The Hedge Fund Truth - Launching and Running a Small Fund

The wintry weather of the last several weeks has left me particularly punchy and bored, which of course means I had ample time to create yet another animated video blog for my series "The Hedge Fund Truth." This week it is time for managers (and potential managers) to hear what may be some painful truths about launching and running a small hedge fund. 

In recent years, it seems new funds have been met with a collective "Meh" from the investor marketplace. As we saw in last week's blog, roughly 90% (or more) allocations continue to flow to large, established firms. So what does it take to launch a hedge fund, or any new alternative investment fund, for that matter? Are there non-negotiable keys to success? How should a new manager approach fund raising? Is seeding an option? This 9-minute video attempts to answer some key questions. 

Pattern Recognition May Make You Poorer

As I was trapped in my Nashville home awaiting rescue after Snowpocalypse 2015 from one of Tennessee’s (not kidding) FIVE mid-state snowplows, I watched a lot of television, ate a lot of carbs and tried to fight off scurvy with gin and tonics and a splash of precious lime juice. But at some point, in between re-runs of Shawshank Redemption, Aliens and The Matrix, I was struck by the increasing mainstreaming of behavioral finance.

An advertisement for the Chevrolet Colorado, what is known in the Deep South as a “Big ‘Ol Truck,” highlighted a series of focus groups weighing in on the characteristics of two men, Truck Guy and Sedan Guy. 

Truck Guy and Sedan Guy from Chevy Colorado Commercial

Now, of course Truck Guy and Sedan Guy are, in fact, the same person, but groups of children, adults, single women, bearded men and old folks were asked to describe the characteristics of each man. The result? Truck Guy was rated as 85% more handsome, 76% more resourceful and 100% more likely to have an “awesome pet” than Sedan Guy.

While it may seem like a silly commercial, and obviously one geared towards my fellow Southern brethren, the reactions of the Chevy focus groups were not unlike the biases displayed in other walks of life. Like it or not, pattern recognition and its resultant behavioral biases are active in every decision you make. Unfortunately, in investing, it may be making you poorer.

Pattern recognition, in particular template matching, is the process by which our brains save time. The brain, which consumes more energy than any other organ in the human body, tries to expend the least energy possible to process data and make decisions by taking incoming sensory data and comparing it to what has already been stored in our memory. Hence why a simple picture of Truck Guy elicited judgments about his character and choice of dog when he was otherwise wholly unknown to the focus groups.

It's true pattern recognition can be beneficial – after all, it would be time consuming and exhausting to start over fresh with each new data set all the time a la 50 First Dates – it can also stand in the way of innovative and profitable thinking. In investing, for example, pattern recognition may impact where you direct your capital.

Let’s consider capital flows of assets into hedge funds, venture capital and private equity.

Hedge Funds – In 2014, 86.9% of asset flows went to funds with more than $1 billion under management per HFR. The “Billion Dollar Club” is approximately 500 funds out of an overall universe of roughly 10,000 funds. Per Pensions & Investments, the 25 largest hedge funds control 46% of all hedge fund assets as of the end of the year.

Venture Capital – Per the Wall Street Journal, venture capital firms raised $32.97 billion in 2014, with a mere 8 venture capital firms of $1 billion in AUM or more accounting for just over one-third of that total.

Private Equity – According to industry watcher Preqin – only 7% of the $486 billion raised in 2014 went to first time funds.

Looking at data like this, it’s clear that investors are thinking along the same lines:

·      I should only invest with firms that are BIG.

·      I should only invest with firms that are old (uh, “established”).

·      I should only invest with firms populated by the pale and male.

To many, this seems like a relatively “safe” approach to investing, along the lines of “No one gets fired for buying IBM.” Unfortunately, it doesn’t leave a lot of room for innovation, eye-popping returns, cognitive diversity and true diversification. So by sticking with these established patterns, what are investors potentially leaving on the table?

1)   Research has consistently shown that smaller funds (particularly on the hedged side) often perform better due to the ability to invest in niche plays and club-sized deals. In an increasingly volatile market, smaller funds may be able to be more nimble and liquidate positions in a pinch more easily than larger funds.

2)   Research has also shown that younger firms may post higher returns as well, due in part to the smaller fund sizes above as well as a smaller safety net provided by management fees.

3)   Research has shown that inclusion of women and minorities may increase returns, in some cases substantially. This cognitive and behavioral alpha may not be available, or may be available only in a limited fashion, at the industry’s largest firms. In addition, a lack of diversity at the fund management level may result in less diversification of deals, stocks, ideas and positions, creating additional correlation within a portfolio. In short, investors may not be as diversified as they think they are if all of their managers think alike.

At the end of the day, pattern recognition has created wealth, but it also leaves money (and risk) on the table. It seems to me that we could all be better off, richer and get better gas mileage if we left our prejudices at the door and just rode with Sedan Guy for a while. 

What “How I Met Your Mother” Can Teach Us About Hiring Fund Raising Staff

As regular readers of my blog know, once a month I try to offer some unsolicited advice to fund managers out on the capital raising trail. Today, I want to tackle the touchy topic of how to hire a great fund marketer.

Fans of “How I Met Your Mother” are likely familiar with the Vicki Mendoza line and its impact on Barney’s decision making. Leaving aside Barney’s oh-so-politically-incorrect humor on dating for a moment, it is possible to apply his matrix-based decision-making to other areas of life, like, for example, choosing a fund marketer.

The Contacts/Context Graph for Fund Marketing Success.

Hiring a marketer (or negotiating salary/bonus?) Where do you fit? (c) MJ Alternative Investment Research

On the Y-Axis I have created a Contacts scale. This measures the relative strength of the contacts your potential marketer is bringing to the table. Please note that the scale starts at 2 because, frankly, for the right price, anyone can obtain a list of investor targets from any number of sources. If that’s news to you, try Googling “Investor List” and you’ll be shocked by what you can buy.   

Of course, there are contacts and then there are contacts. With lists easily available (and potentially overused and/or out of date), it is important to judge the quality of the contacts, not just the quantity, as well.

