The core of what we do is to show to portfolio managers what those who excel in the specific strategy do. This is a sharing of best practice, but not in a restrictive sense. In most areas of activity related to running money there are several ways oftackling the task in hand. By sharing the different ways and then exploring them together, the consultant and client can arrive at a solution/way of operating that suits the specific circumstances and people. This is a key point: the philosophy is that the process should be a fit around the talents of the individuals and the desired risk and return profile of the fund. So, as the circumstances vary so do the range of remedies.
A stage-by-stage approach
How does the process of working with managers unfold? The first stage is discovery. This is about gaining a profound understanding of what the manager does and how they conceptualise what they are doing and why. We begin with a presentation by the managers using the standard marketing materials. This puts the particular team into the context of the firm, and allows the portfolio managers to express themselves and come across as they would to a potential investor in the fund. Typically this first session will last two hours, much longer than a first meeting with an investor. The three things that have to be established from the first meeting are the source of alpha or added-value, the risk management framework used and the desired risk and return profile. Overwhelmingly the source of return, or specifically the source of differential return, emerges in the second hour.
Having gathered an overview of the investment process of the manager, the next phase of discovery is to go into the detail of the different components of the process. Dependent on the manager’s style and what they are already doing well, different components will command attention with each company client and team. So for example if the parent company has a well resourced and appropriate risk team or manager then the exploration of risk measurement becomes much more about what, if any, risk measurements the managers generate themselves. The turning of risk measurement into risk management, that is what is actually used from the flood of data and information available, is explored in great detail with every client.
When a hedge fund manager has an investment style that involves a high frequency of dealing then it will become germane to examine and analyse the effectiveness of the execution process. Most UK based managers put more emphasis on fundamentals, so it is more usual to go into detail in other aspects of the process.
With all investment teams it is important to go into how time is spent, and what the boundaries are in decision-making. For each team member the scheduled activity of the day, week and month are discussed.
Interactions within the team, and wider department and company, are disclosed to understand what internal inputs there are to decision-making, and what constraints there are. Time spent on external meetings, conferences and research trips is covered too. It should become clear at this point what particular roles each team member plays within the group. The questions that need satisfying are: what biases are their within the duo or leadership team that make the investment decisions, such as is one PM more focussed on risk control and portfolio construction, and the other on execution and the bottom-up? Who has the ultimate say? How are differences of view accommodated? Have all the roles and boundaries of decision-making and responsibility been explicitly discussed and agreed? In sub-optimal hedge fund management teams these issues are fuzzy, and it can be surprising how long partners can work together without having clarified roles and responsibilities.
Issues around a lack of appropriate communication occur too often in underperforming teams. In particular, managers have to carve out time for research; for most managers that is time spent on studying fundamentals. Then we turn to external inputs to the investment process. It is important to know what important data and information sources are used in the investment management process. Note that it is not what is available, but is used.
There should be clear fit between the information sources feeding into investment decision making and how the portfolio managers are exploiting their own edge, whether that edge is in perception or in privileged information flows.
When specific issues come up in the discovery phase they can be addressed directly during the next phase, which is analysis. Through the use of tools such as structured interviews, the perspectives held by individuals on differences between partners can be explored.
Achieving consistent process
Trading/investment activity over a typical period is looked at in detail. This allows the manager to express the motivations and thought processes behind decision-making. For the consultant it is the true test of whether the whole process hangs together. Is it internally consistent, or are there contradictions between what is stated in the manager letters and presentation and the real activity? Is the management team doing what is necessary in terms of risk management to deliver the target risk attributes of the Fund given the source of market insight?
Taking the outputs from the discovery phase and the analysis phase Enhance Consulting goes back to the client, and often the internal sponsor of the project too, with the outputs of the consultancy. In a written report to the PMs and the relevant asset management company executive feedback is given on the existing investment process.
Observations and questions are shared in writing and in a presentation, but the core outputs are ranked recommendations and suggestions. These are categorised into “must do’s” and “could do’s” and each are prioritised for the particular circumstances and staff involved.
The output may also be supported by other forms of analysis used, such as heat maps, flow diagrams or graphics that illustrate the ways of operating. So the portfolio managers effectively get an action list of improvements and refinements to their investment process to take them to the next level of return, as that is the ultimate test and measure of effectiveness of the investment process. And achieving the next level of return is a required step on the way if the fund managers are going to achieve hedge fund glory.
Simon Kerr is the principal of Enhance Consulting. He has been in the hedge fund business for over ten years having worked for one multi-manager and two single-manager hedge fund businesses, and run his own hedge fund consultancy. Enhance Consulting has worked for asset management businesses of quoted companies as well as for independent hedge fund groups.