Hedge Fund Selection

Computers and gut feeling both matter

Originally published in the October 2015 issue

We all know that Germany is waking up to hedge funds. Some people started investing, a lot of people are talking about it, but at the end of the day for us it’s important that we have people like you who are interested in learning more about it or who are even at that stage that they are invested and that they want to get an additional insight to what’s going on.

We already indicated that today’s event has to be educational but also provocative. Yes, absolutely, it might be even provocative for some of the managers because when we talk about Alpha we probably have different opinions to some of the gentlemen in the room.

We started with a title for my presentation in German and translated this into, “Forget the numbers, trust your gut feeling.” What I’m going to do is aggregate a couple of anecdotes with regards to what do we do when we are not calculating, not crunching numbers, looking at statistics, returns, etc.? What do we face? What do we need? What do we receive and what do we get out of it? So talking about track records, whenever you see a track record you feel like this is either good or it’s bad. We call this lower-left to upper-right, this is what you see most of the time in meetings because most of the managers are presenting you with good returns.

Alpha does not exist
What you can see however, from an academic perspective and in practice, – and we’re seeing 300 managers each year – is that Alpha in a perfect statistical way is virtually non-existing. When statistical techniques cannot show that this return series is explainable, that’s when we call it Alpha. So long story short, in general, we don’t think that Alpha exists. Do some managers bring Alpha from time to time? Yes, but this is very rare.

The second point is coming back to the track record; you usually get to see track records that have survived for a long-term, which in itself is a certain bias. You do not get to see the dead ones, hence bad track records. There is a very strong bias that the good track records are certainly the majority of what you see. You will never see a manager coming up to say, “Look at this performance, it’s utterly bad over the last three years but I promise it’s good next year.”

So this bias is consistent in our day-to-day work and what we try to do is to stay away from that, but it’s hard. History very often reverses the future. Again, looking at statistics and looking at academic research is important as there is a good sponge of academic research out there.

Separating beta from alpha
Beta in manager returns is pretty consistent. You will never have a manager sitting in front of you saying, “You know what? I’ll bring you some Beta. It’s only 0.3 to the S&P but there is no way around it.” The easiest way for manager is to say S&P performed 15%, I performed 20%, and hence I delivered 5% of Alpha. No it’s not Alpha. That’s not the case because there are certain statistical techniques where you can show that if the 5% are statistically explainable at that point in time, they vanish from the Alpha pot into the Beta pot. Long story short, Beta is a good indication for the future, Alpha is not because Alpha is not stable. This is not only our belief, you can see this in the academic world.

Diversifiers can be unstable
For hedge fund strategies, the same thing applies. You have a lot of investors but also you have hedge funds with their dedicated strategies saying that this is a consistent diversifying strategy, and here we have just one example which is managed futures.

We all know what happened in 2008, the only strategy which survived and which was top of the post was managed futures. A large number of CTAs performed extraordinarily strongly during the financial crisis. Then over the next five years, approximately 60% of all new assets flew into the CTAs space. Was this a prudent move? No, it was not, because over the next five years the strategy on average did not perform that well. When we talk about this we talk about indices, we talk about average, yes, there are CTAs who performed very strongly in this period, absolutely, but in general that was not the case.

If you build portfolios or if you believe in any strategy consistently over a time horizon, you might be wrong, and this is another element which we and every investor should keep themselves aware of, and obviously just the day-to-day work when it comes to analysing strategies that this is a variety which makes it for an investor in particular in Germany rather complex.

Hidden beta exposures
Track records. A lot of managers tell you in the beginning we do this and that. At the end of the period, call it the calendar year, you do certain statistical analysis and you sometimes find beta exposure, which you ask yourself: where is that from?

What helps is if you do the Beta analysis, you can judge if they’ve done what they say with regards to their exposure. A lot of people will say, “Wait a minute, Beta is market risk, right? And risk in the markets you have to follow closely.” Absolutely right, we’d rather look at factor exposure so we want to see, even if you manage a market-neutral long/short portfolio, you might find some Beta exposure that nobody was aware of, at least not the manager.

