Illusory Chase For The Best Hedge Fund
We constantly strive to look for the best in everything. The best partner, best employee, best deal, best career, best education, best investment, and the list goes endlessly on. And the world has as many categories of “BEST” awards as you can think of. Similarly, when someone goes out hunting for a hedge fund to invest, he wants to know which is the best. Somehow, our DNA is hardwired to seek out the optimal solution to whatever we need. The focus is sharp and simple. The behavior is also entirely rational. However, like many things in life, the answers are never as clear.
Are You The Best?
This simple question often has no satisfactory answer. Just use IQ tests as a reference. Is the person with the top IQ score the most intelligent in the whole world? He is definitely very gifted in a way, but I would not go as far to claim the latter. Why? Many reasons. For one, not everyone takes IQ test. Someone better can always be out there. And what really defines intelligence? Is the test comprehensive enough? Are we just measuring a certain aspect of logic reasoning and neglecting others? Does being at the top now means he will continue to be where he is in the future?
Answers to a singular question almost always become a complex multi-dimensional issue. And the search for the best hedge fund is no different. In fact, posing a direct question of “Are you the best in what you do?” to a hedge fund manager is outright pointless. Because the only truthful answer is “I don’t know.”. And if they don’t know the answer themselves, why would anyone else know.
Why Is It That Difficult To Select The Best?
1. More than you can chew — 10,000 hedge funds
According to eVestment, there are an estimated 10,000 hedge funds managing an estimated USD 3.2 trillion in 2017. Not all hedge funds are captured, so the actual number is likely to be significantly higher. Even assuming 10,000 is the correct figure, do you think you have what it takes both in terms of time and expertise to conduct proper due diligence on each of them? Sure, majority may not be worth the trouble and you can filter out a bunch of names according to some criteria. But even if you whittle it down to a few hundred candidates, that is still an extremely daunting task. Not to mention that you are also likely to throw away uncovered gems among the names you weeded out.
2. Many are outside the radar
Not all hedge funds are out in the open. They can’t publicly market due to regulatory constraints. News you see or hear are often about large funds and celebrated managers. Hedge funds are also not required to submit their information to public databases like BarclaysHedge, Eurekahedge or eVestment. This is entirely on a voluntary basis. Beyond that, your chance of knowing the existence of any particular fund may be through word of mouth, referrals, a random internet search landing on their site, friends in the industry, or a chance encounter.
3. Dearth of information
Hedge funds are well known for its secrecy. They are not your publicly listed companies. Getting to know its existence can already be a challenge, and extracting information out of it can be no less grueling. Hedge funds do not follow a standard marketing or reporting template. Their pitch deck or monthly reports can range from a comprehensive one covering all aspects to a black box containing nothing other than some fancy stories or a set of elementary information.
During my earlier career in the role as fund of hedge funds analyst, I have personally come across monthly reports that print nothing other than the month to date (MTD) and year to date (YTD) figures. Of course, you can always ask for the info, but getting it is another story. I have talked to funds who fiercely guards everything beyond what they put on the pitch deck as some “If I tell you, I have to kill you” type of secrets. And there are funds that have grown so big and complicated that unless you are talking to the partners, the rest does not know the whole picture.
4. Even the strong can fall
Hedge fund is an extremely competitive industry. Closures are common. Every year, there are at least a couple of hundred closures. And in bad times like 2008, well over a thousand can bite the dust. While I do not have the numbers, I expect at least as many hedge fund closures in history, if not more, as the number of hedge funds still standing today. Unfortunately, even established hedge funds managed by veterans do not wield immunity against a vicious market. Nobody does. Recent “deceased” funds include multi-billion dollar names like Tourbillon Capital, Highfields Capital and Eton Park Capital.
5. Best is just a transient state
There are competent mangers. No doubt about it. But even then each have its own strengths and weaknesses. The best at any particular period is more a function of being the right people having the right skills, running the right strategies at the right time and place. The best today can be the worst tomorrow and vice versa.
David Einhorn, a prominent billionaire hedge fund manager, who manages Greenlight Capital was a star until 2015. He was plagued by subpar performance and struck a heavy blow in 2018 where his fund tumbled more than 30%. And that is after his fund lost more than 20% in 2015 and is still in the midst of recovering.
He is not alone. Many hedge fund strategies are hammered after 2008 for lagging behind the markets. Why? We can only surmise e.g. change in market dynamics from excessive central bank meddling; and/or thinning alpha as a result of intensified competition. But not all are suffering. Long-only managers running equities or risk parity type strategies flourished during this period from a flood of easy money.
6. Compare Apple to Apple? Sure, you find me the other Apple
Why not compare hedge funds against their benchmarks just like what we do for mutual funds?
As a matter of fact, the industry is already doing it. But unlike mutual funds, which has a very clear and narrow mandate, hedge funds have no such constraints. Hedge funds are typically grouped into strategy silos, say equity long/short, global macro, event driven, relative value, fixed income/credit, volatility etc. And within each silo, you can further break it down into many other sub-strategies.
However, there are potentially so many variations that the full spectrum cannot be fully represented. Even funds within each sub-strategy are likely to be doing things differently from the rest. You can have a long/short equity fund that decide to create a side pocket for illiquid opportunities; or a credit fund specialized in extending privately negotiated loans; or a volatility fund biased on the long side while majority are net short. Hence, unless you know the specifics, the right Apple is hard to come by, or there may simply be no other comparable Apple.
7. You think you are better than the experts?
If anyone has an edge in picking the best funds in the business, they got to be the fund of hedge funds. These guys conduct in depth research on hedge funds and pick managers day in and day out for a living. And if they can consistently pick the “top” managers within each strategy, they should be showing some serious outperformance.
In an article I wrote earlier: Which Is A Better Investment — Hedge Funds Vs Equity Market, fund of hedge funds delivered 6.6% annualized returns between 1990 to 2017. So was this higher than what hedge funds generate in average? No, not by a thousand miles. In fact, it is actually quite a bit lower than the aggregate hedge fund annualized return of 9.7% over the same period. Sure, fund of hedge funds has an additional layer of fees that drags them down. But if they can can keep picking and switching into aces, the added fees should not be an issue. To be fair, they face more challenges than just the fees, but let’s leave this for another time.
In short, even when armed with such resources and expertise, the bulk of the the professionals can’t quite hack it. What makes you think you have an edge against them?
Picking Hedge Funds Is Like a HR Job
When you pick a hedge fund, you are essentially picking people, with the core ones being the investment team. In a sense, it is not that different from a HR function where a company goes through the process to hire someone to fill up specific roles. You will never have access to the entire pool of candidates out there. You can rely on internal job rotations, referrals, work with recruitment firms or advertise externally, but there are only that many you will reach. And among those that respond, you have to look through their CVs, check out their background and credentials. Then you have to ascertain through interviews on other aspects as to whether they will be a good fit for the role and company. Aside from what could be verified on paper, the rest boils down to some form of qualitative assessment which invariably entails a good dose of uncertainty. He or she, for a multitude of reasons, may still not turn out not to be that ideal candidate you are looking for.
The same principles applies for picking hedge funds. You have to know clearly what you want in the first place. Search and filter out a pool of candidates. Do your investment due diligence: understand the managers, their strategies, risk management methodologies etc. Then do your best to pick those you think fits your purpose, and accept the risks that come with your choice. Manage your portfolio and just leave the decision of who is the BEST at any point in time in hands of fate.
Originally published at investmentcache.com on February 25, 2019.
