18
Monday
May. 2015

WANTED: Innovation in Hedge Funds

We could write about direct investing – the new landscape of lending – but most of the large allocations are still going to mainstream alternatives such as hedge funds (and VCs and PE). Unfortunately, the process in which strategies and funds are selected by institutional allocators has the unintended consequence of killing creativity.

Let’s get right to the points: the institutionalization of the alts business has cleaned up many of the ills of the industry. It has also stifled creativity through a self-fulfilling prophesy – arduous and unimportant sections of DDQs and RFPs, and a focus on business risk that has grown out of proportion. The 2&20 model is rapidly fading, as it should. But even at 1&15, it doesn’t take a lot of AUM for a manager to make a good living, assuming strong returns. The problem: institutions and consultants are not seeking outsized, or even large returns. Too many allocations have been put on a governing device.

Why?

Huge long-only Fixed Income returns are on par with the risk-free rate (U.S. Treasuries), which still yields close to nothing. There remain few choices for yield starved institutions seeking Fixed Income-like returns on a risk-adjusted basis. Remember that market and business cycle forces are beyond the control of even the best managers, regardless of asset class.

Risks abound.

Enter hedge funds. Many offer what is perceived as low risk strategies, along with low returns – pathetic returns when compared to equity markets of 2009 and beyond. But low volatility and what are perceived as relatively safe strategies allow many consultants and asset owners to reallocate a big chunk of their Fixed Income allocations to other alternative asset classes to hit their target goal returns.

Big, bigger, biggest are the hedge funds that are gaining most of the large, institutional allocations. The staffing, back office, and longevity hurdles placed on all managers regardless of size only exasperate this already “synthetic” situation. It is generally accepted to be safer to allocate to an existing large manager, a new investment style and structure, even if it doesn’t apply their core discipline. Simultaneously, it is common practice to ignore talented smaller managers who have superior risk adjusted strategies, and few are ever allocating when risk increases but so do returns (remember the original purpose of hedge funds?).

The Net Result – A huge void in creativity

It is hard for talented managers to become discovered. The large allocations and the silence that talented managers receive if their DDQ/RFP response doesn’t check every box has created a process for limiting creative innovation and bringing along the next generation of talented managers. This starves newer firms and PMs of the AUM they need to move their business forward – and become more institutional.

To be allocated, you need the right org chart, and it needs to be filled. You need the right service providers, even if you are too small for them. You need the right track record length, unless you have a portable one from one of the big name brand shops.

In reality, the level of technology achieved by mini-primes, administrators, and the oversight provided by name brand accountants (who are not big four) makes the need for the large staffs “high hurdle window dressing.” In fact, outsourcing can increase transparency and accountability. This myth is embraced and promoted by large firms that can afford the infrastructure, and is perpetuated by the institutional culture that has evolved.

The Bottom Line

My team from when I ran Clear Asset Management and Clear Indexes helped create what is now called “Smart Beta” through our factor model, which was applied to long-only, ETFs and eventually two flavors of long/short. My hat remains off to Osman, Vijay, Emily and Joe, a great but now scattered team. Our luck was knowing investors. Everything else was skill.

Today, highly talented managers must go through mentorships, build the right CVs and portable track records, and hopefully be seeded by the very firms they are leaving for the entrepreneurial world. Managers need the right positioning, messaging and marketing. Talent and skill that can be harnessed into a repeatable process should be rewarded with AUM need to be properly communicated to the right audience. Thought Leadership is a cost of entry to allocations.

For the hedge fund industry to keep its heads held high and not just realize outsized profits, new talent needs to be embraced. An important step would be for institutions to create “blind” emerging manager programs. Talent with a repeatable and scalable process should be recognized, allocated and then grow or die based on their ability to maintain their edge.

Currently, size mostly matters. It is time for this battleship of a process to turn at a pace that will allow these very institutions to fulfil their funding requirements. For those with real talent willing to venture into their own fund, promote yourselves accordingly, and have a solid team to back you up.

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