Incentivization and alignment
Very interesting topic, particularly in Germany where everybody says hedge fund managers are too rich, they make too much money, they don’t pay back to society.

For us the most important element is that there’s an alignment of interest, so no asymmetric incentivization. There is performance fee for the manager, which in itself has an optionality character. The higher the volatility of the manager returns, the higher the likelihood that the manager performs great, performance fee, thanks very much, done. Obviously that’s not the way these guys think but some biased investors could put it that way.

So what we think is important is that this is aligned, which means, we need substantial net wealth of the manger being invested in the fund. Why? We always say it in a very provocative way. The guys get hit first because of bad performance, then it’s us and then we turn to our clients. So this kind of alignment of interest is important for us and this is something which you can’t quantify, you have to analyse, you have to ask and you have to try to get proof.

Assets and diminishing returns
In the traditional word everybody’s feeling confident investing with AGI, Blackrock etc. that’s the same in the hedge fund industry. If you name the big guys out there managing 10 billion plus, everybody feels safe investing because you have a good operational setup, you can allocate money, and nothing will go wrong because they have six compliance officers, they have 20 risk officers and they all will know in advance if something goes wrong.

For us the point is academic research again, which we look at a lot. It shows that there is certain dependency of performance to assets. We have databases where we follow the strategy and the AUM accordingly. Between half a billion and a billion is the sweet spot of a managers size. There are other managers which are larger but nevertheless, research and our own experience shows that from a certain slope onwards – and it depends on the strategy – the risk of being too big, the risk of becoming inflexible is struggling to produce expected returns, and that’s something which you can’t really quantify.

This is academic research in general but for a single hedge fund, it’s almost impossible to create something like this, so there is the gut feeling again: is this fund too big? So you check on a couple of trades they’ve done, you check on a couple of stocks they hold and try to feel if there is a mismatch of liquidity and you have to judge it yourself.

Background checks
Background checks. Every manager in the room is aware that background checks are an important element. We spend up to $10,000 on a fund before we invest, but the point is, what do you get? You don’t get numbers, which you can crunch into an Excel sheet. Do I need to know where these guys spend their time outside of work, which golf clubs do they own, etc.? No. Does it help judging the manager sometimes? Yes.

On-site due diligence
Why is on-site due diligence absolutely key, in particular when it comes to checking on the research capabilities? It’s somehow different with systematic managers but when it comes to fundamental managers, merger arbitrage or distressed credit manager, we want to understand how the research is done. In every manager meeting you receive prepared research examples. That’s not enough you have to check the entire research process on-site.

UCITS hedge funds in Europe
Coming to Europe, UCITS hedge funds, are very much on vogue for the right reason. In particular Europe, which may be difficult to understand for the Anglo Saxon world, faces a very strong regulation. The daily corset, which the regulator pulls in tighter every morning as we get out of bed, is a big burden for investors. Therefore a UCITS hedge fund is an entry point for a lot of investors in particular in Germany as to get understanding of the hedge fund world. Offshore manager are not yet mainstream in Germany, which however might change in the near future.

But there is this perception in the media that because the regulator has done some work on the UCITS fund, approved it and its liquid and it’s certainly cheaper, it’s less risky because these guys can’t use leverage of the offshore world. Misperception!

UCITS Tracking error culprits: Cash drag, and derivatives
In UCITS world, in particular if you have a daily UCITS fund, there’s a certain perception or fear with the manager of a big redemption coming up and that’s when he needs to be ready because he’s a daily fund and has to pay out. If you go through the UCITS portfolios of well-established UCITSmanagers, you’ll see sometimes quite a large cash pocket, so this implicitly is a drag on performance compared to the offshore world.

