

What is the motivation of the fund house?

Ian Rushbrook (manager of the Personal Assets Trust) once said: “The talent in a unit trust group is not usually applied to running the funds; it is applied to expanding the unit trust group. Where investment trusts are run by merchant banks, you will usually find that the best trainees gravitate to corporate finance and the less successful end up on the investment side”. 

It is remarkable that those fund managers or investors (eg. Buffet, Soros, Klarman, Robertson etc) who have become famed for their performance have run a limited number of funds but with large numbers within the fund. In contrast most fund management companies run large numbers of funds but generally without outstanding performance (there are of course exceptions to the rule). From a fund management company’s point of view this diversification of course helps them hedge their bets, but if they are not truly committed to a strategy or fund manager, should you be? One might ask if a fund management house has significant skin in the game by investing alongside their managers.

Avoid overly large investment teams 

Many funds will market that they have vast resources. But Keynes managed an endowment by himself. (And indeed Buffett and Munger manage a considerable portfolio between themselves). The effectiveness of decision-making is inversely proportional to the size of the investment team. As the team gets bigger each member will want their ideas expressed in the portfolio as that is what they are judged on. The number of positions will increase as will the portfolio turnover – but the performance may then converge to that of the market.

Beware of paying for performance on winners but without an offset for losers

Some portfolios suffer by paying for winning strategies without any offset for losing strategies. The benefits of netting performance across strategies can be dramatic.

Understand the investment manager's environment

Keynes resigned the chairmanship of the National Mutual Insurance Company because he tired of cross-examination of his investment decisions and from the ‘Independent Investment Trust’ where he found difficulties agreeing a strategy with the other founders. 

Keynes said: ‘it is better for reputation to fail conventionally than to succeed unconventionally’ and also that a long term investor should be ‘eccentric, unconventional and rash in the eyes of average opinion’. The larger an institution the greater the tendency to recruit staff who conform and push out those who appear eccentric, unconventional or rash. Hence the larger the organisation the more conventional the performance. 

An endowment has the opportunity to outperform by finding the fund managers with the eccentric and unconventional views – but it must ensure that they are in a wise fund management house that provides infrastructure to support the fund manager, not suffocate him with bureaucracy.

Is the investment manager's attitude that of an employee or is he mentally free? 

If a manager is in attitude and role, an employee, then he will be imprisoned into making decisions that please his management rather than himself. Similarly some fund managers, even when running their own business, focus on what will please their investors or is conventional rather than what will profit their investors – mentally they are still employees. 

Neither clothes nor labels reveal what is underneath

The ‘legend of the last two nuns’ applies to many walks of life – one ‘value’ investor or ‘fundamental’ investor is not necessarily the same as another. Even two fund managers sitting side by side with the same ‘label’ can have vastly different portfolios. Understand what the fund manager means by ‘value’ or ‘quality’ or ‘fundamentals’. And build a portfolio of fund managers with different skills, experience and expertise – not a portfolio of styles.

Ask what the fund manager really does during the day

Keynes said: “It might be supposed that competition between expert professionals, possessing judgment and knowledge beyond that of the average private investor, would correct the vagaries of the ignorant individual… It happens, however, that the energies and skill of the professional investor and speculator are mainly occupied otherwise.” 

Many fund managers’ ‘energies and skill’ are spent marketing, writing reports or in seemingly endless meetings. Others tend to be screen watchers – spending their whole day mesmerised by flashing prices or newsfeeds. And yet others appear to spend the day digesting ever increasing volumes of emails and phone calls. In a world of information overload there is risk that some fund managers are becoming ‘well informed but ignorant’.

Never confuse the cost of advice with the value of advice

Select a fund manager on his skill, expertise, experience and temperament. Ensure that he is paid sufficiently that he focuses his ‘skills and energies’ on the task at hand; not on finding a new client. And always remember that bad advice costs far more than good advice.

Is investing a passion or a job?

Ask what a fund manager does outside of work and also what he would do if he was not working in fund management. Far better to invest with one who is passionate, than one who merely sees fund management as an occupation.

Ask how the fund manager makes money and compare with your observations

If you do not understand what a fund manager does then you should not invest. And does the fund manager himself really have insight into how and when he makes money?

If it is too good to believe, don't believe it

The greatest fear of most investors is being swindled. Yet this is often trumped by the fear of missing out on exceptional performance. Ensure that fear of permanent loss of capital remains your number one fear.

