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."
Wishing everyone a joyous and happy holiday season in whatever flavor you prefer. May 2015 bring everyone nothing but the best things in life.
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!
My gym teacher in junior high was a woman named Mrs. Landers. While I truly hated gym, Mrs. Landers was a godsend to an uncoordinated nerd like me.
You see, Mrs. Landers didn’t put your entire gym class grade in one basket. You got 50 points (out of 100) from “dressing out.” By simply changing from my Molly Ringwald-esque garb into a grotty Northport Jr. High gym-suit, I could get halfway to the “A” I craved. The written test counted for another 20 points. “Hello passing grade!” And I hadn’t even broken a sweat. The last 30 points came from actual physical activity, and admittedly, those I struggled with. But volunteer to put up the volleyball net? Five points. Get Mrs. Landers a diet coke and bag of Frito Lays to eat while she supervised our Jane Fonda workouts? Two points. Inevitably by the end of the semester, I had secured an A in gym without ever hitting, catching or running with a ball.
Finding more than one way to skin a cat is often a recipe for success. Today, Private Equity (an altogether different form of PE) has $1.04 trillion of dry powder, the highest on record according to the Private Equity Growth Council. As a result, there is a need to think creatively to ensure the best possible performance outcome for GPs and LPs alike.
Cognitive alpha does exist in PE and in Venture Capital. There have been studies that show the excess return or alpha of women and minority owned firms in particular within the PE/VC space, although unfortunately there is a very small sample to study. Less than 1% of PE and VC firms are run or heavily influenced by women and minorities, along with less than 0.25% of the assets under management.
And yet studies have shown that this small group “gets ‘er done.”
In one NAIC study of women and minority owned Private Equity, diverse firms delivered 1.5X return on investment versus 1.1X for non-diverse firms from 1998 to 2011. In the RK Women in Alternatives Study I authored in 2014, women-run PE firms outperformed the universe at large by one percentage point in 2013.
Now some would insert a best and brightest argument here: with such a small sample, isn't it only the best and brightest women and minorities that are able to rise through the PE and VC ranks to start a fund, causing the large return differential?
My answer is that I believe the reasons for outperformance go much deeper, well into the realm of behavioral finance. Two possible reasons for strong outperformance are pattern recognition and differentiated networks.
Pattern recognition – Even though our brains consume roughly 20% of the calories we take in, making it the greediest organ in our bodies, it is always looking for shortcuts. One of the ways it conserves energy is through pattern recognition. We tend to look for patterns in data so we can make decisions faster. In PE/VC, that means we look for companies that look similar in some way to past successes, and place our bets with those. Women and minorities may be able to recognize different patterns, allowing for profitable investments that are more “outside the box.”
Differentiated networks – Women and minority owned or influenced firms may be able to find differentiated deals due to expanded or different networks. It’s true that anyone who goes a traditional route to PE or VC has some overlap of network (B-school, analyst training programs, etc.) but even subtle differences in network can lead to differentiated deals with less crowding and less competition.
These two characteristics may help women and minority owned and influenced PE and VC to excel in an environment with a tremendous amount of dry powder. It may also lead them down roads less traveled in PE and VC – towards minority and female founders. A recent McKinsey study of UK companies found firms in the top 10% of gender and racial diversity had 5.6% higher earnings while firms in top quartile of racial diversity were 30% more likely to have above-average financial returns. Both desirable traits in a PE or VC portfolio. However, those firms don’t generally fit into the traditional PE and VC mold, as evidenced by the fact that minority and female owned companies are 21% and 2.6% less likely to get funded, respectively, according to Pepperdine University.
In a world where there is a tremendous amount of dry powder, increasing interest in PE/VC from institutions and individual investors alike, and where returns are, as always, key, every advantage is important. For investors looking for that extra “je ne sais quoi,” women and minority owned or influenced firms may be the ticket. For PE and VC firms looking to get an edge on competitors, diversity hiring could be in order, because unlike my gym class, there are no points awarded for simply getting dressed every morning.
When people ask me why I am such a passionate advocate for emerging managers, I sometimes wax a little poetic. But the fact is, after nearly 17 years in the alternative investment industry, I don't believe any investor can have a truly optimized or truly diversified portfolio without allocations to young, small, women and minority-run funds.
With 90% or more of asset flows going to the "billion dollar club" managers, it would certainly seem others don't share my enthusiasm. However, when you look at the different types of alpha, it seems clear why emerging managers should get more than a fair shake. I'm not advocating avoiding large, successful funds. But by ignoring emerging managers, investors risk removing two important types of alpha from their money management arsenal.
