In the current climate of economic downturn and skittish investors, portfolio managers are increasingly concerned about maintaining a stable capital base and avoiding mass redemptions. One reaction to the current environment has been for funds to initiate various liquidity gates and longer notice/lock-up periods; however, an investment manager can take a proactive approach by reviewing their investors and focusing on cultivating a more naturally stable capital base.

While managers are used to using quantitative methods to review their portfolio, there currently is not an analytical framework for managing their capital base. The measurement of the quality can help pinpoint potential capital base issues, as well as help formulate a plan for achieving a more stable base. This article will describe various guidelines for calculating the level of investor quality. It will describe the attributes that comprise the concept of ‘investor quality’ and discusses approaches for measuring them.

Components of quality

The investor quality can be thought of as containing the following four attributes: size, longevity, frequency and sensitivity. By applying various weights, relative to the manager’s concerns, you can derive an overall measure of the quality of the capital base. For instance, if the chief concern is the possibility of the majority of the fund withdrawing at one time, then investor concentration should carry the most weight. If slight downturns triggering redemptions is the prominent concern, then the focus should be on sensitivity.

Size and concentration

Size is simply the amount of capital that an investor currently has in a fund.

Size = investors balance / total capital balance

While that may seem straightforward, the implications of investor size are not. A fund that has a few substantial investors comprising the majority of the capital is going to be captive to the whims of those investors. Like its portfolio, for its investors, the fund’s goal should be towards diversity and away from investor concentration. A less concentrated capital pool will be less susceptible to the predilections of a few individuals. Coupled with other investor characteristics, like geographical region and type of investor, concentration can be a powerful tool of potentially forthcoming redemptions. A fund that has its capital base across several regions is less susceptible to local economic conditions; a fund with diverse types is less sensitive to investor regulations. Of course, a highly diversified capital pool containing many types might require more support by investor services, since each type of investor could have different needs, documents, etc. Although there have been no studies on investor concentration in investment partnerships, substantial research has been done on portfolio and market concentrations, and those methodologies can be applied to a fund’s capital pool. The rule of thumb in modern portfolio theory says that a well-diversified portfolio should consist of 25 to 30 positions, which certainly seems to be relevant when reviewing investor concentration.

If you want a discrete number rather than a general guideline, consider the Herfindahl-Hirschman Index (HHI), which is a widely used measure of market concentration. Here’s the formula for the index, tailored to fund investors:

Where si is the percent of capital of investor i in the fund, and n is the number of investors. Thus, in a fund with two investors that each have 50 percent of the capital, the HHI equals 0.502 + 0.502. The Herfindahl Index (H) ranges from 1N to one, where N is the number of investors in the fund. Equivalently, the index can range up to 10,000, if percents are used as whole numbers, as in 75 instead of 0.75. The maximum in this case is 1002 = 10,000. A very concentrated fund will have a HHI value of 10,000, while a highly diversified one will be close to zero.

Longevity

Longevity is the length of time that an investor has been in the fund. The older an investor, the more likely they are to continue to remain invested (through good times and bad). Analysing longevity is most useful when combined with other characteristics such as investor types and geography. By using the combined metrics methodology, a more focused effort can be made in obtaining ‘desirable’ investors.

Frequency

Frequency is the number of times an investor has made additional contributions. Higher subscription frequency shows a continuing commitment from the investor to the fund. While individual frequency is an interesting metric, appending information from a contact management system can be even more revealing. Questions such as “Are there advisors or institutions that favour your fund and are recommending it to others?” and “Are there similar institutions that have different frequency?” can be answered. Furthermore, when frequency is paired with the investors’ available cash, more accurate forecasting of future subscriptions can be performed.

Sensitivity

Sensitivity is the measurement of an investor’s propensity to redeem if the fund suffers a loss. Of all the metrics, this is the least direct, because it is difficult to determine what time-frame affected the investor’s decision. For example, a 5 bps loss for the period might not have triggered a withdrawal for the investor but rather, when combined with the year-to-date return, the fund had a 50 bps loss and that was the decision point the investor acted upon. While mechanically the redemptions can be associated with the funds returns, a manual review should be performed to verify patterns. A recommended approach to quantifying sensitivity is to review several spans together. Do not merely look at the returns for the period in which the investor redeemed, but also review the year-to-date and possibly the inception-to-date returns for the investor. Also, another consideration is the notice date. For instance, if a fund has monthly withdrawals but a 90-day notice period, then an August withdrawal should not be analysed against the returns for the month of August, but rather for June, which is the month the notice was given. Generating a chart, associating the withdrawal percentage with the various performance values is a simple way of reviewing sensitivity, for example:

where: {1} equals the amount of the withdrawal percentage over then current capital balance, {2} equals the prior financial period’s income over investor’s capital balance at the beginning of the period, {3} equals the calendar quarter to date income over investor’s capital at beginning of the quarter, and {4} equals the year to date income over investor’s capital at the beginning of the year

Looking ahead

As a result of the consolidation of hedge fund managers and an increasingly difficult investment environment, the hedge fund manager has been forced to become more sophisticated. The trend of applying discipline, now present in the investment decisions, will need to carry through all aspects of the business of operating the funds.

Accordingly, effectively managing the capital pool will become a more prominent concern. Funds will increasingly look to their back-office systems and administrators to not just churn out simple investor statements, but to give them the rich analytics they need to operate effectively. Investor quality metrics are among the more vital statistics. Armed with accurate measures, the managers can better cultivate a stable capital base and thus make their investment process easier.

Ron Kashden is president of TKS Solutions, a provider of integrated partnership and shareholder accounting solutions