The Viking Remedy: Concentration as Salvation

July 30, 2010

As hedge funds go, Viking Global is one of the big dogs, with AUM in the neighborhood of $10 billion $12 billion.

Dealbreaker recently posted a mea culpa investor letter from Viking, in which Andreas Halvorsen does a little soul searching to analyze what went wrong in a lousy Q210.

The whole thing is an educational look into the psychology and mechanics of a pedigreed long/short fund.

In particular, the extensive details on hit rates and concentrated position stats — and the rationale for more aggressively levering up “best ideas” — are great food for thought.

A few selected excerpts from the full letter:

…the greatest alpha generation has been in our highest conviction ideas… of the 921 long and short investments we have made in VGE over the past five years that resulted in a profit or a loss exceeding ten basis points of performance on our total capital base, 59% were profitable. Of the 56 investments that resulted in a profit or a loss exceeding 100 basis points, 75% were profitable. Our top ten longs returned 28% per annum, outperforming the remaining longs in the portfolio by over 12 percentage points per annum on an unlevered basis…

…We conclude from these statistics that when we had strong conviction in an investment and scaled it, our success rate increased – in other words, our high conviction has been correlated with improved odds of being right. This is our profit engine…

…To step back, I see concentration as a determinant of differentiated investment returns and think of it as a spectrum that spans two extremes. At one end is a market-weighted or index portfolio, and at the other end is a portfolio containing a single investment. If we position the fund at the former end and own a market-weighted portfolio, we will generate no alpha, which represents the foundation of our business model. Positioning the firm at the latter extreme and putting all capital in one investment would be entirely too risky as well. In spite of our attractive stock-picking statistics, we are frequently wrong, and combined with what would result in extremely poor portfolio liquidity, such concentration would be irresponsible.

Therefore we must find the appropriate position somewhere between the two extremes. Unfortunately, there is no precise formula that computes optimal concentration. We cannot afford to be too concentrated, yet we cannot afford to be too diversified either…

…Recognizing that generating incremental short ideas enables us to scale our highest-conviction longs and thereby amplify expected returns, we chose to address these two challenges by explicitly charging our analysts with generating additional short ideas for VGE. Each analyst now provides on a weekly basis the one or two companies they like least well among their most liquid names. We have instituted this practice because we believe it is inappropriate to further concentrate our most attractive short positions…

…What we consider to be appropriate leverage depends on the balance between longs and shorts in the portfolio – if our longs and shorts are distributed relatively evenly across industry groups and sectors, we may choose to run the hedge fund with higher leverage than if they are not. By recently having introduced somewhat higher leverage, with the expectation that volatility will increase accordingly, it remains our goal to maintain VGE’s return volatility below that of the broad indices…

— Dealbreaker, Viking Global is Greatly Disappointed…


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