With any size or age fund, or within any manager demographic, it is possible to find funds where alpha is generated by luck. The saying "even a blind pig can find a truffle" exists for a reason. Likewise, there are very skilled managers available in each of the groups above. The cyclicality of investment strategies mean that alpha can be generated by emerging managers in any strategy if market conditions are right.
However, when it comes to structural alpha and cognitive alpha, the rubber hits the road. Structural alpha is created when a fund is young and small enough to be nimble, niche-y, under the radar, concentrated, etc. It would be extremely difficult, if not impossible, for a fund in the "billion dollar club" to exhibit these traits. Cognitive alpha, where a fund generates higher returns because the manager thinks and acts differently than the herd, isn't unheard of in the "billion dollar club," but it is exceedingly rare. Think about how many minority or women fund managers you know with more than $1 billion in AUM.
Small and young funds may exhibit structural alpha and they are also more likely to have diversity managers at the helm that can contribute cognitive alpha. Women-run and minority-run funds may exhibit cognitive alpha, and they tend to be small and/or young funds, so may also display structural alpha. With alpha supposedly an endangered species in today's investing world, can investors really afford to ignore emerging managers?
The MJ Alts blog is on hiatus this week for the Thanksgiving holiday. I invite you to check out previous posts on topics like hedge fund failures, conference tips for managers, diversity investing and more while you slip into a L-tryptophan-induced coma.
Next week the blog returns with a post about where to look for alpha.
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!
Throughout my childhood I owned and rode a bike. In the 70s and 80s, no one gave two figs whether I did so wearing a helmet or not. Seriously, we drank out of the garden hose and trick or treated at houses where we didn’t know people, too. Those were wild and crazy years.
In the 1990’s, however, someone decreed that biking was entirely too dangerous to be attempted without a helmet. I promptly stopped biking. For those of you that have met me, or who have even seen my picture, you probably recall one critical fact about my appearance: I have Big Hair Syndrome.’ And it ain’t fitting under a bike helmet.
Flash forward 20 years and we’re discovering some interesting facts about the bicycle helmet craze. In places where bicycle helmets were required by law, bike trips decreased by 30-40% across all demographic groups and by 80% across secondary school aged girls.
Unfortunately, when people gave up their bikes, they also gave up the health benefits of riding. One study by the Brits suggested that the health benefits (in terms of increased longevity) of riding outweighed the risk of injury by 20:1. A study done in Barcelona put this figure at 77:1. In Australia, they found 16,000 premature deaths caused by lack of physical activity dwarfed the roughly 40 cycling fatalities that occurred each year.
And that’s the curious thing about risk. You can focus on a single risk (in the case of biking, that a head-on collision will occur at 12.5 mph) to the exclusion of all else and actually increase your risk of other types of injury.
This is especially true in investments, where there is no single definition of risk. There are a multitude of risks against which to guard, and most of them have corresponding risks they introduce. For example, if you maximize the risk of illiquidity (the risk that you can’t get to your money when you need it) you may compromise returns. Private equity has been the best performing strategy over the last 10 years, but locks up capital for 5-10 years depending on the fund. Likewise, venture capital, which has been on fire for the last few years, has a 10 plus year lock up. Requiring high liquidity restricts the types of investments you can make, which can impede diversification. More liquid investment structures can have lower returns than less liquid investments because they allow for people to trade at exactly the wrong times. Don’t you know someone who sold his or her mutual funds or index funds at the exact bottom of the market? In addition, there can also be a lower premium on more liquid instruments.
Or consider headline risk. Remember the Chicago Art Institute and Integral Capital? When Integral blew up and the Art Institute was a large, and the only, institutional investor in the fund, the headlines abounded. Since that time, there’s been an acknowledged risk of being in the headlines for losing money. For this reason, many investors stick to the same small group of funds so that they’re not alone should the ‘fit hit the shan.’ Unfortunately, this leaves a lot of smaller, less-well-known managers in the cold, and can compromise returns as well. It also increases concentration in a small number of managers, funds and strategies.
And what about fee risks? Being ‘penny wise and pound foolish’ can block access to some of the most successful (read: non-negotiable) managers and funds. It can also cause investors to eschew entire asset classes (private equity, hedge funds) increasing correlations and concentrations and reducing diversification. Or what about the risk of not beating a benchmark like the S&P 500? Chasing returns is not very productive in the long run, and it can cause investors to take unnecessary risks in order to beat a rising benchmark. It’s also difficult to outperform on both the up- and down-side, so targeting outsize bull market returns can lead to bear market catastrophes.
In short, there’s no such thing as a free lunch. Protect yourself single-mindedly from one risk, and you just increase your odds of obtaining a different type of injury.
