Emerging hedge funds manager can offer higher returns for investors

Investors have shown a preference for the safety and security of brand name hedge funds. Allocating to emerging managers can reap high rewards if proper due diligence is followed.

Hedge funds have always been an industry of emerging managers. There is no magic formula for conducting due diligence on emerging managers versus larger, more established managers because the classic rules apply. One of the first rules is to remove size bias.

Frank Meyer, the founder and former chairman of Glenwood Capital, is known for making the seed investment in Ken Griffin to launch Citadel Investments. His experience applies to investing in more established emerging managers today.

“Look at the reasons to invest in funds,” he says. “They can short, use leverage and be nimble about going in and out of the market as the manager sees fit. Historically these were all seen as evils. Those characteristics discouraged big institutional funds.”

As managers grow in size these advantages dissipate, according to Meyer. “As an outsider it gets harder to get your hands around the business.” For those reasons, and because of the hunger of newer managers, Meyer found it “easier and more satisfying, all other things being equal, to follow funds that were newer and smaller.”

It seems that size has become a proxy for safety but it may have also become shorthand for “easy”. Christopher Fawcett, co-founder and senior partner of Fauchier Partners, says that early in his hedge fund investing experience it was easier to conduct due diligence and choose hedge funds.

“Less information paradoxically means it’s easier to select. There is not much to work with. The other side of the paradox is that the proliferation of funds and availability of information makes it harder to choose. More information, a deeper understanding of strategies – it’s an embarrassment of choice and information,” notes Fawcett.

Although there are more choices today and it is harder to choose, Fawcett does not suggest investors take the easy route. More information and tools exist today to help investors make the right decisions.

Ted Seides, co-founder of Protégé Partners, a company specialising in investing in smaller, emerging managers, was still only a child when Richard Elden founded in 1971 Grosvenor Capital Management, regarded as the first fund of hedge funds (FoHF) in the US. He compared the due diligence process to the equity research process to make the case that evaluating smaller managers is actually easier.

Hedge funds, like equity analysts, assess management teams and their ability to execute against a set of metrics. Protégé invests in a lot of small-cap companies that all have a single product. This method, however, illustrates a major problem with choosing only large managers.

Most hedge fund investors “invest in GE. If you’re an equity research analyst looking at GE, you have to meet every manager at every subdivision to conduct a comprehensive analysis. It’s a lot of work and you don’t really have the access to do it,” notes Seides.

Investing in small hedge funds is similar to investing in small-cap stocks because “there is a lot of work to do but you can do it, because you can go and meet each manager,” notes Seides. According to Seides even the resource-rich Yale Investment Office where he began his investing career had few investments in large hedge funds. He cannot understand how other organisations can analyse them effectively. “I wouldn’t know how to do it; how to get their time and attention to grant you access when you’re just another of their 300 clients.”

Meyer learned from his Citadel experience. “Get rid of biases such as never looking at a manager who doesn’t have a five-year record or who hasn’t worked for a major firm. You can get blinded by the past and by prejudices, but you have to look at things as objectively as you can,” he comments.

Similarly, Seides offers one of the best reasons to eliminate size bias. “If rules are too tight, you can create your own adverse selection. I’m not a big believer in artificially limiting the opportunity set.”

Historically, investors chose managers rather than strategies. Seides says his thinking has changed. “At Yale we would go out and find the best jockey. Now people have realized you also have to be riding the right horse.”

Fund size automatically becomes less important if investors focus on their objective first and then the type of hedge fund strategy that meets the objective. Sometimes non-market factors such as assets under management (AUM) and liquidity may impact the performance of one manager versus another.

If investors focus on strategy selection, then the focus moves to finding a manager that belongs in the portfolio. This may open up the search and make the job harder but it also increases the chance of finding a fund that will help achieve portfolio goals.