• I started with a basic list as a 2.
• A good list with some personal (not just purchased or Googled) contacts gets a 4 to 6.
• Because it’s important not just to know investors, but to know the investors who match well with the fund’s strategy and life cycle, a robust list with at least some relevant personal contacts (e.g. the right type of investors for your fund, be they individual investor, family office or institutional) gets a 6 to an 8. After all, an emerging manager who hires a public plan marketing specialist may have difficultly quickly securing the early capital they need.
• Finally, an outstanding list with deep, relevant, personal contacts who have a history of investing with the marketer gets an 8 to a 10. 

The X-Axis is the Context Scale - how this individual fits in the context of my firm. Unfortunately, I had to start this scale with a -2 since there are some hires that are not only not a great fit with your organization, they are actively bad for your firm.

For example, I still remember the marketer I met more than 10 years ago who, after unsuccessfully pitching me in 5 minutes at an Opal conference cocktail hour said, and I quote, “Well, I’m here to raise assets, not to make friends. I’ll catch you later.” Or the guy who called me and my staff at Van Hedge on Fridays to ask if we were ready to invest yet. Every. Freaking. Friday. As a result of his calls, spontaneous laryngitis was common and highly contagious in our office at the end of each week.

Rest assured, folks like those will not only be unsuccessful at raising assets for your firm, they will also actively diminish your brand and reputation in the industry.

Think of it this way: I still remember the exact words from these guys after more than a decade. And while I am occasionally accused of being a little Rain Man-esque when it comes to facts, I can assure you that a bad impression lasts a really long time, no matter who you are.

The Context scale attempts to measure a number of things: sales skill, their personality fit in the overall make-up of the firm, willingness to pitch in outside of their domain, knowledge of the strategy and industry, attention to detail, compliance focus, proactive versus reactive nature, organizational skills, etc. It’s a broad scale, and I would suggest that before you start looking for a marketer you think about what elements of Context are most important to you and your firm.

So, let’s get down to brass tacks.

• If a potential hire scores below 0 on the Context line, they are firmly in the NO GO ZONE. No matter what their Contacts score look like.
• Below a 5 on both scales is what I call the Danger Zone. This may be a decent hire, but you should watch for friction within the organization and/or longer-lead time sales. A large part of their success will depend on attitude, general people skills and EQ.
• Above a 5 on the Contacts line but below a 5 on the Context line and you should consider hiring the individual as an outside contractor or a third party marketer (3PM). This will minimize friction in the organization (and any blowback outside the firm) and allow you to still capitalize on the marketer’s contacts.
• A 5 to 10 on the Context scale but low scores on Contacts means the person could be an excellent fit for the organization, but perhaps not the best marketer. They could be a tremendous addition to another area of the firm (investor relations, operations, entry level marketing) but will need time to build relationships and “season.” Understand that if you make a marketing hire in this zone, patience will likely be required.
• The Safe Zone contains good hires. They may be slower to fit in or to close business, but chances are they will get there.
• Between an 8 and a 10 on the context scale and a 6 to 8 on the contacts scale you’ll find Really Good Marketing Hires.
• If someone scores between an 8 and 10 on both scales, you should give them equity and encourage them to work at your firm forever. Actual golden handcuffs may be required.

Even, if you aren’t looking to make an internal hire, the Contacts/Context matrix works for third party marketers as well. We all know that 3PMs don’t always have the best “street cred” in our industry, but there are good choices out there. Select candidates using the Contacts/Context criteria and then rank further based on things like retainer, length of contract, trailing commission, geographic focus, etc.

Of course, there are exceptions to every rule, matrix and formula, but at least thinking through the issues raised by the Contacts/Context Matrix before making an internal or external hire should help you position your fund well above the Midas Line. 

Don’t Listen to Greg Weinstein

In the 2000 movie release “Boiler Room” Greg Weinstein (in)famously talked about how to sell stocks to women. His advice? Don’t.

“We don't sell stock to women. I don't care who it is, we don't do it. Nancy Sinatra calls, you tell her you're sorry.” – Greg Weinstein

While I’m not on a Hollywood big screen, I am here to tell you this: Greg Weinstein is a moron.

Let me give you a few facts about women, wealth and investing.

• Studies have shown that women control 51.3% of personal wealth, and that number is expected to grow to 66% by 2030;
• U.S. women are an economy equal in size to the entire economy of Japan;
•  Women make up 47% of the top wealth holders in the U.S.;
• Women are either the sole decision maker or an equal decision maker in up to 90% of high net worth households;
• A 2014 MainStay Investments study showed that 89% of women who had invested in alternatives had a positive experience and that 27% of women (compared with 20% of men) are looking towards alternative investments; and,
•  High net worth women are more likely to invest in alternative investments. According to a 2015 CNBC article women are “three times more likely to invest in hedge funds, venture capital and private equity and twice as likely to invest in commodities and precious metals.”

Affluent women are a powerful and growing force in the alternative investment investor landscape.

According to a 2014 Preqin report, high net worth investors account for 9% of hedge fund investors by type and 3.6% of the total assets in hedge funds. For many emerging hedge funds, high net worth investors comprise up to 100% of their assets under management. High net worth investors are therefore a critical part of the alternative investment investor-verse.

One final fact: Preqin released statistics on Monday showing that assets under management in alternative investments (including hedge funds, private equity, real estate, private debt and infrastructure) has grown to $6.9 trillion dollars.

If high net worth investors account for 3.6% of the AUM in alternatives, then nearly $250 billion of all alternative investment assets come from their pockets.

If women are sole or equal decision makers in 90% of high net worth households, then women control or influence nearly $225 billion of alternative investments.

As managers struggle to raise assets, as RIAs and CFPs look for new clients, as first funds look to launch, there should be a concerted effort to integrate this significant segment of the investor-verse. Failure to do so is not just short sighted, it’s also business-limiting.  

If you haven’t started thinking about how you can attract female investors, it’s time to start. I attended a women and wealth conference in New York last week. There were only three men in attendance. One was a speaker. One worked for another speaker. I didn’t get a chance to meet number 3, but suffice it to say that, based on my experience last week, it seems the emerging market that is women is continues to be overlooked by the financial services industry.

