Rikard Lundgren was a Chief Investment Officer (CIO) for over 20 years, managing a number of institutional size portfolios investing in all asset classes with large allocations to all types of actively managed non-traditional investments. 

His last operational role was as CIO for an independent seeder fund, capitalised by Europe’s largest pension fund, APG. During that time, he interviewed hundreds of fund managers seeking seed capital. Together with his team of analysts, he developed analytical tools to better understand different managers’ investment strategies and how they would behave in different market situations.

The first part of this analysis was to write a very detailed technical description of the actual investment strategy itself. What the manager actually does. In this every detail of the strategy was scrutinised. Which instruments were used. Limits. Trading methodology. Financing arrangements. Geographical focus. Stop-loss disciplines. Decision hierarchies, to just mention some.

The second part was to make performance predictions, together with the managers, for various market conditions. When would the returns be good? What markets would the investment strategy not generate any returns and when would the strategy show significant losses.  
 
He and his team called this second part of the analysis: “The Good, the Bad and The Ugly.”

The market scenario questions are simple, intuitive and can be used by any Director to get an understanding of an investment strategy by connecting it to its investment environment. What does the best possible market scenario, when the strategy will generate its best returns: The Good. When will the strategy struggle: The Bad. In what market situations, or disruption, will the strategy loose a significant part of the invested capital: The Ugly. 

The Good 

YP: Tell me about a typical Good, Bad and Ugly interview. 

RL: We normally spent an hour with each manager exploring the Good, Bad and Ugly scenarios. 

Most manager’s marketing presentation includes a description of the best possible scenario for their strategy and how it would generate great returns with limited risk-taking. 

Typical follow-on questions could be: What is it you are trying to take advantage of to create your additional returns? What is it that makes your strategy unique? Have you found something in the markets that nobody else has found or are you just better at finding and selecting the individual investments? Does your value added come from how you are executing transactions? Do you try to time markets? Or is your risk management your secret sauce? Or is it something else? Are the opportunities you exploit endless or can they only be exploited up to a point in time or maximum applied capital, after which returns will start to go down? 

Such questions gave us a good grasp of what the “Good” scenario for the strategy looks like.  

This part of the interview was generally quite easy as the manager liked to talk about how he would make us, as investors, and themselves, lots of money! 

The Bad 

YP: What about the next scenario, the Bad?

RL: The interviews became a little harder when we asked each manager what market scenarios would affect their investment performance badly enough to make positive performance near impossible or could bring YTD performance down towards zero. 

There are some obvious factors such as large or sudden market dislocations, persistent bear markets, suddenly widening credit spreads, erratic sector rotation, volatility shifts, etc. But which of these is the worst depends on the strategy, and the manager is best placed to know this. We took careful note.

We would ask the manager to include other negative factors such as increasing competition, shifting investor preferences, loss of key staff, insufficient AuM, etc. We would also ask them to describe in some detail how they mitigated the effects of such negative markets in the past. 

Eventually, we would have a list of observable market factors that we knew would be bad for the strategy’s investment performance. We would also have gained some insight into how the manager would, or could, mitigate the impact on the portfolio of such negative factors – i.e. how good their risk management skills could be expected to be in difficult markets. 

The Ugly

YP: And now to the finale! What was the “Ugly” part of each interview?

RL: Finally, we asked the manager what could occur, however likely or unlikely, that would make the manager doubt the viability of their strategy. In other words, when would the manager want to take their own money out of their strategy and stop trading? 

This was always the most difficult question for the managers as it required them to dig deep into their worst fears about their strategies. Clearly not an easy topic to discuss with a potential investor. To elicit an answer, we would sometimes need to tell managers that their ability to understand and cogently describe their Ugly scenario was a necessity for us to contemplate allocating any capital to them. No credible Ugly scenario = No money!  

After some serious soul-searching, all managers eventually come up with Ugly scenario descriptions. 

Putting it to good use 

YP: So what did you do with all this insight?

RL: We would write comprehensive minutes, which we asked the managers to comment on to ensure we had really understood their strategy and how it could be expected to perform in these three scenarios. 

Good managers liked this exercise and often added items during the editing phase. Some even used parts of it in their marketing materials. 

We used our insights to decide whether to take our investment decision-making process to the next level, i.e. our Investment Committee. 
 
After we had invested, we used the scenarios as a performance evaluation and risk monitoring tool. Was the manager’s strategy in its Good, Bad or Ugly market environment? Did the strategy behave as we had predicted?

If a strategy is operating in its Good territory, performance should always be positive. If in Bad territory, we would expect flat or close to zero performance. And if in an Ugly scenario, the discussion with the manager could be about stop-loss triggers, limits or if any risk reduction measures had been taken. 

YP: So your main focus post-investment was to monitor risk management in Bad and Ugly scenarios, right?

RL: We did not just focus on the Bad and the Ugly. Unusually good performance, especially when not supported by a Good scenario could also be a warning signal. If we saw any disconnect between the current market scenario and the manager’s actual performance, this could mean that we didn’t have a good grasp of what actually drove investment performance. Or maybe something yet unknown was happening in the portfolio. For example, one manager had done some unauthorised grey market trading, which produced positive returns that were not in line with the actual market scenario.  

YP: So how can a Director, who is not an investor, use these tools?

RL: A Director who understands the investment strategy and how it is connected to what is happening in markets will often be one of the few in the eco-system of service providers who the manager can have a meaningful discussion with regarding the fluctuations of investment performance. The majority of managers see such interactions with a Director as very positive.

A Director who understands the strategy and its Good, Bad and Ugly scenarios can also be useful in communications with the other parts of the fund’s eco-system, such as investors, the risk department of the AIFM etc. This is especially important when performance is negative. 

YP: That sounds great, but have you ever experienced that as a Director?

RL: Yes. I have seen managers under stress during prolonged periods of poor performance being relieved to hear that there was someone who understood that the negative performance came from market factors and that performance was in line with what should be expected in a Bad scenario. 

I once convinced a board to allow a manager to wait a week before enforcing adherence to a VaR limit because the cause of the portfolio volatility limit overrun was the direct result of a Bad scenario event which was most likely only temporary.  

YP: Any final thoughts?

RL: I have used some of the Good, the Bad and the Ugly questions in discussions with sponsors about possible Board mandates. This has almost always been well received and has given me and the manager a good start to our working relationship.

YP: Thank you, Rikard, for sharing some of your very intuitive and simple tools to understanding investment strategy market risks and how Directors can make effective use of them. 

RL: My pleasure. I plan to write a more comprehensive description of how we, as a seeder, selected managers, illustrated by real-life examples. I would be happy to share that with ILA members, once it is ready. Hopefully sometime before this time next year! 

       Rikard Lundgren
        Non-Executive     Director

                Yann Power
           Non-Executive            Director