Brad R. Balter
Balter Capital Management
A gatekeeper can be defined as anyone who is responsible for selecting, screening and eventually allocating capital on behalf of others. For the purposes of this article, when we speak about the role of the gatekeeper, we are referring to the hedge fund and fund of funds universe. We are in the position of both gatekeeper and “gate knocker”, as we are always screening potential hedge fund investments while simultaneously attempting to work through various gatekeepers who provide investment advice to prospective investors.
Gatekeepers come in many shapes and sizes, ranging from professional consultants whose clients include individuals, endowments and pension funds, to those hired specifically by a high-net worth family office as “in-house” experts.
Gatekeepers are the watchdogs of the wealthy and in this regard they serve a necessary function. Just as most investors have no desire to be their own accountant or attorney, similarly most investors rely upon investment professionals for appropriate guidance in making investment decisions. When it comes to evaluating alternative investments, obtaining professional advice is essential but how many gatekeepers can live up to this task? In pondering this question, we have observed that many gatekeepers exhibit similar qualities in the way they view and evaluate hedge fund investments and this has led us to categorise gatekeepers as follows:
1. The Good – forward thinking, sophisticated and independent thinkers.
2. The Bad – unsophisticated, alarmists and having a tendency to generalise.
3. The Ugly – sophisticated, crowd followers and often victims of their large size.
“Good” gatekeepers in the hedge fund industry are not afraid to be where others fear to go. They are willing to do their own homework and set their own path. This is not to say they stray into strategies or areas which they are not comfortable with; rather, they approach all situations with an open mind. The hedge fund landscape is always morphing. They do not rely only on quantitative analysis but see the qualitative aspects of a potential manager as just as important as any number crunching.
Expanding on qualitative analysis, “good” gatekeepers will look for people who are knowledgeable, intense and passionate about investing. While they should and will have their own set of standards that help them to screen out the plethora of potential alternatives coming across their desk, they tend to stay flexible and avoid extreme rigidity. Most importantly, they are not afraid to admit what they do not know.
“Bad” gatekeepers generally exhibit an exiguous understanding of the hedge fund industry. They tend to focus on hedge fund fees instead of net returns and take a stance that is irrational and illogical when it comes to investing in alternatives. Gatekeepers in this category believe they know as much as they need to know about the hedge fund industry. In their view, sensational media headlines justify their belief that hedge funds are vehicles destined to end as a blow-up. If they do invest in hedge funds, it will be done reluctantly to satisfy a client demand. To save face and to demonstrate their prowess, they may even make an investment decision without the guidance of an expert in the field. Hoping to appear knowledgeable, they will select a high profile industry name. Sub-par returns are acceptable as long as they can claim to be invested where other well known investors are also invested.
We once asked a gatekeeper of a large pension fund why they had made a commitment to a particular fund whose reputation was one of low communication, extremely high leverage and, most importantly, lack of clarity as to the fund’s main business line. The gatekeeper shrugged saying, “well, they seem to have pretty good returns but we admit we are not quite sure what they do”. In fact, a director of a well-known investment division was quoted as saying, “there is a tendency to look at brand names…we’re conscious of it. We’re trying to move away from it but it’s there”.
Denial is another trait we often find in “bad” gatekeepers. As hedge funds continue to gain in popularity, such gatekeepers refer to a “bubble” and liken hedge funds to a fashion fad. “Bad” gatekeepers refuse to accept the fact that hedge funds are now part of the fabric of the investing universe. They have closed minds regardless of what may change structurally (e.g. fee levels, lock-up periods and transparency). Of course, sometimes they will be right. There will always be the poor performer and the occasional blow-up but that is no excuse for writing off investing in hedge funds altogether.
Gatekeepers in the “ugly” category share many of the characteristics of the “bad” gatekeepers but “ugly” gatekeepers are more sophisticated. Subscribing to a philosophy that, for the most part, is crowd-following, they will invest only where other big players have invested. This gives them the illusion of safety and theoretically ensures they never get fired by their employer. They place their faith in terms such as “factor analysis” and “statistically significant track records”, often forgetting the old maxim that past performance is no indicator of future performance.
“Bad” gatekeepers often oversee significant capital but they let their fears bias their investment decisions. Recently we heard a story from a hedge fund manager who received a visit from a potential institutional investor. The investor’s first question was, “who are some well known names who have invested with you?”. Gatekeepers who believe that name dropping is a key due diligence criteria are deluding themselves. If they would honestly reflect, they would realise they are calming their uncertainties by relying upon the alleged investment acumen of others. If they are questioned about a poorly performing investment, they justify their choice by citing a long list of high profile investors who are also on the same “Titanic” passenger list. In fact, quoting again from the investment division, “there is more public relations risk from going with non-brand names”.
“Bad” institutional gatekeepers also have a problem of size. The sheer size of the gatekeeper’s client assets under advisement may force allocations toward only the largest and most well known hedge fund entities. Capacity arrangements may have been secured and then the question arises - which clients get the benefit of capacity? We have found that having large amounts of money to direct toward hedge funds can trigger a behavioural move towards a protectionist mentality, as opposed to a forward thinking one. Even though a gatekeeper may have a large amount of money or a well-heeled client base, one should not assume that they are doing things the right way. In the same way that some of the world’s largest hedge funds are not always the best funds, the same philosophy can be applied to the world of manager selection and screening.
Richard Bookstaber’s, “A Demon of our own Design: Markets, Hedge Funds and the Perils of Financial Innovation”, provided a quote which we think appropriate for all gatekeepers:
“Hedge Funds are the unconstrained version of traditional investment funds in that they do not have restrictions on shorting, levering or expanding to innovative asset classes. They can do everything a traditional manager can do and then some. Because of this, hedge funds should dominate the traditional funds in generating returns. Looking at it another way, any traditional investment manager who finds himself passing up an opportunity to improve returns because he cannot get short exposure, cannot lever his exposure to a trade idea or cannot trade on a promising position because it lies outside of his allowable universe, will be left behind by an equally talented counterpart, who is following an identical investment method in a hedge fund.
This simple point, that an unconstrained investment process will dominate a constrained one, means that in the end hedge funds, whether in their present or some reformulated structure will move from being the alternative to being the standard”.
There is always value in a “good” gatekeeper. The “good” gatekeeper’s role can make a significant difference for even the most sophisticated of hedge fund investors, even if the role played is purely one of risk measurement or operational and business due diligence. We have seen many investors who have built up large hedge fund portfolios who have absolutely no oversight or any ongoing process of review, other than waiting for their next performance statement. In the institutional world, we often find investors who have actually commented that they are aware that their gatekeeper is sub-par but feel “comfortable” because of a well-known name. Investors who want top performance will benefit tremendously from choosing a “good” gatekeeper.
We are sure many gatekeepers reading this paper will nod their heads up and down thinking, “I fall into the ‘good’ category”. We ask you to ask yourself the question again and, if you come up short, remember even the ugly duckling can turn beautiful!
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