Relatively Keeping Up With the Joneses

When A.W. Jones pioneered the first ‘hedged’ funds in the 1950’s thus launching an industry that would eventually go on to change the face of finance, he had started with a seemingly simple conceptual notion: Portfolio management is a relative game; gains and losses from a ‘smart’ investment strategy must be understood separately from gains and losses caused by market trends. Basically, there’s a big difference between being lucky and being good.

This basic premise led him to a number of conclusions and innovations that would come to define modern hedge funds and change how people thought about market risk and return. To Jones, trying to time the market was a fool’s game; a sustainable investment strategy must be insulated from unpredictable market movements. Short selling to hedge market risk did this. Jones also decided that the portfolio risk is based less on the risk of the underlying assets and more on their correlations to the rest of the market and each other. By always picking and hedging the best stocks regardless of their individual risk, he could use leverage to adjust for the amount of exposure he wanted.

While this may be over simplifying a 60 year long industry evolution, the idea that hedge funds changed portfolio management by acknowledging the importance of ‘relativity’ is a powerful one; however, even today, it is still not universally applied. In another part of finance, banks and other lenders are attempting to manage large portfolios of small and mid-market loans with a total lack of relative perspective. They’ve been flying blind for years.

The key capability required to analyze a portfolio in this way is a benchmark: a way to compare and correlate a specific asset to the rest of the market (or a segment of the market). For Jones and his original hedge funds this wasn’t a problem. Public stock data could be aggregated and analyzed easily. It’s not so easy when your assets are small and mid-market business loans. Bankers and other lenders don’t have access to the type of aggregate data on small and mid-market credit risk they need; and even if they did, the data is so vast, most would have no way to make any sense of it. Without a benchmark, there’s no way to know how one portfolio of loans is doing compared to the rest of the market.

If you can’t compare your portfolio to the market, you can’t evaluate how good a job you’re doing at managing that portfolio. Back to Jones’s original hedge fund premise: how can a lender tell what to attribute to normal market trends (which he has no control over) versus his ability to build and manage a quality portfolio? The changing market masks the results.

Acknowledging the need to understand portfolios from the relative perspective was a game changer for the stock investments. It enabled hundreds of innovative investment strategies and gave birth to the entire hedge fund industry. The WAIN Street Business Credit Health Index gives lenders the necessary knowledge to also have that same game changing realization. It will free lenders to develop new tactics and strategies around small and mid-market loan portfolios allowing them to better manage risk and improve performance.