Wake up, y’all. Greg Weinstein was wrong.

Sources: Fara Warner: “Power of the Purse” & the American College of Financial Services, IRS, Bank of America Merrill Lynch, CNBC, Preqin)

#SaveTheEmergingManager

Recent asset flow patterns and fund closures reveal that small (and new) hedge funds may be on the endangered species list. Recent data shows that funds need at least $250 million to break even, and even that may not be enough to successfully run a business. But if small hedge funds go the way of the dinosaur, what happens to structural alpha? Will niche investments, club deals and micro-caps be permanently overlooked? Where will investors look for outsized returns and differentiated portfolios?

Recent asset flow patterns and fund closures reveal that small (and new) hedge funds may be on the endangered species list. Recent data shows that funds need at least $250 million to break even, and even that may not be enough to successfully run a business. But if small hedge funds go the way of the dinosaur, what happens to structural alpha? Will niche investments, club deals and micro-caps be permanently overlooked? Where will investors look for outsized returns and differentiated portfolios?

New Year’s Resolutions for Investors and Managers (Part Deux)

Last week I directed everyone’s post-holiday attention to making New Year’s Resolutions for investors. Now that everyone has had a week to digest those mantras, get over the soreness you inevitably felt after hitting the gym (for the first time in 12 months) diligently, and have balanced your ketones after a week of low-carb, New Year dieting, I thought it best to turn attention to resolutions for money managers.  If you missed last week’s post, you can find it HERE. For those of you still looking to make a few investing resolutions for 2015, read on.

Money Manager Resolutions:

I resolve to create a business plan around capital raising – Raising and maintaining assets under management has perhaps become as critical as performance. Don’t believe me? Look at recent fund closures. Paul Tudor Jones just announced the shuttering of his longest standing fund, which at $300 million was absorbing a disproportionate amount of firm resources. Merchants Gate, which peaked at $2.3 billion in AUM, decided to close as assets shrank to $1.1 billion, despite above average performance. Woodbine Capital closed after assets dipped to $400 million. Indeed, during the first half of 2014, Hedge Fund Research (HFR) reported that 461 funds closed, which was on pace to equal or exceed the worst year on record for hedge fund liquidations: 2009.

While many people believe that hedge funds “fail” in a blaze of glory a la Amaranth or Galleon, most hedge funds die a death of 1,000 cuts, either never gaining enough performance traction or amassing enough assets to create a sustainable business. According to a 2012 Citi Prime Services report, hedge funds now need between $250 million and $375 million just to break even, and the relatively large closures listed above make me believe the number may be closer to the higher end of that spectrum.

So, with ten hedge fund firms accounting for 57 percent of asset flows in 2014, what’s a fund to do? At the very least, make a plan. If I’ve said it before, I’ll say it again: Your capital raising efforts should be executed like Sherman marching through Georgia in 2015.

We all talk about the “business and operational risk” in hedge funds, and I, for one, would include an effective capital raising (and retention) strategy as one of those risks. Without an effective asset raising campaign, a hedge fund manager may have to:

1)   Spend more time on capital raising, potentially taking time away from generating strong performance;

2)   Worry more about redemptions. Any redemption payouts will likely have to be liquidated from the active portfolio, potentially compromising returns;

3)   Lower the investment minimum so investors will invest (and not be too large of a percentage of the fund). Sure, more investors is great, but client communications will also take more time;

4)   Constantly assuage investor (their own and their employees) fears about the long-term sustainability of the fund.

In 2015, make a plan for capital raising. Pick three to four conferences with a high concentration of potential investors and really work them. Get on the speaking faculty. Get the attendee list in advance and set up meetings before you arrive. Have great materials available. Practice your elevator pitch. After the event, have a plan for follow up. Write great investor letters. Polish your performance template. Host a webinar on your strategy. Hire a writer/capital raiser/graphic designer or whatever you need to fill in the gaps. People are already predicting 2015 will be a worse year for hedge fund closures – Let’s prove folks wrong. 

(NOTE: This does not mean I don't think there is still a place for small, niche funds. If a manager is content and profitable and generating returns smaller, that's fantastic, and needed in the industry). 

I resolve to find my own niche, but not tell everyone I’m the only one there – If I read the words “Our competitive advantage is our fundamental, bottoms-up [sic] stock picking” one more time, I will put out my own eye with a pencil. It’s very hard for a traditional stock picker to demonstrate alpha right now, so you must find, demonstrate and articulate an edge.

The fact is, many of the investors to whom I speak have vanilla investing covered. Whether it’s equities, private equity or credit, if it ain’t something they can’t do themselves, they aren’t likely to invest. If you do something really unique or spectacularly well, make sure you highlight that in every conversation and in all of your marketing efforts. For example, I’ve seen managers with great equity strategies market themselves as simple long/short funds, when in fact there is much more meat in their burger. Don't hide your light under an anemically worded bushel.

With that being said, I think if I hear “I am the only one who is long ________ now” one more time, I will poke out my eardrums with a number two pencil. Hubris is never attractive, and it can result in some spectacular losses. Just ask Long Term Capital Management.

At the end of the day, you often need other folks to figure out the equation (although preferably after you do) in order for your ideas to generate returns. If no one else ever unearths your undiscovered company, or piles into energy, or gets on your disruptive bandwagon, you’ll end up holding a nice position at par for a really long time. Not as attractive, eh? Explain why you're early in, but also why others will eventually get the memo for the best results.

I resolve to stick to my guns – This one may be tough. With the amount of pressure on money managers to outperform, avoid all losses, lower fees and generally walk on water, it can be hard to stay with a strategy that hasn’t been shooting the lights out, hold the line on fees to protect a fund’s long-term viability or not branch into strategies where expertise may be lacking. It’s also a fine line between maintaining conviction and riding an idea or stock to the bottom. For the most part, trust what you know. Explain when you have to. But always at least listen to what others and your intuition are telling you. 

Wishing all of us a safe, happy and prosperous year!