One night last weekend, I was in bed reading when I was distracted by a noise coming from the bookcase in my master bedroom. I heard a thump and then scratching. Convinced it was one of my pets messing with my suitcase, which was out and packed for a trip the next day, I ignored the sounds. Thump, scratch. Thump, scratch. Thump, scratch. Finally I sat up in bed to admonish my cat for being a pest, however I quickly noted that said cat was on the other side of the room. And he was staring intently at the bookcase.
When I got up to look more closely at the bookcase, the door actually opened a little bit. The thump of it shutting was followed immediately by scratching noises. I stared at the door. Thump, scratch. I wondered if I should open it and see what was in there. Thump, scratch. I was pretty convinced it was an animal. Thump, scratch. A squirrel perhaps. Thump, scratch. Maybe even a honey badger.
Whatever it was, I was sure it had rabies.
I called the wildlife removal company and asked if they could come in the morning. They assured me that they would be at my house at 8:00 am, and I went to bed downstairs – after taping the doors shut and barricading the rabid honey badger in the cabinet with an ottoman.
The wildlife people came to my house after I left for the airport, but called me to report on their findings before my flight took off.
“Ma’am, we’ve contained the situation,” they said.
“Was it a honey badger?” I asked.
“No, ma’am. Your DVD player turned on and was trying to open, which bumped the door. Then it spun and scratched the door, before shutting and trying to open again.”
Yes, the wild animal in my house was a vicious DVD player.
Why am I telling you this pretty humorous but somewhat embarrassing story? Because every person to whom I’ve told the story in person asked me the same question: “Why didn’t you open the cabinet door and look?” My answer? At the end of the day, I knew I had two long-term solutions to the problem. Either the wildlife folks would show up in 24 hours and remove the critter, or it would die and I could safely remove it myself with gloves and a shovel. I didn’t need to act right away, and doing so could actually have caused more damage.
The same thing is going on in the markets right now. The thumps and bumps of market volatility have a lot of folks spooked. But some people are checkers – they look at what the market is doing daily and try to develop a short-term solution. They are convinced if they act now, they can save themselves from whatever may be lurking in the dark. Other people are waiters. These folks develop a long-term solution and trust that their plan will work out for them in a defined period of time. I’ll let you guess who sleeps more soundly through the thumps and scratches.
The key to surviving volatility, hysterical commentators, and even market corrections (which will happen), is to have a long-term plan. To be able to disengage enough from the noises in the night to ask the following questions:
“Would I buy this stock/invest in this manager/choose this strategy today?”
“Has anything fundamentally changed with this stock/manager/strategy or is this purely market movement?”
“Do I need liquidity from this investment now or in the immediate future?”
“What conditions would need to be in place for these undesirable changes to become the new status quo? Are those conditions likely to occur?”
By logically thinking through what might be causing the noise, it is possible to develop and stick to a plan that reduces reactivity and focuses on long-term goals and objectives. After all, in the words of Warren Buffett, “In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.”
Don’t get me wrong. I am a fan of active investing and I’m not saying, “let it ride no matter what!” I am not, however, a fan of re-active thinking. I believe successful investments require discipline. And while you might jump when you hear noises in the market, you need a plan and conviction to avoid letting the rampaging honey badger into your portfolio.
In 1965, the Byrds released Turn! Turn! Turn! The song’s lyrics were taken almost directly from Ecclesiastes and promises: “to everything there is a season.” After reading that Macro funds made an overdue performance comeback in September 2014, I walked around my office singing that hippie ditty all day. While it was an annoying earworm in less than an hour, after nearly four years of market gains, maybe we could all use a little repetitive reminder that investment strategies fall in and out of favor.
If you look at Hedge Fund Research’s top performing strategies for the last 14 years, for example, you can easily see where investors might have some short-term memory loss when it comes to performance. After all, the S&P 500 has taken top performance honors for the last 3 out of 4 years. If you look at the last decade, however, you can see that Emerging Markets strategies have been at the top of the charts for three years as well. In fact, the S&P 500 and Emerging Markets hedge funds have been as equally likely to lead the pack as to end up in the bottom half of investment strategies over the past decade. And Macro/CTA funds, which have been both maligned and heavily redeemed from in past months, were the number two performing strategy in 2007 and 2008 at the height of the financial crisis. Many investors were extremely happy to have allocations to those strategies at that time, and flows into CTA/Macro surged in the 12 to 18 months that followed the market meltdown. Interestingly enough, however, Macro’s top-notch performance was preceded by, you guessed it, bottom half performance rankings in the years immediately prior to the crisis.
