(Edited version of a letter written in May, 2011.
It has remained a problematic environment since May 2011 for traditional mean reversion strategies. The winning solution has been to time the markets and be in for the ride – long equities, short commodities, long mortgages, etc. The issues in this letter remain largely the same today.)
The world is still trying to work out whether everything is okay. On one day Greece’s travails are magnified onto the world’s stage – the next a mollifying statement from Merkel defuses the situation. Good quarterly earnings pump up the market; bad jobs data deflate it. Chinese prospects create optimism; municipal crises elicit fear. The U.S. deficit weakens the dollar; the Japanese nuclear disaster strengthens the yen.
Global geopolitics and the evolution of the financial system remain topics of keen interest and discussion and even action – although no decisive or well-balanced action. As such, investors still remain subject more to macro impact than to true fundamentals. Nonetheless, it has not been a great environment for making money. Interest rates are low and many early gains have been eroded or lost. Everyone is trying to work out how to improve their portfolio performance; and yet, the fears of rising interest rates and equity market setbacks make investment decisions very difficult.
We have seen an almost unprecedented quest for ‘beta alpha’ – the value created by effective shifting among sectors and varying gross and net exposures. This is all well and good, but in less sophisticated times, this was called ‘market timing,’ an endeavor sought by many yet achieved by few. Hedge funds are seen as a primary source of beta-alpha, yet at Cadogan, we continue to believe the greatest value from the hedge fund sector as a whole is the efficient capture of mean reversion through superior research, rather than merely timing. As is the case with sectors, styles also have cycles – the timing, however, is hard to predict.
In this letter we will revisit the perennial issue of what is the optimal scale for a hedge fund (and FoHF). In doing so, we will undoubtedly restate many of the traditional arguments. The reason for doing this is not to pass on thrilling new insights; rather, it is to bring back to the fore a key debate, where one side appears to be gaining a huge surge in popularity without a concomitant shift in fundamentals.
Traditional benefits of greater AUM
There is little doubt that size brings with it a number of advantages
– Perception of safety/stability. Investors, like consumers, like individuals in general gain tremendous comfort from being involved in something that many others also endorse. The belief that collective wisdom is composed of the sum of individual insight is widely held and is often accurate. On the other hand it can also be the cause of bubbles, and abrupt shifts in markets, when facts become evident to the majority long after they have been clear to the few. The generation of alpha is most frequently a result of either superior or more timely analysis and implementation by the few!
– Ability to hire broader/deeper team. More revenue, allows for more expenses. Many of the larger funds have reached their size based on track record or visibility of their principals; this creates a cachet that often makes attracting top level players somewhat easier.
– Ability to spend on outside research services. A greater budget allows one to use outside resources that smaller funds might not be able to afford or might use ‘soft dollars’ to pay for.
– Ability to ‘move’ prices. Although this will not be readily admitted by many, larger funds can often move the price of securities they are invested in. This can often lead to improved performance numbers over a period of time, particularly during strong bull or momentum-driven markets.
– Bully pulpit. Larger funds are able to make larger investments and potentially have more impact on their own destiny by taking either control or utilizing significant influence. If well used, this can help improve the value of positions invested in.
– Better ‘calls’ from research desks. Although it may be hard to believe, if you pay more in commissions, you might get better access to information. Historically, this has been a very relevant factor. In an environment of increased regulatory scrutiny, particularly vis-à-vis insider trading and research practices, it will be interesting to see how this evolves. It would be hard to imagine, however, that a group paying $10mm in commissions will not get better ‘service’ than one paying $50k!
– Flexibility on diversification. A larger fund has a better ability to move in and out of sectors/areas as their level of interest changes. Having different teams that one can support, even if there is little current activity is a potentially big advantage.
Traditional benefits of lower AUM
– Focus. Many specialist funds are almost by definition smaller. To get direct exposure to a particular area of expertise (e.g. biotechnology, microcap, trade claims, weather derivatives, etc.), the best access is often through a specialized hedge fund manager. Many of these are either smaller by design (because the specialty has more limited liquidity) or because of their stage of evolution. In either case, it can be an interesting opportunity for investors.
– Ability to invest in off-the-run securities. With ever-improving quality and speed of information flow, the efficiency of pricing in better ‘covered’ securities constantly improves. Betting against the flow can make money, but over time creating sufficient alpha to counteract the fee loads can be very difficult. Finding differentiated information on more obscure companies and/or classes of security can lead to sustainable alpha.
– Nimbleness, easier to build and get out of positions. Being able to operate in less well-trafficked names, by definition, means lower liquidity; smaller funds can move much more easily in and out of such less liquid names.
