Choosing a hedge fund - Where to begin

The 3 P's of hedge fund investing

1. Performance
   
   Performance is a measurable output and you have to recognise what you are seeking to achieve in your analysis because past performance will not necessarily be a guide to future performance. 
   Look at one, three and five year (or longer) time periods.  Look at how the investment manager has performed in down periods or through crisis events.  How did they recover from past mistakes?  I find it comforting that Buffet 'underperformed' through the dotcom bubble because he stuck to his guns on pricing and valuation issues.  It is not simply a case of relative comparisons between investment managers; you have to take into account different strategies, consistency of returns, maximum loss periods (known as 'drawdown'), percentage of winning versus losing months and (non) correlation to the performance of the stock market or bond market. 
   Conventional theory has it that hedge funds should do better when the stock market is down and less well in a bull market.  The analytical data supports this but it is important to remember that while hedge funds may not necessarily be negatively correlated to the market, their returns should be independent of the overall market over longer time periods.
   
2. Pedigree
   
   For those that know the industry, the pedigree and experience of the investment manager is vitally important. 
   If the investment manager has ten years or more of investing experience at major firms such as Goldman Sachs and Morgan Stanley, has survived the recruitment and 360 degree evaluation performance reviews for a long period, and can demonstrate an investment track record in his past or present firm then this provides an indication that the investment manager could be entrusted to manage your money. 
   
3. Passion and Enthusiasm
   
   The best investment managers love what they do and many have achieved sufficient monetary reward that they often technically do not need to work any more.  They are instead motivated by the intellectual and emotional challenge of being the best, delivering outsized returns and a competitive spirit that goes way beyond beating an index.  
   How much time is the manager focused on the portfolio (vs. on investor relations and management issues)?  What drives the manager to come into the office each day and do the conference calls across time zones, the company visits across continents, the fundamental analysis and respond to their investors?
   If the manager loses this commitment and hunger, it is time to change funds.  Good examples of investment managers where the key person is passionate about investment and love what they do include Richard Perry at Perry Capital, Warren Buffet at Berkshire Hathaway and Daniel Och at Och Ziff.

Other factors to consider when choosing a hedge fund

Minimum size and scale: Don't take operational risk

There is no magic number in terms of fund size, but some things to look for include:

1. Does the manager have enough scale to pay and incentivise a high quality team?
2. Do they have adequate risk management and reporting systems?
3. Can they shoulder the regulatory overheads such as SEC or ASIC registration?
4. Finally, do they use high quality outsource service providers such as custodians, administrators and accounting and tax advisers?

Operational risk tends to be highest for new managers so you may want to revert to the second point about pedigree and do some more research at that stage.

Size is also important because if AUM is sub-scale, the manager may be more tempted to take short cuts, spend too much time on fund raising or manage for cash flow rather than performance. I recommend lower volatility, proven formula managers who have done it all before.

Closed to new investors or selectively open?

Scarcity value can appear to be good marketing but is a reality in quality hedge fund investing.

The best funds are typically 'closed' or at best 'selectively open'.  How an investor prises the window open will be a function of the perceived quality of the investor, the investment term, whether the investor has an existing investment with the manager and possibly also a 'warm' introduction. 

The KPMG chart below graphically illustrates the trade off between the 'star' managers with limited capacity versus the 'wannabes' and 'has-beens' who are looking for money.

Figure 1: KPMG Chart - Around 15% of managers are clear stars.  They provide the prime capacity that is
capable of generating risk-return characteristics in line with client expectations.  Most of them are ex-proprietary
traders from investment banks, with the majority based in the US.

So scarcity does have value, as is starkly illustrated by the consistent underperformance of hedge fund indexes made up of 'investable' (i.e. open) managers relative to indexes containing funds that are closed to new investors.  The true stars of the investment management industry are probably less than 5% of managers and not the 15% suggested by KPMG.

Listed funds (or close-ended funds) on the other hand provide a number of advantages. Examples include the liquidity provided to the investor, ASX transparency and regular monthly NTA reporting which allows investors to monitor performance.  Listed funds also allows managers to make longer term investment decisions on behalf of investors, because the pool of capital might be considered more "permanent".

Typically, the advantage of an unlisted fund is an investor's ability to exit the investment at the NTA price, but this often comes with a liquidity discount (i.e. "lockup") and less transparency on a less frequent basis.

Alignment of interests

When selecting a hedge fund you should consider the amount of capital invested within the Assets Under Management (AUM) by the owners and key personnel and on what terms i.e. are they invested on the same terms?  In addition to this, staff with options and deferred incentive schemes will be motivated to make money for their investors.

The reason that 'skin in the game' is so important is that the performance fee structure creates an incentive to take higher risks with other people's money as you share in the upside but can walk away from the downside - a classic call option payoff.  Having substantial investments in the fund introduces real downside for the manager and mitigates this risk. 

Risk management and transparency

Risk can be defined as the potential loss of capital invested.  An investor that is risk averse will be on the lookout for:

• Prudential risks (integrity checks, internal resources, custody and prime brokerage arrangements)
• Performance risks (associated with issues such as 'style drift', liquidity and transparency)
• Portfolio risk (diversification according to strategy, markets and geography)
• Market risk (outlook for strategies, exposures and foreign exchange)

The collapse of Bayou Capital in August 2005 highlights that many people make false statements on their résumé.  Proper risk management would also have uncovered that the purported auditor of the fund had resigned from that position two years earlier.  A clear red flag.  Lastly, the degree to which the manager is transparent in disclosing its investment and risk management practices to investors, (and how frequently), should be a measure of quality.

Leverage

Borrowed money can enhance or exacerbate profits and losses.  In certain strategies such as macro investing, commodities trading and selected arbitrage strategies including fixed income and convertible arbitrage there is, generally speaking, a higher use of leverage. 

It is important that investors understand the difference between internal leverage within a fund and the degree of external leverage used by various managers, and the consequences of each.

Avoiding Conflicts of Interest

Again, recent failures have highlighted several things to look for and avoid.  For example:

• Advisors and consultants who recommend clients invest in their own funds' management business
• Fund of funds that attract assets to their own managed funds or a sub-contracted manager
• Investment banks and prime brokerage operations that recommend their own businesses that generate high trading and, in some cases, a third tier of fees
• Funds that do not outsource their administration (valuations) to a third party independent administrator.

It might appear to be common sense but you would be surprised how often these checks can result in warning signals.

Fees

In itself, fees should not be the driver of the investment manager decision.  Absolute return funds are more expensive than traditional asset managers and index funds because they are paid to deliver absolute returns and are motivated to do so.

Typically, the fees are 1-2% management fee per annum and 20% performance fee and this sort of level tends to be non-negotiable.

A criticism levelled at fund of funds is that you are paying two layers of fees.  This is true, but in return there are several benefits which include: access to the managers, manager research, risk diversification and management and lower threshold levels of investment for smaller investors who cannot come up with (in some cases) up to US$25 million minimum investment amounts.

In summary, hedge fund investing with the 'star' managers will deliver sustained absolute returns that exceed traditional asset management year in and year out.  The challenge of choosing your manager(s) remains a constant.  If you find it difficult to make this decision, then ask a fund of funds manager to make the decisions for you.  The old dictum of caveat emptor applies: if you are about to choose a hedge fund, do it with care.  This applies across all asset categories and is not unique to hedge funds.
 
Think of hedge fund investing as an alternative investment strategy that in essence is not that different to investing in private equity or direct property.  Whilst there have been a number of hedge fund failures, investors with memories can point to a greater number of failures and scandals in mutual funds, corporate Australia and in the bureaucracy.  If you choose well, you will prosper.