Implicit tracking-error issues can arise from derivatives. I don’t want to talk about who’s good in UCITS world to structure a fund and who’s bad but there are swaps involved. Swaps trade on a bid-ask spread, and even if it’s just a basis point or two basis points, here again you might have implicit trading costs, which all add up and which – and this is our own research – results in tracking error. We follow 40-50 managers where we know precisely the offshore vehicle and the respective UCITS vehicle running, so we can measure the tracking error.

A comparable portfolio of 12 managers with an offshore and UCITs vehicle, equally weighted, have developed since April ’10, a tracking error of almost 14% in aggregate. If you annualize this you probably get to 1.5% – 2.0% per annum of better performance in the offshore vehicle. Again, investors might find the UCITS performance okay. What these guys can do in offshore world is possible in other ways, starting with leverage, than to use in this UCITS world, but nevertheless, the fact is that these high quality UCITS managers with their same offshore world have created a tracking error. Some pension managers in Europe say, “So what? I can’t go offshore, I need UCITS,” and that’s the frustrating element for us. Again, should investors sacrifice a larger proportion of expected return for taking almost the same risk?

When is “daily” liquidity truly daily?
People in our day-to-day business, investors and in particular the managers talk about daily liquid funds and they say, “We’re daily, we’re liquid and we can certainly give you your money back quite quickly.” But there are daily managers out there where the notice period is up to a week and the settlement period is sometimes two weeks. So in fact you call this guy and you get your money back three weeks later. Is this daily?

Qualitative, face-to-face, analysis is key
If you are lucky and honoured, then managers might come to you like today, but most of the time they are certainly not coming to Germany because Germany is not a place where hedge fund managers usually go. If you were in Chicago or New York, that’s where you meet them, so you have to fly there. You have to touch them, you have to meet them, you have to provoke them, you have to ask them for information, and once you get information, you ask the same question next year and hope that they say something different because then you can say, “Last time you said this,” and that’s when you extract the information. So we have to get out of your own comfort zone as well.

What do we spend time wise on quantitative analysis and qualitative analysis? Everybody with gut feeling says 80% quant? No, 75% of our time is spend qualitatively, and qualitative includes discussions in the office if the received background check is either good for us or bad for us. Computers are shut down; no Excel sheet is on because you don’t need it at that point in time.

You have to get away from your own desk. Every year, we see between 100 and 125 managers on-site, and on top of that we attend a vast amount of prime broker conference meetings and consistently monitoring calls. This all adds up to approximately 200 manager meetings outside our offices. This is key for us – this is the core element of our business. Do we probably sidestep from time to time? Yes, absolutely. Have we invested in funds that didn’t perform as we expected? Absolutely, but rarely. The point is sitting at your desk doesn’t help, so we have to get out there ourselves.

To sum it up, two points. First, the implicit reaction to a good track record is an elementwhich we always try to avoid. It might be an indication and from a philosophical point of view you could say the track record itself is not repeatable but this guy who created it is still there so it’s probably the guy, but you can’t measure the guy. Chicken and egg.

The second point is that you have to do your own research. You have to go out, you have to see these guys in their own environment.

The above is a transcript of a presentation made at the 4th FERI Hedge Funds Investment Day, held in Bad Homburg, Germany on 10 September 2015.

Marcus Storr is Head of Hedge Funds and joined FERI Trust GmbH in 2005. His responsibility combines general strategy allocation, manager selection, due diligence and portfolio management. From 1999 to 2003 he was a director within the global equities department of Dresdner Kleinwort Wasserstein in London, being responsible for European equity research within the Capital Goods sector as well as being the lead analyst on several successful IPOs and M&A transactions. Prior to this he was working for Robert Flemings (acquired by JPMorgan) in London. He has over 20 years experience in capital markets, transactions and manager selection. Mr Storr holds a masters degree in Finance / Capital markets and international management / economics from the Humboldt University of Berlin in addition to a two-year apprenticeship as a bank manager.