New Year’s Resolutions for Investors & Managers (Part One)

As we enter 2015 refreshed from vacations, overstuffed with tasty victuals and perhaps even slightly hung-over, it’s time for that oh-so-hopeful tradition of New Year’s resolutions. Many of you probably resolved to spend more time with your family, eat better, exercise more, floss daily, or to give more to charity. Despite what the research says, some of those resolutions may even stick. So before the holiday afterglow completely fades, I would like to turn attention to some investing resolutions, designed to bring more (mental) health, wealth and happiness in 2015. Without further ado, here are my top three New Year’s resolutions for investors. (Due to the length of this post, I’ll cover money manager New Year’s resolutions in next week’s blog.)

Investor Resolutions for 2015

I resolve to not confuse absolute and relative returns – When you profess to want “absolute returns” you do not get to invoke the S&P 500 in the same breath. In 2014,  “absolute return” came to mean “I expect my investments to absolutely beat the S&P 500” or “My investments absolutely cannot lose money (or I will redeem them at my first opportunity).”  

Absolute returns actually means you make an investment in an asset class or strategy and then you judge whether you are happy with those returns based on absolute standards. Did the strategy perform as expected, based on returns, volatility, drawdown, and/or diversification? Do I still believe in this strategy or asset class going forward? If there was a loss, do I believe this is a substantial, long-term problem or is this a buying opportunity? Trying to turn absolute investments into relative investments after the allocation fact causes a lot of knee-jerk investment decisions, leads to return chasing and, ultimately, underperformance.

I resolve to not get tied up in my investing underpants – This probably needs some explanation because I do not want any of my blog readers to Google “tied up in underpants”  - the answers you get will absolutely not be suitable for work.

Instead this (quaint?) colloquial saying basically means that you shouldn’t get so wrapped up in perfecting the small things (underpants) that you can’t get to the big stuff (getting dressed and leaving the house).  For example: “That meeting was worthless. We spent all morning tied up in our underpants about where to get lunch and we didn’t address the sales quotas.” For non-Tennesseans, the less colorful turn of phrase would involve forests, trees and all that.

When it comes to investing, there are any number of “underpants issues” with which to deal. Fees are a great example. Every time someone wants to argue with me on Twitter about alternative investments, they inevitably start with “You don’t have to pay 2%/20% to [get diversification, manage volatility, achieve those returns, etc.]."

It’s always interesting to chat with these folks about what they think an appropriate fee structure would be. Most people say they are willing to “pay for performance.” And in fact, perhaps with the exception of investments into a small number (less than 500) of “billion dollar club” funds, you are.

Since more than half of all funds have less than $100 million in AUM, it’s pretty difficult for the bulk of funds to get rich from a management fee alone. Management fees tend to be, on average, around 1.6%. In comparison, mutual funds charge between 0.2% (index funds) and 2% in management fees, with the average equity mutual fund charging, according to an October 6, 2012 New York Times article, around 1.44%. Not that different, eh? As for the incentive fee, that only gets paid if the manager makes money. It’s designed to align interests (“I make more if you make more”), not steal from the “poor” and give to the rich. Perhaps a hurdle makes sense, but why dis-incent a manager entirely?

At the end of the day, this laser focus on fees hampers good investment decision-making. We run the risk of focusing too much on what we don’t want others to have than on what we might get in return (diversification, a truly unique or niche strategy, reduced volatility, expertise, returns). We run the risk of negative selection bias (with managers and with strategies) if we choose only low fee funds. We also risk dis-incentivizing smaller, niche-y and more labor-intensive start-up funds, which could completely homogenize the investment universe.

Is there room for fee negotiation? Of course. I am a big proponent of sliding scales based on allocation size or overall AUM. However, making fees your sole decision point is, I believe, penny wise and pound foolish over time and will leave you, well, tied up in your underpants.

I resolve to take a holistic approach to my portfolio – Say this with me three times “I will not chase returns in 2015. I will not chase returns in 2015. I will not chase returns in 2015.”

Why should auld performance be forgot? Let’s look at managed futures/commodity trading advisors. It hasn’t been an easy ride for macro/futures funds. In 2012, they were the worst performing strategy according to HFR. In 2013, they were edged out of last place in HFRs report by the Barclays Aggregate Bond Index, but still under performed all other hedged strategies. The last two years saw heavy redemptions, with eVestment reporting outflows from Managed Futures funds for 26 of the last 27 months.

And in 2014? Managed Futures killed it.

Early estimates from Newedge show that Managed Futures funds returned an average of 15.2% in 2014. January 2015 predictions are that Managed Futures will either win or place amongst top strategies for 2014.

It’s always tempting to dress for yesterday’s weather, but savvy investors look not just at what’s performed well, but where there are future opportunities and potential pitfalls. Even an up-trending market, maybe especially in an up-trending market, it’s important to look to out-of-favor and diversifying strategies, niche players and contrarians to create a truly “all weather” portfolio.

Stay tuned for money manager resolutions next week, and in the meantime, best wishes for a Happy Investing New Year.

In Case You Missed Them - 2014 Blogs By Topic

In case you missed any of my snappy, snarky blogs in 2014, here is a quick reference guide (by topic) so you can catch up while you gear up for 2015. My blog will return with new content next Tuesday – starting with my "New Year’s Resolutions for Managers and Investors."

“How To” Marketing Blogs

http://www.aboutmjones.com/blog/2014/12/8/anatomy-of-a-tear-sheet

http://www.aboutmjones.com/blog/2014/11/12/emerging-manager-2015-travel-planner

http://www.aboutmjones.com/blog/2014/10/21/conference-savvy-for-investment-managers

http://www.aboutmjones.com/blog/2014/9/11/ten-commandments-for-pitch-book-salvation

http://www.aboutmjones.com/blog/2014/7/18/emerging-managers-the-pitch-is-back

Risk

http://www.aboutmjones.com/blog/2014/11/10/look-both-ways

http://www.aboutmjones.com/blog/2014/11/3/the-honey-badger

General Alternative Investing

http://www.aboutmjones.com/blog/2014/10/25/earworms-and-investing

http://www.aboutmjones.com/blog/2014/10/7/alternative-investment-good-newsbad-news

http://www.aboutmjones.com/blog/2014/9/17/pay-what

http://www.aboutmjones.com/blog/2014/7/21/investing-and-the-law-of-unintended-consequences

