# The Forgotten Denominator

In the late 1990s and early 2000s, the world’s best cyclists – including Lance Armstrong – were being coached by Italian Doctor Michele Ferrari. While Ferrari has since been issued a lifetime ban by the US Anti-Doping Agency for doping violations, he was still arguably one of the world’s greatest sports scientists. In a fascinating tell-all book by Armstrong team-mate, Tyler Hamilton, called The Secret Race, the metrics required to win the Tour de France were prescribed by Ferrari as follows:

“He [Ferrari] explained that the best measure of ability was in watts per kilogram – the amount of power you produce, divided by your weight. He said that 6.7 watts per kilogram was the magic number, because that was what it took to win the Tour.”

To this day, professional cyclists and other athletes target watts per kilogram. And, by definition, there are two ways to boost this ratio: (i) train hard to increase your power output; and/or (ii) reduce body weight. And often, counterintuitively, it is a reduction in the denominator that can have the greatest bang for buck. For instance, a 60kg pro cyclist that can lose 1kg boosts his/her watts per kilogram ratio by +1.7%. This is often significantly easier than boosting power output (the numerator of the ratio) by an equivalent amount.

As an aside, to see how serious these cyclists were about boosting their watts per kilogram, see the extreme techniques they went to in order to reduce their bodyweight:

“Bjarne [Riise, another former pro cyclist] recommended his special technique: come home from a training ride, chug a big bottle of fizzy water, and take two or three sleeping pills. By the time you woke up, it would be dinner, or, if you were lucky, breakfast.”

So what does this have to do with investing? Investing is entirely concerned with generating reward-per-unit-of-risk taken. And many investors forget about the denominator in this ratio. How often are headline returns mentioned and compared in the media? But learning about such returns on their own is almost meaningless. Returns should always be viewed in the context of how much risk was taken to achieve them.

For instance, in the 20-month period from July 1, 2015, to February 28, 2017 (the life of the Montaka strategy at the time of this writing), the global market increased by 8.6 percent in USD terms. Now, imagine a hypothetical 3x levered global long-only fund that returned 20 percent over this period. The headline return of 20 percent sounds great. But is it better than a regular 1x levered fund delivering just 8.6 percent? No, it’s worse. Given the fund is 3x levered, its “risk-equivalent return” – the return which reflects the market-risk borne by the investor but which assumes no value has been added or subtracted through stock picking – is 3x the market return, or 25.8 percent. The 3x levered fund tripled the risk but delivered only 2.3x the return. So the reward-per-unit-of-risk ratio was lower for this particular 3x levered fund than it was for the 1x levered fund.

And if you are reading this thinking: ‘20 percent is just fine, thank you very much’; the mental mistake you are making is that you are viewing the result after the fact, rather than viewing it through the lens of what could have happened before you knew the outcome. This is the very essence of risk: many things can happen but only one thing will happen.

If the market had of turned down by 8.6 percent over the last 20 months instead of its corresponding gain, the expected return of the 3x levered fund would be negative 25.8 percent! That’s what an investor in this fund was risking in order to achieve the resulting 20 percent return. Does that sound like a good trade to you?

By way of an alternative example, consider Montaka which has averaged approximately 50 percent net market exposure. What is the risk-equivalent return of this fund over the period in question? It is approximately 4.3 percent, or 50 percent of the market return over this period. So, if Montaka performed higher than 4.3 percent (in USD terms) over the period, it suggests that our stock-picking has added value. And indeed it has: Montaka’s performance over this period was 9.7 percent, net of fees, in USD terms.

An investor at Montaka’s inception has achieved returns above the market; but while taking only 50 percent of the market risk. This is a significant gain in the reward-per-unit-of-risk ratio (by more than double, in fact); and it has stemmed from reducing the denominator, in addition to boosting the numerator.

Keeping the denominator in mind can seem counterintuitive but is critical for any investor to understand what they should be seeking to maximize. Reward-per-unit-of-risk. And one of the best recent illustrations of this concept again comes to us from the world of sport.

Pine City High School in Minnesota is not a famous school. Yet they are doing something potentially revolutionary in the sport of basketball. As the Wall Street Journal recently reported, the school’s basketball team has effectively defined the reward-per-unit-of-risk ratio for each shot-location on the court:

“Pine City High School seeks out only the most valuable shots in basketball: from underneath the rim or beyond the 3-point line. They play as if they’re allergic to all the space in between… Pine City has become so obsessed with efficiency that its players don’t bother looking at the basket if they’re not in the paint or behind the arc.”

This is entirely logical and will maximize the reward-per-unit-of-risk ratio. Over time, this will result in a higher shooting average. And they will achieve this higher shooting average even if they don’t become better shots – they have simply reduced the risk. They have remembered the denominator.

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Our Montaka Long Only funds strive to act as a core, high conviction, global portfolio holding. Consistent with the long portfolios in our Montaka Variable Net funds, this offering is focused on owning the world’s high quality, undervalued businesses – and cash when appropriate – to outperform its benchmark.

Our Montaka Active Extension funds strive for maximised return over the long-term. Owning the Montaka Variable Net long portfolio typically scaled up to approximately 130 percent - and the Montaka Variable Net short portfolio typically scaled down to approximately 30 percent – this these funds results in a net market exposure of approximately 100 percent most of the time.

Our Montaka variable net funds strive for significant downside protection – but with minimal upside reduction. Focused on owning the world’s great and growing businesses when they are undervalued, while managing a portfolio of short positions in businesses that are deteriorating, misperceived, and overvalued, this these funds are our flagship long-short.

## Our Funds

Our Montaka Long Only funds strive to act as a core, high conviction, global portfolio holding. Consistent with the long portfolios in our Montaka Variable Net funds, this offering is focused on owning the world’s high quality, undervalued businesses – and cash when appropriate – to outperform its benchmark.

Our Montaka Active Extension funds strive for maximised return over the long-term. Owning the Montaka Variable Net long portfolio typically scaled up to approximately 130 percent - and the Montaka Variable Net short portfolio typically scaled down to approximately 30 percent – this these funds results in a net market exposure of approximately 100 percent most of the time.

Our Montaka variable net funds strive for significant downside protection – but with minimal upside reduction. Focused on owning the world’s great and growing businesses when they are undervalued, while managing a portfolio of short positions in businesses that are deteriorating, misperceived, and overvalued, this these funds are our flagship long-short.