Alternative Investment Management Association
Richard Phillipson, Investit
Cashflow into hedge funds has increased dramatically over recent years. But many hedge fund managers are still failing to win in client pitches because they cannot properly communicate their investment processes. Why? Because the hedge fund client base has changed and many managers have not yet understood this change. This increased cashflow is coming from institutional investors. But institutional investors have responsibilities to their own clients that are different from the traditional hedge fund investor – the high-net- worth individual. There are new ‘gatekeepers’ involved: Investment consultants and fund of hedge fund managers. Institutional investors and their gatekeepers, need to understand how hedge funds manage their money. If they do not understand it, they will not buy it.
You know who your new clients are
The hedge fund client base has evolved; it is no longer the domain of wealthy private investors. Institutional investors increasingly want access to the diversified return streams that hedge funds can offer. A recent report by The Bank of New York and Casey, Quirke & Associates , estimates there is around $361 billion in global institutional money invested in hedge funds. This equates to around 30% of total hedge fund assets and institutional money in hedge funds is estimated to grow to over $1 trillion by 2010.
Changing client requirements
For many managers, accessing this source of assets under management will depend on convincing those professional buyers employed by fund of hedge funds, or investment consultants and/or advisers acting on behalf of corporate schemes. These professional buyers and consultants need to take a view on the likely future correlations of the different return streams in their clients’ portfolios. They can only derive this from proper communication by managers. In addition, many fund of hedge fund managers are in fierce competition. They want to buy into new performance but have to be convinced the returns will be sustainable.
My performance is great; surely that’s the only marketing I need
Recently I bumped into an old colleague who constructs fund of hedge fund portfolios for one of the largest multi-managers in the world (he will remain nameless…) He looked tired. Having been to a major Cap Intro event run by one of the big prime brokers (where hedge funds meet potential investors) he had interviewed representatives from ten hedge funds in an afternoon. His feedback? “Good performance and great CVs,” he said, “but not a single hedge fund could tell me how they managed money. I can’t hire them, or even justify seeing them again soon, until they give me something better.” I was surprised. Many individuals who start up hedge funds do so because they have a clear view of the investment strategy they believe works best. So, why do they have difficulty communicating this to anyone else?
The Bank of New York and Casey, Quirke and Associate’s report also provides evidence on institutional clients’ hedge fund selection criteria. The report posed the question, “what are the most critical factors in selecting a hedge fund and/or fund of hedge fund?” The majority of respondents cited understanding and validating the sources and sustainability of an investment manager’s returns as the most important selection criteria. The performance track record came second to this.
Figure 1: Institutions’ Hedge Fund Selection Criteria - What are the Most Critical Factors in Selecting a Hedge Fund and/or Fund of Hedge Fund?
Source: Bank of New York and Casey, Quirke and Associates.
Institutional Demand For Hedge Funds 2
Say what you do and do what you say
Clearly communicating their investment processes has never been more crucial to managers. If their performance is good and process is sound, winning client pitches is straightforward. Say what you do and do what you say and say more about what you do, that is better than everyone else. Sounds simple doesn’t it? While managers easily grasp complicated investment strategies and instruments, clear communication still seems to elude many. How do we know? At Investit, we have worked on over seventy projects with both hedge fund and conventional managers to help them communicate what they do – and what they do better than the competition. Managers must be able to demonstrate their positive differentiators both in a twenty minute beauty parade, or a full-day consultant visit.
So, communicate beliefs…
The sales mantra ‘philosophy, people, process and performance’ is well known. What is not always evident is what each manager believes about markets. In other words, a clear opinion of why it does what it does. What market inefficiency is the manager trying to exploit? What behavioural failing leaves investable opportunities? Managers need to know what they think they need to find, before they can start looking for it. Beliefs, and conviction in beliefs, are what clients are looking for, yet this is the part of the investment approach that is most often missing from pitch presentations. Many managers start a client pitch with “what I do”, rather than “I believe there is an opportunity in the market for me because….”.
…and communicate models
Perversely, the managers who can most easily describe what opportunities are being exploited are generally quantitative hedge fund managers, even if they do not care to give away their whole statistical models. Non-quantitative managers can achieve similar clarity if they can describe a mental model of why and how they manage money. When Investit works with managers, we read their material and discuss what they do in order to infer what they believe. The way funds perform will be a clear signal to informed buyers whether the approach is being faithfully implemented. Managers need to fully understand their performance attribution and use this to substantiate investment decisions and investment beliefs.
There are also a number of functions that support managers’ entire investment processes, such as systems, supporting staff and control functions. While managers do not necessarily need competitive advantages in these areas, investors will want to have sensible discussions to satisfy their due diligence processes. Does the manager have the right tools to deal effectively without detriment to portfolio performance?
Hedge funds are increasingly popular among a new type of client – the institutional pension funds and fund of hedge fund providers. This trend is likely to continue. Substantial assets are available for those managers who can adapt to institutional clients’ requirements. Managers need to say why and what they do and do what they say. Where possible, say what they do better than everyone else. These are the things institutional investors and their gatekeepers – investment consultants and fund of hedge fund managers – want to hear.
Bill Muysken has recently joined Thames River to run funds of hedge funds. Prior to this he was Global Head of Research at Mercer Investment Consulting. He epitomised the view held by both fund of hedge funds and investment consultants when he said, “clearly identify the areas where you think you have a competitive advantage, because if you can’t identify these clearly, then we probably won’t be able to either.”