 “The Truth About” Animated Blogs – Debunking Hedge Fund Myths

http://www.aboutmjones.com/blog/2014/10/13/the-truth-about-hedge-fund-correlations

http://www.aboutmjones.com/blog/2014/9/6/the-truth-about-hedge-fund-performance

http://www.aboutmjones.com/blog/2014/8/8/the-truth-behind-hedge-fund-failures

Diversity Investing

http://www.aboutmjones.com/blog/2014/12/8/getting-an-edge-in-private-equity-and-venture-capital

http://www.aboutmjones.com/blog/2014/11/21/the-simple-case-for-emerging-managers

http://www.aboutmjones.com/blog/2014/9/29/mi-alpha-pi-a-look-at-the-sources-of-alpha

http://www.aboutmjones.com/blog/2014/7/21/affirmative-investing-putting-diverse-into-diversification

Private Equity and Venture Capital

http://www.aboutmjones.com/blog/2014/12/8/getting-an-edge-in-private-equity-and-venture-capital

Emerging Managers

http://www.aboutmjones.com/blog/2014/11/21/the-simple-case-for-emerging-managers

http://www.aboutmjones.com/blog/2014/11/12/emerging-manager-2015-travel-planner

http://www.aboutmjones.com/blog/2014/9/29/mi-alpha-pi-a-look-at-the-sources-of-alpha

http://www.aboutmjones.com/blog/2014/8/25/submerging-managers

Anatomy Of A Tear Sheet

Having been an investor, a PerTrac employee and a general statistics nerd, I have seen more than my share of performance tear sheets. While some people think of them as unnecessary, I can tell you that a good performance tear sheet can help make the case for an investment in your fund, and can also highlight why an investor should should stay with your fund through tough times. Make no mistake: A strong tear sheet isn't optional. 

Logo - Your entire marketing toolkit, including your tear sheet, needs a look and feel. This is no longer optional. If you want to compete in this industry, your fund has to look like it's part of a viable, successful, long-term business. This ain't the days of two guys and a Bloomberg terminal. If you don't have a logo, get one. And with logos available for under $1,000, there are really no excuses on this front.

Contact information - You would be shocked to see how many folks have no contact info on their materials. People can't invest if they can't find you. Include the contact person's name, email, address, phone, website, Twitter handle and all other pertinent information.

Strategy description and monthly commentary - The strategy description SHOULD NOT say "Our goal is to provide attractive risk adjusted returns over a three to five year period." It should actually say what you do. If there is room, you should have a few sentences about the current month's performance as it relates to your strategy as well. This will not replace your monthly letter to investors, but it will help put the numbers folks are looking at into perspective.

VAMI Chart - a simple Value Added Monthly Index (mountain) chart versus appropriate benchmarks helps people visualize how the fund performs.

Another compelling chart - Depending on the strategy goals and attributes, this could be an up and down market outperformance graph, an underwater chart, correlation analysis, etc. The goal is to visually demonstrate to investors that your fund delivers on its promises (protect in down markets, provide uncorrelated returns, limit drawdowns, etc.)

Monthly and annual returns - Uh, monthly and annual returns. NET OF ALL FEES

Peer ranking - Shows how you do against other funds like you.

Risk/reward table - includes the relevant statistics (CAR, standard deviation, Sharpe, Sortino, maximum drawdown, etc.) versus relevant benchmarks.

Top holdings or attribution - Some type of granularity into the portfolio make-up. Solidifies the strategy in people's minds.

Manager bio - People invest in people, not vehicles. Don't miss this opportunity to connect.

Terms and service providers - If people don't know when they can get in and out of your fund, your fees, your partners (service providers), it's hard to invest.

Explanatory notes - Go to a second page (or the back of the page) if necessary. Do not squish everything else (or make tear sheet sacrifices) to fit in what can be lengthy explanatory notes.

Of course, you don't have to follow this layout exactly, but these elements should be included in some way, shape, form or fashion on any useful and compelling tear sheet. Happy number crunching!

Emerging Manager 2015 Travel Planner

As emerging managers start thinking about capital raising for 2015, it's time to think about travel planning and investor meetings. Even though a recent survey of investors found that two-thirds are willing to meet with a manager in whom they don't plan to invest, who has time for that? To help you on your way, I've created this handy-dandy map of public fund emerging manager interest for your Expedia booking pleasure, along with some (hopefully helpful) notes below.

Arizona - Has made at least one investment in a large 'emerging' manager.

Arkansas - Teachers Retirement System reportedly tabled the program in 2008 but 2011 document shows active investments in MWBE managers. 

California - Looks for EM's based on size and tenure but prohibited by Prop 209 from looking at minority status or gender.

Connecticut - Based on size, minority status or gender. Awarded mandate in 2014 to Grosvenor, Morgan Stanley and Appomattox. 

Florida - Looks at emerging managers on equal footing with other managers. 

Hawaii - CIO has been historically pro-emerging manager. Plus, well, Hawaii.

Illinois - Perhaps the most active emerging manager state, based on gender, minority status and location. 

Indiana - Based on size, minority status, or gender. 

Kentucky - Reported $75 million allocation.

Maine - Has made at least one investment in a large 'emerging' manager.

Maryland - Very active jurisdiction with details available online for gender and minority status manager information.

Massachusetts- Includes size, minority status or gender. 

Michigan - $300 million program.

Missouri - Status based on size. 

Minnesota - Past investments in emerging managers. 

New Jersey - Status based on size. 

New York - Status based on size, minority status or gender. $1 billion mandate in 2014. $200 million seed mandate in 2014.

North Carolina - Status based on size and HUB (minority and women owned) status.

Ohio - Status based on size, minority status or gender. 

Oregon - Emerging manager program in place. 

Pennsylvania - Status based on size with preference for minority or women run funds.

Rhode Island - Plan in place from 1995.

South Carolina - Status based on size.

Texas - Actively engaged with emerging managers. Status based on size, minority status or gender.

Virginia - Status based on size, minority status or gender.

Washington - Has issued prior emerging manager RFPs. 