On choosing a hedge fund manager, Ted Seides says: “At the core the manager needs to have a philosophy about what they’re trying to do, not just what works but why it works, and have an execution strategy that makes sense. They must have an identifiable competitive advantage, meaning they either gather or process information better than their competitors. Underpinning the fund should be a sector, strategy, or assets that – independent of the manager – provide an attractive opportunity set.”

Glenwood Capital’s Meyer believes a manager’s ability to run his business affects the viability and longevity of the company as well as his ability to manage a portfolio. “The manager has to succeed in carrying out two key tasks – he has to run the money, and he has to run the business,” Meyer explains. He says portfolio managers typically get better over time because they have seen more markets and made more trades but they often stumble for business reasons.

“If you don’t invest in your own infrastructure or don’t have enough respect for the roles of the companies or the people that provide it, you probably won’t have good returns and a good business,” comments Kathryn Hall of Hall Capital Partners.

Strength over size should be a consideration, too. Business management is an area where size can matter although it can also mask poor business management skills because larger managers can throw money at problems. More important is the mindset, the vision and the capability of the hedge fund manager.

Also of vital importance is the issue of professionalism. When looking at the business practices of emerging managers, investors should make a qualitative assessment of the fund’s professionalism given where it is in the lifecycle.

Investors conducting due diligence on emerging managers could gain insights from Meyer’s experience seeding Ken Griffin at Citadel.

Running a hedge fund requires a variety of skills, he says. “A manager is usually great in some of those skills and not great in the others”.

Investors should look for companies with well-rounded employees good at multiple functions. If smaller managers do not have talent in-house a good question to ask is how they are accessing it. Outsourcing a function is preferable to performing it poorly in-house.

Investors should also want to know if the manager has a history of entrepreneurship or increasing responsibility at previous organisations, if he was the manager or working at a company previously that managed more money. Before investing allocators should what to know how a manager performed before setting up a hedge fund, particularly in their previous role and whether they lost assets due to investor liquidity or portfolio losses.

How a manager overcomes weakness and adversity is something to look at. Griffin was young and unknown when he tried to launch his first fund. He met with Wall Street traders personally to convince them of his seriousness and abilities. Meyer notes, “He made being a college student his strength.”

Despite the tremendous growth and significant changes in the industry, investors would do well to follow the advice of Elden at Grosvenor Capital Management. He retains the same investment objectives he espoused in 1971 – “Look for talented managers who can produce good returns, take modest risk, and who are essentially hedged.”

Manager selection characteristics

Edge: Regarding newer managers, edge is important. What is it and will they keep it?

Pedigree: While investors should factor in the manager’s pedigree, they should look at his overall experience and accomplishments and avoid being name biased.

Personal character: The character of the manager is one of the most important elements of selecting a manager.

Relationship: Spend time with managers to observe their behaviour.

Motivation: Why is the person getting up in the morning? When will they meet their personal goals? Thinking about motivation relates to the calibre and the kind of person the manager is.

Negotiation: Avoid managers with a ‘take no prisoners, stomp on the other guy’ approach. Investors should do as much reference checking as possible on such business behaviours.

Culture and ethics: The character and ethics of the hedge fund’s leader are an important determinant of the company’s culture. To evaluate culture investors should focus on incentives and whether they are aligned with the investor. Review and evaluate the incentive programme to make sure it rewards the manager to do the right thing.

Distractions: Find out what distractions the manager faces. Larger funds may get caught up in the accoutrements.

Teams: Some investors recommend interviewing members of the team at all levels. Investors should use this tactic to learn how decisions get made, who produces the work and how the manager sets and communicates objectives.

Access: While reporting, transparency and other services are important, it is also important to have access to the investment decision makers. During times of trouble having the ability to talk to the manager gives investors an understanding of the manager’s conviction, objectivity and stability.

Cathleen Rittereiser is director of investor relations and business development at Concordia Advisors and co-author of Top Hedge Fund Investors: Stories, Strategies and Advice.