Many of our recent posts have touched on various elements of the push and pull between manager and investor. Certainly, several of our recent comments related to service providers, be they auditors, administrators, or lawyers, have focused on the question of who is the client....Is the client the manager, who hires and fires the service provider, or the investor who pays the bill (or to be technically accurate, 80% of the bill if the fund goes up, with the particular twist of footing 100% of the bill if the fund goes down).
We have accumulated a number of observations around this topic over recent weeks and will touch on several topics in future posts. However, we wanted to start our comments by referencing a very interesting article from the Hedge Fund Law Report (an excellent legal resource) which raised a slightly different distinction - do you invest in the fund, or in the manager? The HF Law Report's article was focused on the question of the risk of an investor bringing an action for style drift, but we were particularly drawn to the phrase we have emphasized in bold:
"In the hedge fund context, strategy drift (also known as style drift) broadly may be defined as a material deviation from the investment strategy represented to an investor – in the fund’s governing documents as well as orally, for example, in marketing meetings – prior to and during the investor’s investment in the fund. Implicit in this definition is the notion that a hedge fund investor purchases a product. But there is a competing, often more apt, view of the hedge fund investment process which holds that sophisticated investors do not invest “in a fund,” but rather “with a manager.”
The question of whether you invest in a fund or a manager is a very interesting - and critical - distinction. In reality, there is no "right" answer: as an investor, your answer depends on your own preferences and sensitivities.
In broad terms, the hedge fund industry has long been dominated by the view that you invest in the manager. When the industry was still the "secret club of the super rich", relationships and investor confidence in individual investment professionals was the mantra that drove industry growth. Performance was the only consideration: the fund itself was no more than an administrative convenience (or, more accurately, inconvenience) put in place to allow the manager to make money for the investor.
In today's market, many investors continue to share this broad view - that hedge fund investing is driven by the skill needed to identify managers with genuine and sustainable ability to generate performance. Inherent to that process is also the ability to identify honest managers. For these investors, weasel words in the offering document, liability disclaimers, broad abdication of responsibility by service providers are just not high priorities: they know, and have decided to trust, the manager. That is absolutely fine - these investors gladly accept the principle of caveat emptor.
However, for many other investors - and particularly institutions - the starting point is to emphatically invest in the product, not the manager. For these investors, hedge funds are just one, relatively small component of a broader asset allocation policy and should be selected and judged in accordance with criteria applied consistently across other asset classes. The industry has a profound problem if it expects such allocators to rip up the rule book that applies to all their other investments the moment we start thinking about hedge funds.
To this point, it's always very helpful to remember that, in the long only world, an asset manager is hired to do a specific job, generally in a managed account format under terms of an investment management agreement. Implicit in such an agreement is the view that the manager, while a valuable partner, is still "hired help" who can certainly be fired if they don't do their job properly. In Q4 2008, for example, the "long only" mindset would not have thought a second about replacing poorly performing hedge fund managers with either a transition manager or a new, permanent advisor on the grounds that the investment decision makers who got a portfolio into a loss making position may not be the best people to get it out. That is, of course, hardly an action which is commonplace in the hedge fund industry.
It is also critical to remember that most institutions are fiduciaries and, moreover, have reputational risk across a very broad range of stakeholders. Indeed, reputational damage may exceed direct, monetary losses should one of their hedge fund investments get into their difficulty. For these investors, it's not too hard to suggest that many institutions may be notably more sensitive to an unexpected loss on the downside than they are to outperformance on the upside: quite the opposite of the "performance is everything" viewpoint. Sure, performance is great, but don't lose us money (especially by stealing it) before you start thinking about making any.
For such investors, therefore, the "product" view is central. Firstly, as above, this matches the rules of the game in the rest of the portfolio; secondly, as a fiduciary, you need to allocate your beneficiaries' capital to investments which are clearly defined, structured and protected.
Thinking about these points, our expectation is that the industry will become more bifurcated between investors and managers who adhere more closely to either the "invest in the manager" or "invest in the fund" viewpoint. As we have already stated, there is no right or wrong here - rather, the issue is to correctly match investors and managers who share the same priorities and investment decision making framework.
We do have two points to make, however. Firstly, the trend of the industry - as we all know - is for an increasing proportion of hedge fund capital to come from institutions. Set against this progressive shift of capital sources, the progressive shift of hedge fund attorneys to develop structures which have more indemnifications, less service provider responsibility and more "broad and flexible" provisions is directly opposite to the needs and preferences of the investor group that is driving ongoing industry growth. This is the real stress point and something our firm grapples with on a daily basis.
Our second point refers back to the article at the top of the page, and specifically to the comment that it is "sophisticated" investors who are ready to invest "with a manager" rather than in a fund. The sophisticated investor argument is one we have heard several times recently: as an example, we were recently speaking with a senior audit partner from one of the Big 4 firms. We raised the well worn topic of auditor confirmations and received the well worn response of privity (see our earlier post). However, we found it very interesting when the audit partner commented that there are plenty of safer investment choices, such as regulated mutual funds, if investors were not "sophisticated" enough to allocate to hedge funds. The point being made, therefore, is that of course hedge funds are imperfect, and you need to be "sophisticated" if you are to play with the big boys without a comfy safety net.
This argument is, quite simply, an insult to the intelligence of every "sophisticated", institutional investor. It is precisely because we are sophisticated that we know what are the tough questions to ask: and it is precisely because we are sophisticated that we can quickly recognize unsatisfactory - and unsophisticated - answers.
www.castlehallalternatives.com
Hedge Fund Operational Due Diligence
"Risk Without Reward" is a trademark of Entreprise Castle Hall Alternatives Inc.
