Fund boutiques have been attracting increased interest from family offices and traditional institutional investors for years. Markus Hill spoke on behalf of FONDSBOUTIQUEN.DE with Oliver Klehn, Managing Director of Paladin Quant GmbH, on topics such as singularity theory, quantitative asset management, and ESG. In addition to these technical aspects, topics such as “permanent employment versus entrepreneurship”, seed money and experiences with fund selectors were discussed. The portfolio manager’s professional impressions are complemented by personal reading thoughts on the topicality of Thomas Chromwell, Brexit, and Corona (“Mirror and Light”, Hillary Mantel).
Hill: You have taken an interesting professional path, what exactly did you study?
Klehn: I still remember the evening walks with my father. I looked up at the sky with fascination and had many questions. My father explained the world to me, he talked about the finiteness of the universe and about astronauts for whom time in space would pass much more slowly if they moved in space at approximately the speed of light. That the astronaut would only have aged a little, while the people on earth would have been old people long ago. And that all of this would come out of Einstein’s theory of relativity. These answers sparked my interest in science, I wanted to understand things. After the German Army, I began to study mathematics and physics. Since I had to commit myself to a core subject, I decided to study mathematics with physics as a subsidiary subject. What fascinated me about mathematics was the clarity of the methods and the fact that everything has to be proven, but then once and for all it is irrefutable. During my studies, I chose as my main subject a field that is considered to be one of the most difficult and abstract within mathematics, the so-called singularity theory. It is a branch of geometry and deals with places in geometric spaces, the so-called singularities, which conventional mathematics fails to investigate. For example, the Big Bang of our universe is a singularity in physical space-time geometry. The equations of general relativity collapse here because the curvature of spacetime becomes infinite. To investigate singularities, completely new mathematical methods are needed, and singularity theory develops them. What I found particularly appealing about this was the drilling of thick planks and the forging into completely unknown territory. I have a passion for solving difficult puzzles. Consequently, I thought to myself: if you have to do mathematics, then do it right. The most challenging topics were always the most interesting ones for me. It had little to do with finance. But today, as a fund manager, I benefit from the fact that I had to learn in my studies to tackle even very complicated issues with courage and perseverance. However, I had a certain affinity for the financial markets even as a youngster. Even then, I was concerned with the fact that Germans have little to do with financial markets and often regard the stock markets as the devil’s work. I never understood why the Germans did not want to participate in their economy. But at that time, and also during my studies, I had not yet planned to go into the financial sector later on. Directly after my studies, I received an offer from my then-doctoral supervisor to do a doctorate with him at the institute. What appealed to me above all was the fact that I was able to research a comprehensive topic for three years completely independently. However, it was clear to me that I did not want to spend my whole life at the university, but that I would go into business after completing my doctorate. I eventually joined the Market Risk Controlling department of a bank.
Hill: What made you choose the path of self-employment in the asset management sector after this “secure” employment relationship?
Klehn: In the later years of my professional life I went through several stages in risk and asset management. The last one before becoming self-employed was with a medium-sized asset management company. I was asked to develop a product range of purely rule-based funds and to set up a dedicated team to manage them. The focus was on institutional clients. That worked well: the interest of institutional investors was great and we were able to build up the volume very quickly. From then on, however, more and more people wanted to have a say, and it was clear to me that the full potential of the methods we had developed could only be brought to the street under our responsibility. I, therefore, decided to become independent but needed a partner to compliment me. This partner should preferably have a mutual fund with a track record of several years, as well as expertise and infrastructure in sales. In Hanover, distances are short, so I came into contact with the Paladin Asset Management Group. The group emerged in 2011 from the family office of the Maschmeyer family of entrepreneurs. Their equity fund Paladin ONE is a “handmade deep value fund”. After a period of trial and error, we decided to establish Paladin Quant GmbH in autumn 2018, thereby expanding the Group’s offering to include purely rule-based strategies for institutional investors, family offices, foundations, and asset managers. The clasp between what at first glance appears to be very different approaches is that all strategies aim to efficiently manage risk and reduce draw-downs. In autumn 2019, we launched the first mutual fund of Paladin Quant GmbH and were also able to acquire a special mandate from an insurance company. We are in the same boat as our investors: All employees and management are invested in our mutual funds with significant amounts. For example, I have invested all the reserves that I do not need in the short term in Paladin Quant Aktien Global Nachhaltig.
