Identifying the Alpha

Profiling the people behind the performance

Russell Corn, Managing Director, Diligence UK
Originally published in the November 2006 issue

The Amaranth blow-up in the late summer prompted a rash of media commentary on the vulnerability of the market to 'alternative forms of investment' and hedge funds in particular. Speculation was rife over the vilified commodity specialist, Brian Hunter, enjoying an unsupervised life of Riley in Canada as a result of the spectacularly successful bets he had made on the previous hurricane season.

As Amaranth losses (resulting from a less successful view of the weather in 2006) surpassed $6bn poor risk controls were cited and fund of fund managers' judgment called into question. These fund of fund managers struggled to explain why their one and 10 fees had not been put to better effect. In the final analysis, it seems, Amaranth may have been something of a damp squib; the markets proved more than capable of absorbing the losses and there was no LTCM-esque 'fall out'. However, the Amaranth situation did put a spotlight on the manner in which funds and the fund managers themselves are judged and analysed.

A debate has reigned for many years concerning the role of individual brilliance in investment success. Hedge funds have become homes for exceptionally capable investment managers who have often created their reputations within an unforgiving market where the results of trading judgments are there for all to see as individual performances are assessed against the market average.

Indeed, there are probably very few examples of a perfect meritocracy, but one would have to say that the world of investment management is pretty close. However, as in any other burgeoning industry there are the opportunists and 'wannabees' who crave the kudos of the hedge fund world without having the ability and experience to back it up. Then there are also the many who are good, but not that good.

The challenge for both hedge fund managers and indeed funds of funds managers is to be able to identify those individuals and funds that are exceptional from those that are average. As the volume of investment into the hedge fund industry expands at spectacular rates, it becomes increasingly difficult to identify the wheat from the chaff and reduce the risk of a poor investment decision. Whilst fund managers will always conduct legal and financial due diligence it is less common to assess the individuals behind a fund or perhaps the credentials and capabilities of a new hire.

In the case of Amaranth, Brian Hunter's managers and Amaranth's investors were undoubtedly delighted when decisions to back hikes in gas prices resulting from a particularly destructive hurricane season in 2005 resulted in a meteoric performance (Hunter is reputed to have personally earned $75-$100m on the back of these decisions). They may have glossed over the issues surrounding Hunter's departure from Deutsche Bank where there were rumours over trading losses amounting to $55m. They may also have glossed over the fact that as a result of his success, Hunter had demanded a move to Canada and away from the fund offices, despite this being an unusual situation. Indeed, it is not entirely clear how many investors knew Hunter was on the Amaranth team at all.

Understanding the people behind the funds

Amaranth – and other examples – highlight a requirement to understand both the companies and the people behind them. At the heart of investment success lies individual judgment. Individual judgment is a product of experience garnered over time and exposure to the markets.

The role of intelligence gathering entities in providing individual profiling to confirm the appearance of brilliance and to inform potential employers and investors of potential weaknesses, issues and pitfalls, is ever more prevalent. In the same fashion that head hunters identify the best candidates for a job, business intelligence firms may be employed to give a realistic, dispassionate and objective view of both individuals and companies. This runs from prosaic concerns over misrepresentation, to the more complex value-added discipline of searching out accurate and balanced views of strengths and weaknesses.

There is a natural alliance between business intelligence firms and investment managers, with many of the latter employing the former to augment and add value to research teams and capabilities. Business intelligence firms bring an alternative methodology to the problem solving arena and often have the contacts and sources that are required to answer seemingly difficult questions in challenging and opaque markets and situations. Such answers can reveal an investment opportunity or indicate a 'steer well clear' situation. As investors seek out the alpha in both funds, situations and individuals, they are looking increasingly toward business intelligence groups to help in providing the answers.

'Investment intelligence' whether provided by a business intelligence (BI) specialist, by a sector specialist or indeed, by an in-house team of analysts, has much the same aim; to provide substance and justification for an investment decision. The added value of using a business intelligence specialist is typically the reach of the expertise. BI firms, in order to be able to execute the day to day requirement of reputational risk management (for example – understanding the source of wealth for a prominent Ukrainian businessman in advance of an investment decision by the client investment bank) will have a broad range of international contacts and sources.

Provided one is absolutely clear on the source of information (i.e. that it is available publicly) it is relatively straightforward to migrate these contacts and sources toward the provision of useful and informative investment intelligence; the skill is in the framing of the questions. The provision of such intelligence has become an ever more pressing requirement as increasing numbers of funds and investors look toward newly emerging markets and investment opportunities therein.

Other uses for business intelligence

A further synergy between BI firms and alternative investment specialists lies with the long-only funds market and 'investment protection,' most commonly in emerging market situations where a company has been disadvantaged or disenfranchised in some fashion. Hedge funds may hold high risk/high return holdings such as mining companies and/or oil and gas companies with assets in Africa, Central Asia and Russia etc.

As such, investments are often the subject of wild fluctuations in value through 'local market pressures' (i.e. regime change). It helps to be able to predict these movements and to mitigate the risk from such events. BI firms, again through local presence and understanding, are often in a position to assist in seemingly hopeless situations, thereby mitigating potential loss or recovering actual loss.

Identifying the alpha remains the challenge for many parties involved in fund management of a wide variety of persuasions, from fund of funds to emerging market specialist funds, to hedge funds themselves. BI has a multi-faceted role to play in many situations, whether orientated toward the personalities behind funds or indeed toward the focus of their investment research.