Passive investing does not mean not making investment decisions – the issue is only that the decisions are different

It is amazing how passive investing is seen as a panacea by many investors. Yet often such portfolios are filled with multiple different passive vehicles. 

A number of issues arise:

• Who makes the decision on which passive funds to purchase? And how is the decision made? Based on geography? Sectors? Factors? What edge or expertise does the decision maker have?

• Frequent switching between passive funds has a cost.

• Humans directly or indirectly ordain what the composition of a passive basket is – even if there are ‘rules’ or a ‘computer model’.

• Some passive funds are highly concentrated.

• Not all passive funds are alike (for instance does the fund have liquidity constraints, some hold assets via synthetics, etc).

• Some ETFs have hidden counterparty risk.

• There is a liquidity mismatch between some passives and the underlying assets.

• The overlap between passive funds may be contributing to overvaluation of some underlying assets.

• The growth of passives is probably driving increased correlations.

• Many passive funds do not vote at all, or rarely vote against management at AGMs and so overall corporate governance may be deteriorating.

• The scheduled planned rebalancing or roll of certain passives open them to be gamed by other market participants.

• Some passives suffer significant and regular roll costs. These reflect the cost of carry of the underlying instrument. Without being aware of this a naïve investor can become unstuck.

• Some investors who have neither the experience, the inclination or the balance sheet to trade futures or use leverage are inadvertently doing so via passives eg. inverse levered ETFs.

Do not confuse documentation and reputation with due diligence

A number of foundations and others invested in Madoff simply on reputation. Due diligence requires not only receiving documents but checking every statement and comment and also observing a fund manager at work. And the most powerful detector of fraud is often not a checklist but rather your nose.

Temperament and attitude 

Meet fund managers and judge whether their temperament and attitude suits and fits with yours. Once you have selected a fund manager feel free to speak to him regularly, but not excessively. Indeed many fund managers delight in speaking with investors. Consider an investment with a fund manager the beginning of a relationship – not a transaction. And the single greatest question to ask when selecting a fund manager is: ‘Will I trust him in a crisis?’


Use databases to screen and short list managers; due diligence to study and understand managers and personal meetings to select managers. Databases, checklists and personal relationships are three legs of a stool – all three legs are required.

Famously Keynes ran the Kings College endowment for a number of years making investment decisions himself. It is unlikely that nowadays many bursars would endeavour to invest by themselves, but would look to find fund managers to invest with. So I wondered what advice Keynes would give to his successors or indeed anyone tasked with investing for an endowment, family office, pension fund or sovereign wealth fund. 

Based on my experience being on the other side of various ‘allocation’ meetings, I thought the above list would be useful for AlphaQ readers who manage endowments or family offices. I drew heavily on an excellent paper by Chambers, Dimson and Foo (“Keynes the Stock Market Investor: A Quantitative Analysis” Journal of Financial and Quantitative Analysis Vol 50, No 4, 2015 pages 431-449). 

There are many things to recommend from the paper but one point struck me above all others. Independently of Benjamin Graham (who published Security Analysis in 1934), Keynes was discussing stock selection on the basis of discounts to ‘intrinsic value’ in 1934 and probably as early as 1932.

In the checklist, Keynes’ discussion on ‘skills and energies’ of professional investors is mentioned. At one point in my career I was receiving between two and three thousand emails per day and a couple of hours of voicemails (often before I even got to the office in the morning). I found I was spending much of my day clearing my inbox and dealing with phone calls. 

Eventually I ended up changing my email address and phone number and removing all direct contact details from my business card. It is likely that even today there are fund managers literally ‘drowning’ in incoming unrequested information and data – and their energies are being diverted to deleting messages and emails.

I was also struck by the comment by Ian Rushbrook quoted above from the book ‘Money Makers: The Stock Market Secrets of Britain’s Top Professional Investment Managers’ by Jonathan Davis. Comparing notes with colleagues and friends, it seemed to be apparent that the best fund managers are increasingly seeking smaller intimate organisations or starting their own fund to obtain autonomy.

Perhaps the greatest example of frustration of a larger organisation comes from Tolkien himself who, on reviewing galley-proofs of the first volume of The Lord of the Rings, wrote to his son, Christopher, to say that ‘the impertinent compositors have taken it upon themselves to correct, as they suppose, my spelling and grammar: altering throughout… elven- to elfin’.

Author Profile