Hill: What are the best features of your approach?
Klehn: The special feature of our approach is that we efficiently bring together the issues of sustainability and stability. The basis of our investment strategy is the assumption that it is not possible to predict the markets or engage in market timing. In our view, the only way to make a successful investment is through effective risk management. The best possible decisions must be made under uncertainty. Do you remember the poker boom a few years ago? You could observe that the same players were always successful in big tournaments. How can this be explained when every player is dealt the same good cards on average and no one can see into the future or the cards of the other players? Admittedly, they do exist, the masters of psychological warfare. Those who can bluff and interpret the expression on the other player’s face. But that alone is not a sufficient explanation. The only satisfactory explanation for the success of individuals is their superior risk management. Good players can protect the chips on the table in front of them. The amount of the stake is precisely quantified in terms of expected profits and risks. The best poker players are therefore always the best risk managers. This means extreme discipline in the game when implementing strategy. A good poker player does not let emotions or irrationality guide him. Bad poker players, on the other hand, are often the ones who get carried away with impulsive actions. This is also true for portfolio managers. Capital investment is not a game of chance, but uncertainty is also encountered there. Nobody can reliably predict where the markets will be tomorrow. In our opinion, there are no models that could do this, even if some people claim the opposite. We only promise what we can deliver. That is why we do not deal with glass spheres. Our focus is solely on perfecting risk management, from which our investors benefit. The use of quantitative investment strategies enables us to make strictly rational decisions.
Hill: How exactly do you approach risk management? What role does capital market theory play here?
Klehn: Mathematical portfolio optimization according to Markowitz is about developing a portfolio that is as efficient as possible from a selection of securities. A portfolio may call itself efficient if there is no other portfolio with at least the same expected return and lower risk. An efficient portfolio at a given expected return is therefore optimal in terms of risk.
Investors are constantly looking for optimal portfolios. No investor is prepared to bear an avoidable risk. Investing in an efficient portfolio is therefore the most effective way of risk management.
It is well researched that market capitalization-weighted stock indices like the MSCI World are far from being efficient. Even naive weightings, such as equal weightings, cannot achieve this. Determining an efficient portfolio, i.e. the optimal implementation of the “don’t put all your eggs in one basket” recommendation, is a complex mathematical task. As impressive as Markowitz’s idea may be, there are numerous points of criticism of conventional portfolio management approaches based on it. Simplifying assumptions that were made at the time do not stand up to reality. In this case, for example, historical data are included in the calculations, which are simply extrapolated into the future. However, we can observe almost daily that reality refutes this assumption. For example, when the markets crashed at the end of February, equity correlations jumped to unprecedented levels. This could not be measured with moving averages of historical time windows, and other, more modern methods are needed.
We have made significant improvements to Markowitz portfolio optimization and also to risk measurement using historical data in key areas to eliminate its weaknesses. We analyze a large amount of global financial market data daily and apply modern statistical models based on pattern recognition. The focus is on the prompt identification and management of risks. Our procedures are based on scenario analyses and are aimed at permanently optimizing the portfolio. Ultimately, we use our algorithms to select 35-45 stocks from a population of around 200 and determine their weighting in the portfolio.
Hill: What role does sustainability play in this context?
Klehn: The procedure described above can be perfectly combined with sustainability criteria, as we are completely free in the composition of the investment universe. We are in a position to implement very ambitious sustainability approaches without having to make restrictions in terms of expected returns and risk management. On the contrary: we are convinced that strong sustainability criteria enhance portfolio quality. With our approaches, we can also tailor strategies for institutional investors very flexibly within the framework of special fund mandates: Whether equity or mixed strategy, a special sustainability profile, the consideration of risk budgets or maximum draw-down requirements or even certain foreign currency limits: We can design it and implement it efficiently.