This information has been culled from some pretty extensive research, a host of conversations and, frankly, just knowing where some of the bodies are buried. Please remember that 'emerging manager" is a term that has a lot of definitions. There may still be minimum size requirements, minimum track record requirements and strategy restrictions.  I will update the map as I get more data. Happy hunting!

Conference Savvy for Investment Managers

As part of my series on fund marketing, I thought I’d take a moment to talk about conferences. You can’t swing a dead cat without hitting a conference these days. There are events at least weekly, if not more often, all vying for your conference dollars and even more precious time. To maximize your conference experience, consider the following:

DO – Be choosy about conferences. Ask to see attendee lists (current or past, with contact info redacted if the organizer is touchy about sharing). Ensure that the audience matches your target demographic. Sometimes the only family office you will see at a conference is in the title of the event. Also, be aware of how many conferences you attend in a year. It was always a due diligence red flag for me if I saw a manager at too many events during a year, both from the perspective of expense management and time away from investments.

DO – Approach conferences with a battle plan. You should work an event like Sherman marching through Georgia. Make sure you get the conference attendee list with your paid sponsorship or registration and schedule meetings BEFORE the event. Have a target list of people you’d like to see in addition to your scheduled meetings. Bring your pitch book and one pager (if applicable) and plenty of business cards. If you are planning a dinner or lunch or golf outing, have the invites out at least 3 weeks in advance for maximum attendance.

DON’T – Stalk people. While this may seem counter to targeting attendees, there is a difference between seeking people out or asking mutual contacts for introductions and tailing people through an event. Once upon a time, there was a conference that offered homing devices to all attendees. It was not unusual to see an investor darting through the exhibit hall with 10 asset managers hard on their heels. It’s like Wild Kingdom - No one wants to be the antelope at the watering hole. Don’t approach people in bathrooms or lie in wait for them outside of lunches or other conference activities.

DO – Practice your elevator speech in advance. You need to be able to clearly articulate your value proposition in a NON-SALESY way. Rehearse a 2-minute and a 5-minute version. Role play with your colleagues how to seamlessly move from talk about a lunch speaker/panel/weather/golf outing into a quick summary of what you do.

DO – Ask questions when talking to your prospects. No one wants to hear a monologue about you or your firm. When practicing your elevator pitch, think of some questions to ask attendees to make the conversation more interactive. If you’ve done your homework on the attendees in advance this should be easy. Search Google for news or their website for RFPs and other information prior to the event.

DON’T – Commandeer your speaker spot (panel or standalone) to talk about your fund. Seriously. People will pass notes or text each other about you in the audience if you do this. Others may walk out. You’ll be known as “that speaker.” If you are lucky enough to get a speaking slot, think about how you can educate the audience. What is happening in the markets? What makes a particular investment strategy interesting? What is the outlook for a strategy? Always educate, never sell. Exception to the rule? Meet the manager, speed dating type of pitch events.

 DON’T – Sit behind your exhibit table if you have one. Stand up and move around in front of your exhibit so you can engage with people. If you sit, the only people that come up will be people that either know you or who want to have a serious conversation. You can miss more casual opportunities if you’re sitting down.

DO – Delegate effectively. If you aren’t a good public speaker and you have one in the firm, select him or her for speaking roles. If someone is better at marketing or capital raising, put them at cocktail parties or at the booth. There shouldn’t be a lot of ego involved in conferences – it’s a job function just like any other. Select the best person for roles to generate the most interest and effectively raise assets.

DO - Agree to follow ups during your conversations. The goal is to move the ball forward and have a plan (and buy in) to send follow-up emails including pitch books, monthly updates, commentary, white papers or other information. If you don't have a plan to continue forward momentum, you might as well not have gone to the conference at all. 

Stay tuned in November for more unsolicited fund raising advice!

Alternative Investment Good News/Bad News

Good News

According to HFR, emerging managers performed best during last 12 months, gaining 11.3% through 1H2014.

Diversity funds (women and minoirites have outperformed the HF universe at large during the last 12 months, gaining 11.1% through 1H2014

Marco/CTA funds led performance in August 2014. The beginning of a comeback?

Pattern recognition helps PE and VC firms recognize successful investments?

Seven high quality hedge fund start ups launching in London

CALPERS sticking with Private Equity despite "complexity and fees."

Companies founded by women yeild 12% more for their VCs and use 1/3 less capital

IFK will welcome two women to the stage in 2014, Nehal Chopra and Nancy Prial.

Hedge fund liquidations declined in 2Q2014 according to HFR.

Skill is back? Fed says "moderately active" outperforms passive investments.

NY Common's equity hedge managers exhibit "above averages stock selection skill.

Bad News

The largest, most established U.S. based hedge funds control more assets than ever before, with $1.8 trillion as of July 2014.

Many women and minority led hedge funds continue to struggle with AUM, and therefore face the same fund flow problems as other emerging funds.

156 trend following CTAs liquidated, the first decline in the number of CTAs since 2005.

But keeps VCs from hiring women & minority staff and investing in diverse founders?

Not a single female manager listed among them.

CALPERS decision to exit hedge funds used as a club in the fee war.

Women run companies received just $1.5b out of a possible $50.8 billion from VC firms

In the previous five years, only one woman, Meredity Whitney, had been included.

Trailing 12 month liquidiations was still the highest it has been since 2009.

Blackrock research shows "alpha trades" don't work.

Articles on HFs still act as if beating the S&P 500 is relevant.

Mi Alpha Pi – A Look At The Sources of Alpha

While at the Grosvenor Small and Emerging Managers Conference last week in Chicago, I started thinking about alpha. Despite all of the naysayers out there quick to announce the death of alpha, I would actually suggest that alpha is alive and well and living in many portfolios. I think maybe investors, quick to flock to a very concentrated handful of extremely large funds, have forgotten where alpha lives and what drives alpha. 

For that reason, I’d like to announce the formation of a new co-ed fraternity. A fellowship, if you will, called Mi Alpha Pi. Mi Alphas have no dues and no secret handshake. We are merely called upon to remember that alpha comes in different size funds, diverse managers, life cycle investing and from innovators. 

