It’s natural to focus on the ‘big questions’ when interviewing a manager, and one of the most popular requests is “Tell me about your BIGGEST position.” Upon hearing this request the manager usually responds with a beautifully rehearsed story about their highest conviction idea and why it’s the perfect opportunity.
I want to thank Tom Brakke of @researchpuzzler who brought to my attention a much better question which is likely to have a much larger impact: “Tell me about your SMALLEST position.”
The brilliance of this question is twofold:
1. The manager is unlikely to have a well-rehearsed answer and as a result you are more likely to get an honest answer.
2. It gets at the heart of the manager’s investment approach and their portfolio construction process. If it’s a long/short manager with 30 names in the portfolio, what is the incremental value of having the 30th in there? Is the manager trying to mitigate volatility? Or are they opening a ‘toe-hold’ position to see what happens?
As to the latter point, using a small position to ‘mitigate volatility’ is often a euphemism for adding fluff to a book and diluting the (allegedly) high-conviction ideas as a means of playing it safe. Similarly, as Tom points out, a toe-hold position is usually a euphemism for “I want to see if it goes up”. When managers take this approach they are willfully subjecting themselves to anchoring bias and simply playing momentum.
Investors need to understand whether a manager is truly building a portfolio of high-conviction best ideas or whether they are simply spreading the darts around and playing to their biases.