We have accumulated a number of observations around this topic over recent weeks and will touch on several topics in future posts. However, we wanted to start our comments by referencing a very interesting article from the Hedge Fund Law Report (an excellent legal resource) which raised a slightly different distinction - do you invest in the fund, or in the manager? The HF Law Report's article was focused on the question of the risk of an investor bringing an action for style drift, but we were particularly drawn to the phrase we have emphasized in bold:
"In the hedge fund context, strategy drift (also known as style drift) broadly may be defined as a material deviation from the investment strategy represented to an investor – in the fund’s governing documents as well as orally, for example, in marketing meetings – prior to and during the investor’s investment in the fund. Implicit in this definition is the notion that a hedge fund investor purchases a product. But there is a competing, often more apt, view of the hedge fund investment process which holds that sophisticated investors do not invest “in a fund,” but rather “with a manager.”
The question of whether you invest in a fund or a manager is a very interesting - and critical - distinction. In reality, there is no "right" answer: as an investor, your answer depends on your own preferences and sensitivities.
In broad terms, the hedge fund industry has long been dominated by the view that you invest in the manager. When the industry was still the "secret club of the super rich", relationships and investor confidence in individual investment professionals was the mantra that drove industry growth. Performance was the only consideration: the fund itself was no more than an administrative convenience (or, more accurately, inconvenience) put in place to allow the manager to make money for the investor.
In today's market, many investors continue to share this broad view - that hedge fund investing is driven by the skill needed to identify managers with genuine and sustainable ability to generate performance. Inherent to that process is also the ability to identify honest managers. For these investors, weasel words in the offering document, liability disclaimers, broad abdication of responsibility by service providers are just not high priorities: they know, and have decided to trust, the manager. That is absolutely fine - these investors gladly accept the principle of caveat emptor.
However, for many other investors - and particularly institutions - the starting point is to emphatically invest in the product, not the manager. For these investors, hedge funds are just one, relatively small component of a broader asset allocation policy and should be selected and judged in accordance with criteria applied consistently across other asset classes. The industry has a profound problem if it expects such allocators to rip up the rule book that applies to all their other investments the moment we start thinking about hedge funds.
To this point, it's always very helpful to remember that, in the long only world, an asset manager is hired to do a specific job, generally in a managed account format under terms of an investment management agreement. Implicit in such an agreement is the view that the manager, while a valuable partner, is still "hired help" who can certainly be fired if they don't do their job properly. In Q4 2008, for example, the "long only" mindset would not have thought a second about replacing poorly performing hedge fund managers with either a transition manager or a new, permanent advisor on the grounds that the investment decision makers who got a portfolio into a loss making position may not be the best people to get it out. That is, of course, hardly an action which is commonplace in the hedge fund industry.
It is also critical to remember that most institutions are fiduciaries and, moreover, have reputational risk across a very broad range of stakeholders. Indeed, reputational damage may exceed direct, monetary losses should one of their hedge fund investments get into their difficulty. For these investors, it's not too hard to suggest that many institutions may be notably more sensitive to an unexpected loss on the downside than they are to outperformance on the upside: quite the opposite of the "performance is everything" viewpoint. Sure, performance is great, but don't lose us money (especially by stealing it) before you start thinking about making any.
For such investors, therefore, the "product" view is central. Firstly, as above, this matches the rules of the game in the rest of the portfolio; secondly, as a fiduciary, you need to allocate your beneficiaries' capital to investments which are clearly defined, structured and protected.
Thinking about these points, our expectation is that the industry will become more bifurcated between investors and managers who adhere more closely to either the "invest in the manager" or "invest in the fund" viewpoint. As we have already stated, there is no right or wrong here - rather, the issue is to correctly match investors and managers who share the same priorities and investment decision making framework.
We do have two points to make, however. Firstly, the trend of the industry - as we all know - is for an increasing proportion of hedge fund capital to come from institutions. Set against this progressive shift of capital sources, the progressive shift of hedge fund attorneys to develop structures which have more indemnifications, less service provider responsibility and more "broad and flexible" provisions is directly opposite to the needs and preferences of the investor group that is driving ongoing industry growth. This is the real stress point and something our firm grapples with on a daily basis.
Our second point refers back to the article at the top of the page, and specifically to the comment that it is "sophisticated" investors who are ready to invest "with a manager" rather than in a fund. The sophisticated investor argument is one we have heard several times recently: as an example, we were recently speaking with a senior audit partner from one of the Big 4 firms. We raised the well worn topic of auditor confirmations and received the well worn response of privity (see our earlier post). However, we found it very interesting when the audit partner commented that there are plenty of safer investment choices, such as regulated mutual funds, if investors were not "sophisticated" enough to allocate to hedge funds. The point being made, therefore, is that of course hedge funds are imperfect, and you need to be "sophisticated" if you are to play with the big boys without a comfy safety net.
This argument is, quite simply, an insult to the intelligence of every "sophisticated", institutional investor. It is precisely because we are sophisticated that we know what are the tough questions to ask: and it is precisely because we are sophisticated that we can quickly recognize unsatisfactory - and unsophisticated - answers.
www.castlehallalternatives.com
Hedge Fund Operational Due Diligence
"Risk Without Reward" is a trademark of Entreprise Castle Hall Alternatives Inc.
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