– Access to top talent. As much as there is a desire to categorize investing as a science, it remains truly an art. The great longer term track records are most often obtained by those who can not only apply a consistent methodology, but who also have the feel of when to press or lighten their exposures. Unfortunately, there are very few truly gifted investors. Many of these are great at investing but less good at corralling the thoughts/efforts of others or running/growing organizations. The advantage of some of the smaller, more focused shops is the access to talent that is not being attenuated by too many non-investment-related responsibilities.
– Better alignment of interests. When a manager is hungry, he/she is often more focused on achieving results. When the incentive fee is the primary source of reward, rather than the management fee, there is generally much better alignment, assuming one has done sufficient due diligence to fully understand and agree with the manager’s risk taking proclivities.
– Flexibility on terms/willingness to work with investors. Hedge funds operate at the epicenter of the world of supply and demand. When demand is high, which is certainly the current case for larger hedge funds and FoHFs, there is little immediate incentive to be flexible to the needs of most specific investors. Obviously, this is not always the case and many larger managers balance short-term versus long-term benefits, but in most instances, smaller managers with a desire to fill more unused capacity and build a better margin of safety, are willing to work more closely with investors to find solutions that are more ‘balanced.’ Needless to say each basis point less in fees paid is a basis point more of alpha!
– Better long-term ability to generate alpha. This is a summary of all of the categories discussed above. It remains controversial, with academic studies still coming out on both sides (more on the side of small over big), but the rigor and validity of the results are subject to imperfect data, short time streams, etc. In summary, the facts are insufficient to outweigh instinct.
How does the current environment impact this debate?
Naturally, there is no pre-defined set of solutions for an appropriate structure and one of the defining variables is the environment in which one operates. As such, we would like to look at how the current environment impacts the organizational needs of hedge funds and FoHFs.
– Macro Driven. For most of the past three years, the dispersion in return among securities within sectors and even among sectors has been low (to extremely low). This has made bottom-up research less valuable, whether this is long-only value or any form of mean reversion capturing hedge fund. Outsized returns have generally been achieved by those focusing on macro variables and successfully choosing the appropriate directionality (recovering debt markets, surging equities, increasing commodity prices, weakening dollar, etc.), In this environment there is little benefit to smaller funds – not necessarily any disadvantages – although many argue considerable heft allows for better access to sensitive political information or sophisticated trading systems increase the predictability of flows.
– Unstable financial system. The fact that the financial system has not yet been ‘solved,’ brings risks to all investors, not just to hedge funds. However, the greatest risks are on the access to and terms of leverage, the reliance on OTC securities, the terms of ISDA agreements, the access to and terms of shorts, the custody and rehypothecation terms, etc. Although these impact most strategies, they are particularly important to more complex and highly leverage ones. In this environment, the ability to fully understand all terms and negotiate is very important. Larger funds are more likely to be able to make inroads in negotiations. As such, except for basic strategies, there is a current advantage to larger funds.
– Increased regulation. Whether it is Dodd Frank, changes in E.U. regulation, the impending Solvency 2 or Basel 3 or changes in pension fund regulation, it is clear the trend is that more regulation is on its way, not less. Most of it will be well-intention, but likely to be badly conceived and executed. This will mean that investment managers will have to be both careful in their adherence to changing rules and reporting requirements and potentially clever in finding opportunities emanating from the changes. We believe the compliance burden will go up, requiring most hedge funds to dedicate more resources to the area – thereby raising costs; however, the incremental cost, in most cases, is likely to involve some outside legal advice and the hiring of one professional (or maybe even less than one full-time employee) and, therefore, only to be onerous to very small funds.
– Increased institutionalization. As institutions find their traditional investment options less and less appealing, more and more seek out alternatives. Hedge funds represent the most accessible liquid alternatives and have been attracting more and more interest. The lack of transparency, more onerous terms, higher fees, etc. have represented obstacles, but the pace of increased interest continues to grow. We do not see this as abating. To date, and for the near to medium term, this will be strongly to the advantage of larger funds. Over time, as investors become more familiar with the area and have a clearer understanding of the alpha generation engines, the focus is likely to broaden out to encompass less ‘attractive’ (i.e. traditional institutional) structures, with better investment returns.