And hedge funds aren’t the only alternative investments to fall into cyclical patterns. While venture capital is positively on fire now, it has been a long road to recovery in the wake of the tech wreck. According to data from Cambridge Associates, US Venture Capital funds returned 26.1% over 15 years, but only 8.6% over the past 10 years and 7.5% over the past 5 years. Now venture capital is coming back with a vengeance, with a three-year return of 14.4%. There is even talk of a new VC bubble, which was probably pretty unimaginable just a few years ago.
Even private equity, which seems untouchable at this point, has its good and bad performance periods. With a 15-year return of 12.0%, according to Cambridge, a five-year return of 11.0% and a one-year return of a whopping 17.2%, private equity is clearly not immune to some degree of strategy cyclicality.
Why does this matter? We all have a tendency to chase winners and sell losers, whether they are strategies or managers, and even when we know that investment philosophy doesn’t often work. For example, a study by Commonfund Hedge Fund Strategies Group in August 2014 showed that chasing returns was not a long-term strategy for success. The study concluded that “there may be a natural tendency for hedge fund investors to gravitate toward managers that have captured a significant share of the market’s upside. However, since such equity upside capture is not common or persistent among hedge fund strategies, using it as a selection criterion may lead to adverse selection.”
Investing isn’t easy. It can be a fight against your instincts and ingrained behavior. So it’s healthy to take a moment every once and a while to remember that markets change and that strategies come in and out of favor. A relentless chase of returns is not only exhausting, but often suboptimal. And by definition, if you’re chasing returns, you’re already behind.
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!
There are high correlations all around us. For example, there is a very high correlation between the per capital consumption of cheese and the number of people who are killed by their bedsheets each year. Hedge funds currently have historically high correlations to the indices. Is this a tragedy waiting to happen? Time will tell, but it's really too early to call.
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.
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.
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.
In recent weeks, there have been a number of articles lamenting how much hedge fund managers get paid.
“Most Hedge-Fund Managers Are Overpaid, Big Investor Says”
“Everyone Knows Hedge Funds Are A Rip-off”
“Hedge Fund Moguls Pay Has The 1% Looking Up”
Most of the assertions are, once again, predicated on the assumption that hedge funds all look alike. After all, if Forbes runs an article highlighting the top 25 hedge fund earners and a manager that raked in $280 million in 2013 takes the number 24 spot, all hedge fund managers must be making serious bank, right?
Most of these articles point to two sources of hedge fund manager income: the management fee and the incentive allocation. It seems that the management fee causes the most ire for investors and pundits. This flat fee is charged on the assets under management, or AUM, of the fund. If a fund manages $2 billion for investors and has a 2% management fee, the manager makes $40 million in base salary. Right? Well, maybe.
But let’s think about this logically.
- There are only about 500 funds (out of 10,000 or more funds) that manage more than $1 billion;
- The average management fee is actually closer to 1.5% than 2%.(around 1.64% by my last calculation);
- So yes, there are some hedge fund managers that can earn millions without investing a penny.
Hedge funds getting rich off their management fee are the exception, not the rule.
According to Hedge Fund Research, 56% of hedge funds managed less than $10 million at the end of 2013. That’s right, I said roughly 5,600 hedge funds have ten large or less under management. Those managers’ management fee payout? $200,000. And that’s if they are a solo operation. If they have to pay additional traders, administrative or back office staff, that number only decreases.
Another roughly 21% of funds managed less than $100 million according to HFR. Their total team base pay? $2 million bucks assuming a (not average) management fee of 2%. If you have a team of even five professionals, that’s $400,000 per person. More labor-intensive strategies split the money amongst more people.
Sure that’s more than a kindergarten teachers makes, but it’s not out of the realm of normalcy in business. Even small business owners with ten years of experience earn more than $105,000 while small business owners in New York can top $125,000 per annum according to Chron. In comparison, kindergarten teachers earn between $39,000 and $77,000.
And that’s just small business owners. Most CEO’s of Fortune 500 companies make up to $1 million in base salary per year. In 2010, the median bonus for Fortune 500 CEOs was $2.15 million. And in case you think that the bonus equates to an incentive or “pay for performance” fee in hedge funds, research in 2011 showed 97% of companies paid bonuses. Bonuses in corporate America have become pretty much ubiquitous.
I get that hedge funds have become in many ways the poster children for economic inequality, and I do think that perhaps it’s time to think of a sliding management fee scale based on AUM. However, I find it difficult to tar all hedge funds managers with the same "fat cat" brush.
As for the incentive fee, since managers only receive this if the fund performs, I have heard less pushback on that front. I guess it’s hard to argue with making money for, well, making money.