MI ALPHA PI

WHERE DOES ALPHA COME FROM?

Skill – Obviously, this is what we want in all of our hedge fund managers: the ability to find and make the most of investment opportunities. Skill comes from a variety of sources. Intelligence, experience, intuition, emotional awareness and other factors contribute to manager skill. Skill is long-term and must be judged in a variety of market environments, good and bad. And in Mi Alpha Pi, we don’t believe that short-term losses necessarily are indicative of loss of strategic acumen. We even have special hazing for investors that think that way.

Cognitive Alpha – Cognitive alpha comes from being able to think about the markets and investing differently than your investing peers. Instead of looking at Apple and AIG along with every other large hedge fund, these managers look outside the box. Many investors have a tendency to be heavily influenced by market news and earnings and, over time, buying attention-grabbing stocks has a tendency to diminish returns. How do you find cognitive alpha? Look to contrarians, women and minority run funds for less homogenized thinking.

Structural Alpha – There has been a plethora of research, including my own at PerTrac, that suggests smaller, emerging managers outperform larger, older funds. One of the reasons why this may occur is what I will call “structural alpha.” When a fund is small it can take advantage of niche plays and club-sized deals that larger funds may ignore. They also may have fewer issues with liquidity, volume and short-squeezes. As a result, emerging funds may be able to exploit their smaller structures to produce outsized gains.

Behavioral Alpha – Although it’s difficult to separate behavioral alpha from cognitive alpha, I think it is an important distinction. Cognition is how you think about the world, while behavior is what you do with that information. Behavioral alpha may be created by less frequent trading, less inopportune trading and infrequent return chasing. Young funds and women and minority owned funds may be fertile grounds for behavioral alpha.

Luck/Chance – It is difficult to admit that sometimes what we think is alpha is really just luck or chance at work. For example, in the late 1990’s when I first began researching hedge funds, there were a number of funds that had no real shorting skills but that, at the time at least, didn’t need those skills. The rising tide of the bull market lifted all ships, so to speak. However, when the markets broke during the tech wreck, it was quickly evident which hedge fund managers were wearing no clothes, luckily figuratively and not literally. This is why it’s always critical to ascertain whether a manager is riding a good strategy or a good market.

It’s time to look a little further than the 500 largest hedge funds to find excess returns. Finding alpha isn’t always easy, but the 2014 pledge class of Mi Alpha Pi is looking forward to welcoming you. 

Will Accreditation Changes Turn Emerging Managers into Submerging Managers?

Most of my non-industry friends don’t know what I do. They all know that I do research in finance, but to most, my alternative investment research focus is as mysterious as if I was a pre-Snowden NSA operative. This is in part because many of them consider finance to be frightfully dull. However, the primary reason for their lack of knowledge is something called "accreditation."

The SEC restricts data on and investments in hedge and PE funds (as well as other private investments) to those folks that are “accredited investors.” For decades, being an accredited investor has meant either having a million dollar net worth (excluding your primary residence) or an income of $200k/$300k (single/married). These income and net worth standards are used as a proxy for financial savvy. If you have enough in the bank, then you must understand money, the SEC reasons, and therefore you are allowed to take more risks with your cash.

However, even as I type, the Securities and Exchange Commission Investor Advisory Committee is weighing changes to accreditation standards. Some of the considerations on the table include raising the income threshold to $500,000 and the net worth threshold to as much as $5 million. In addition, there has been mention of a financial literacy requirement, such as passing the Chartered Financial Analyst exam. The monetary requirements would wipe out a huge portion of the HNW investor community, while a CFA requirement would take out a significant portion of the rest. For example, increasing the net worth requirement from $1 million to just $2.5 million would reduce the accredited HNW investor base from 8.5 million to 3.4 million people according to some studies. (http://www.cnbc.com/id/101933881)

While I understand the urge to “protect” investors, I happen to think these changes are unwarranted and may potentially have a significantly negative impact on innovation and diversity, and ultimately returns, within the alternative investment industry. And frankly the proposed changes just raise a lot of questions for me.

Why this particular threat?

There are a number of financial arenas in which enhanced knowledge, wealth or sophistication could make a material difference in outcomes. For example, according to one study, 15% of all bankruptcies are caused by credit debt, including credit cards, large mortgages, and car payments (http://assets.clearbankruptcy.com/infographics/leading-causes-of-bankruptcy.jpg).

In 2010, there were nearly 1.6 million bankruptcies. So approximately 240,000 Americans potentially could have avoided bankruptcy if the government controlled how much credit one could obtain, how much creditors could extend, or how well people have to understand credit before taking on such burdens.

Likewise, look at day traders. In order to manage a pattern day trading account, one must maintain a mere $25,000 balance. Yet, one study showed that four out of five day traders lose money, while another determined only one out of every 100 day traders consistently make money. Let’s assume that roughly 10,000 people in the U.S. day trade as their primary job. Of those professional day traders, 100 consistently make money and the other 9,900 consistently lose. Why not regulate this more closely? Maybe require a CFA?

And don’t get me started about gambling or the lottery. According to a Gallup Poll on Gambling, 57% of American adults reported playing the lottery in the last 12 months, with 65% of those falling into the $45,000 to $75,000 income bracket (http://www.naspl.org/index.cfm?fuseaction=content&menuid=14&pageid=1020#LotteryOdds) Your chances of winning the lottery? Less than getting injured by your toilet this year, according to National Geographic. How many folks do you think really understand those odds?

Hell, the average investor can contribute to a Kickstarter campaign for potato salad (over $40,000 raised) or a Chipolte burrito ($1050) which are both completely stupid investments AND utterly unregulated. Or what about Bitcoins? Mt. Gox lost over $409 million for its clients.

In short, there is no end to the ways you can “invest” your money. And any way you slice it, there are plenty of ways that these investments can destroy your wealth. Why doesn’t the federal government care about the “sophistication” required to understand, withstand and mitigate other "investment" risks, particularly ones that have a lot lower chance of success?

Isn’t this a self-limiting problem?