– Low interest rates. There is a need today for income and return. When nominal interest rates are low, this eliminates a large source of income for many investors (whether individual or institutional); this changes the risk profile investors are willing to take. With the volatility associated with higher potential return strategies, there has been an understandable move to hedge funds. The goal, in many cases, is not pure alpha generation, but more efficient capture of beta (i.e. some downside protection) and beta alpha (timing). In our opinion adopting to low interest rates has little to do with the size of a hedge fund, and more to do with its strategy. For example, in this type of environment, short selling (and the short component of long/short investing) is more challenging, because there are no returns on cash or short rebates going to managers, thereby removing a key element of return from the strategy.
What is the minimum size necessary to be ‘institutional’ in quality?
Essentially, in most cases there are three separate metrics that need to be satisfied in ascertaining whether a hedge fund or FoHF is institutional.
– The level of AUM. There is no set amount, but many organizations don’t like being more than a certain percentage of a fund’s assets. In most cases this now ranges from 10% to 20%. To be attractive to most mid-sized or larger institutions, the fund must be able to accept an allocation of at least $50 million (often much more). As such a fund that is less than $250 million is very unlikely to meet the criteria, while $500 million is more in line with general expectations. For larger allocations, naturally, there is a strong bias to much greater size. The exception is in separately managed accounts, where a number of sophisticated investors look to take advantaged of the greater flexibility and/or expertise of a smaller manager while not feeling ‘trapped’ into a structure in which they might be too dominant.
– The breadth and depth of staffing. For a hedge fund, the range can be quite large. Even large institutions are often willing to accept a more constrained staff, as long as the strategy does not involve inordinate complexity. For a long/short manager, the key is to have a distinctly superior quality of research/trading staff, a good back office/compliance function and an ability to meet client information demands (often significant). Generally, this would be hard to accomplish with fewer than seven staff. Once again, the modal number is much larger and there are also exceptions on the low side.
For a FoHF, the trend has been towards larger managers, with extensive research staff that divides into ‘silos’ of expertise, complemented by portfolio managers for the different types of products. This is supplemented by an independent Operational Due Diligence team and a quantitative risk team. The back office needs controllers for the funds, appropriate legal, compliance, IT and general management. And finally, to allow for a breadth of clients and increasing informational demands, a healthy client service and sales function. Looking granularly, unless the FoHF is specialized and/or limited to a small number of underlying managers, it would appear that one would need an absolute minimum in research of four people (and then only if they are very experienced), one or two in ODD, one in Risk Management, two or three in control functions, one for legal and compliance, one for IT and three or four in client facing functions. This totals about 15. Most capital, however, is flowing to funds with considerably more staffing, as there is a perception of safety in numbers. This leads to the last criterion for size.
– Perception. Larger numbers of staff are deemed to signify stronger processes, procedures and control – all important issues in today’s world of greater transparency and public scrutiny. Although there were large firms that became mired in Madoff and other problem funds and small firms that avoided them all, there is an increased belief that the risk to the institution is lower if there is an appropriate ‘optic’ and a stable of large co-investors. The old adage of ‘no one can be fired for buying an IBM’ has certainly evolved into the FoHF domain. And, there are good reasons that firms grow and attract a growing level of support – performance, avoidance of blow-ups, strong presentation/client skills, etc. However, the problem in the liquid alpha space, is that in many cases finding liquid alpha is not an institutional process – it is much more art than science and can be very entrepreneurial in nature. Many of those best at doing so, are not the best as presenting to Boards and absolutely cannot define the process in a way that is reproducible by others. The risk control process in many cases involves understanding the underlying strategies and securities exceptionally well and deliberately underweighting or overweighting positions in complete contradiction to risk models. The understanding of managers, strategies and risks is often found most in those who prefer to focus on these areas and who, frequently, are not good managers of teams and of people.
In the alpha game, becoming part of the pack is, axiomatically, self-defeating. As we have often said “Alpha is where other people are not.” Although some process and procedure is necessary, the full ‘institutional package’ is probably better targeted towards beta strategies. The idea of endorsing and embodying style drift and tracking error is one that is often fundamentally at odds with an institutional ideal and is a clear reason why most institutions have avoided hedge funds. As more begin to invest, the strong temptation is to concede to all their perceived needs, even those that detract from performance. Trying to fit a size 12 foot into a size 10 shoe generally leads to pain; we are concerned that the hedge fund ‘industry’s desire to meet the new institutional requests will, over time, lead to a severe degradation in alpha generation. In a market, where most returns are beta-driven and where timing is the key differentiating factor (such as the one we have experience over the past three years), this might well be masked. However, over time, the generation of alpha will continue to be best executed by a small group of obsessive, focused, visionary idiosyncrats. The most important job of a great fund of funds will be to find and harness this talent, not to go with the biggest players with the longest track records and most institutional processes.