Hill: What experiences have you had with investors in pitch situations, in the presentation of your concept, in seed money searches and fund launches? What challenges or interesting lessons have you learned from these discussions and your independent work as a “boutique manager”?
Klehn: The new thing about being self-employed was that I was suddenly responsible for everything. During my employment, I was responsible for one area. Now I’m responsible for an entire company and have to look after it accordingly. The nice thing is that I can act on my responsibility and do things the way I think is best. Politics in the company, which often plays an important role in larger companies, no longer eats up time. Important things can now be moved forward quickly. You sacrifice a secure salary for this, but this uncertainty pays off. From a professional point of view, I come from the institutional sector. I often had to do a lot of tough rounds before I got the chance. That is now completely different. I often sit directly at the table with the decision-makers. Often, this is also directly linked to a nice reward: more than once we have received an investment commitment within the deadline. What I underestimated at first was the importance of personal meetings. People invest primarily in minds, not just in a product. The high quality of a product must stand up to any critical examination. I had one of my most formative and instructive experiences right at the beginning: Sometimes our presentations were too extensive and detailed. This does not always meet with the approval of all listeners. We learned quickly: our presentations today are “to the point”. More concise, even with the courage to leave gaps. The most challenging project to date was the launch of our mutual fund Paladin Quant Aktien Global Nachhaltig. In addition to defining the setup (investment company, depositary, investment guidelines), seed money had to be raised. Here we have the classic chicken-and-egg problem: investors want to see a track record that a newly launched fund naturally cannot provide. But without an initial investment, no fund launch is possible. After some discussions with potential seed investors, we finally defined our investment strategy completely and finally. The goal is a sustainable, global equity portfolio that at least achieves the return of the global equity market, but with lower volatility and significantly lower draw-downs. It is a simple, pure product: only shares and liquidity in EUR, no derivatives. We do not want to engage in market timing and we do not want to dilute the sustainability profile with derivatives on a non-sustainable stock index. In retrospect, our approach has proven to be very successful: Despite Corona, we now have a fund volume of EUR 18 million and continue to grow.
Hill: After all, the world is not just about mathematics and finance. Which book are you reading right now?
Klehn: I’m currently reading “Mirror and Light” by Hillary Mantel. This is the third and last part of her so-called Tudor trilogy. But this trilogy is not primarily about the Tudors or King Henry VIII. (the one with the many women), but about his advisor, Thomas Cromwell, the second man in the state. The trilogy describes his rise from the simplest of circumstances to become the second man in the kingdom and his subsequent fall, which, as is often the case at this time, ended on the scaffold. In doing so, Mantel remains very close to the historical facts. However, it is less a historical novel than a political one. It takes completely Cromwell’s perspective. He can be called the architect of a more modern England. Why am I reading this? One of the subjects I am particularly interested in is politics. Even though personal opinion or subjective market assessment is not important for our rule-based strategies, I like to understand what is happening around me – closer or further away. Now and then it is also good to get away from the daily news stream and read something completely different. The Mantel trilogy is just the right thing for that. The most amazing thing is how many parallels there are to today’s politics and society. The trilogy is also about Brexit. The Brexit of that time, however, was that England renounced the Church of Rome. At that time England was also afflicted by epidemics. But 500 years ago it was not Corona, but sweating fever and the plague. The methods of coping with this epidemic were very similar to the current methods at that time: one isolated oneself. Also, nowadays much-discussed fake news played a big role 500 years ago and was an essential instrument of many political actors. The book is free of historical kitsch and written in a very modern way, it completely captivates you, also because the political methods of the past are very similar to those of today. Fortunately, political failure today leads at most to political insignificance and does not end up on the scaffold. Today, large sections of the population complain about technological and social change, feel driven and uprooted, and would rather return to a supposedly more manageable time. The astonishing thing is that this was already the case back then. Rationally speaking, however, the upheavals 500 years ago were much greater. And this is brought out very well in the book.
Hill: Thank you very much for the interview.
Paladin Quant GmbH: https://paladin-am.com/anlagestrategien/paladin-quant/