 If this is aimed specifically at hedge funds and private equity, the issue of high net worth investors putting all of their cash into “risky” investments is somewhat limited by the structure of the funds themselves. With high investment minimums (generally between $250,000 to $1 million), it is unlikely that a “lower level” high net worth investor will be able to make more than one investment, if that. For some who are early stage “friends and family” money, those investment minimums may be waived, but then the potential “damage” is mitigated as well. Most managers don’t want a fund filled with small investors (more work, less capital), so they tend to limit small investments. The market forces alone seem to be pretty efficient at limiting the hedge fund investments of your average millionaire in this case.

Won’t this submerge emerging managers?

 One of the arguments to make these accreditation changes is that no one has really squawked about them yet. Of course, this doesn’t take into account that the funds that have the financial wherewithal to actually make a fuss probably won’t even notice. There are about 500 funds that have more than $1 billion or more under management. There are about 5,000 funds that manage less than $100 million. As you look across this size spectrum of funds, the importance of the high net worth investor decreases as the size of the fund increases. Generally speaking, larger funds tend to be better influencers and squeaky wheels. Its likely HNW investors just aren’t a very important part of a large fund's business model any more.

And for those that say HNW isn’t important to the entire industry, it is true that about 65% of the AUM in the hedge fund industry now comes from institutional investors. It’s also true, however, that virtually none of that is in the emerging fund (small, new, women or minority owned) manager category. The 35% of assets that are controlled by HNW and family offices remains vitally important to this group of fund managers. Without access to a significant pool of HNW capital, and specifically early stage “friends and family” capital, many emerging funds might never, well, emerge.

Why do we care? Smaller managers can produce higher returns. Smaller managers can provide liquidity to parts of the market that are ignored by larger funds. Smaller funds may innovate where larger funds may care-take. Limiting opportunities in the emerging manager space is a key step towards the homogenization of the industry.

Will there be any unintended consequences?

Angel investors who help small businesses launch, fund innovation and create jobs would be swept up in this as well.

Of course, I imagine the SEC cares about as much about my opinion on accreditation as my non-industry friends do. So after today's blog, I'm only talking about beer, boats and BBQ. At least until after Labor Day. Enjoy the long weekend, y'all!

Unsolicited Advice: The Pitch is Back

I've decided to dedicate one blog per month to providing unsolicited capital raising advice. This is the first in the my "Two Cents From The Peanut Gallery" asset raising series. 

Over the past three years, I have had the opportunity to speak with more than 200 emerging managers about their marketing efforts. In my prior life, I was engaged in manager selection for a fund of funds. Needless to say, I’ve seen a lot of pitch in my day. And unlike pop music, for emerging managers there ain’t no auto tune when it comes to finding the perfect pitch.

During the actual pitch or in the midst of a capital raising triage exercise, I often hear the same refrains:

“We haven’t focused on our pitch book.”

“We have a pitch book, but we really don’t use it.”

“No one is going to invest with us because we have a good pitch book.”

And I couldn’t disagree more. A very good, if not great, pitch book isn’t a “like to have.” It is a “need to have.” And here’s why:

1)   Your pitch book helps you refine your message. Many of the managers I worked with who chose not to focus on their pitch book gave disjointed or rambling presentations in person. It wasn’t at all unusual for a manager to get caught up on their bio for example, and skimp on telling me about their secret investing sauce. Thinking through and honing your written pitch establishes a cadence and sequence to your fund raising message. It’s also what helps you refine your message so you can clearly articulate your competitive advantages. Having a pitch book in this case isn’t about taking potential investors on a death march through the deck, it’s about taking the time to think about what you want and need to say to differentiate your fund, while checking all the boxes you know investors care about.

2) Your pitch book helps an organization “sing from the same hymnal.” It’s true that many emerging fund managers may be simultaneously wearing their fund’s money management and marketing hat. It’s also true that lean emerging fund organizations usually draft a variety of players into roles outside of their core competency. I have often seen emerging hedge funds where the portfolio manager(s), IR staff and CFO’s all get into the fund raising game. Having a strong pitch book helps anyone from your organization that finds himself or herself in front of a potential client tell the same story. Otherwise, each individual is likely to spend the entire meeting focused on what they know, and not make the key points that generate investor interest.

3)  Your pitch book works for you when you’re not there. Investors get hundreds of pitches from emerging managers. Sometimes a manager gets a full hour of undivided attention, and sometimes you get a scant 20 minutes at a “meet the managers” event. Often, emerging fund managers may get only a few minutes of distracted attention at a cocktail party or industry luncheon. Whether you get an hour or 90 seconds, the pitch book you provide during or after this meeting is your fund raising proxy. If you have a great deck that clearly articulates your competitive advantages, your performance, your strategy and your organization and operational infrastructure, you will have a much easier time getting future meetings and pushing follow up with an investor. If you don’t, getting back off the slush pile post meeting or conference can be difficult.

4) Your pitch book forces you to think about your brand. The emerging manager landscape is like the MMA of the investing world. In the hedge fund space alone, industry watcher Preqin has found the 500 largest managers control all but roughly $33 billion of invested capital (as of June 2014). Today, there are more than 5,000 managers with less than $100 million in assets under management, and on average these funds raised less than $500,000 each in 2013. To say the emerging manager landscape is competitive is hyper-hyperbole. While it is true that no glossy pitch book will make up for lackluster performance, craptastic operational controls or an alpha-less strategy, an institutional quality deck can help differentiate your firm and fund. The mistake many managers make is to think their brand is simply their bio, strategy or performance. It’s not. Your brand is not just the data about your fund, but the way in which you present it. Over the past 16 years, I’ve seen clip art, quote overload, typos and other pitch book missteps not just lengthen the capital-raising cycle, but stop it in its tracks. With online graphic design services like www.logomyway.com and www.inkd.com, and with the increased accessibility of professional design services firms, there’s no excuse for not building a strong brand.

Think of it this way, all other things being equal, an emerging manager who is thinking holistically and long-term about growing a business is more likely to get the investment than one who slaps materials together.

In the coming weeks, I'll be talking about how emerging managers can execute a marketing plan like Sherman marching through Georgia.  In the meantime, don’t forget to follow me on Twitter (@MJ_Meredith_J) for news and views on emerging managers and more.