How Not To Invest In Hedge Funds:

We all know what to look out for when contemplating a hedge fund investment.

• Independent administrators and independent valuation of assets and calculation of fund NAV.
• Independent prime broker, reputable auditors and legal counsel.
• Independent board of directors consisting of seasoned industry professionals
• Rigorous processes, documented and inculcated throughout the team.
• Independent risk management with a risk manager who can override the trader or portfolio manager.
• Manager must invest a substantial portion of wealth in the fund.
• Strong track record
• Reference well
• Etc
• Etc

The list of criteria is endless, sometimes controversial, and sometimes even self contradictory.

This is NOT how to invest in hedge funds. It is a particularly poor way of investing in hedge funds, or any funds, or making decisions in general. Particularly in a field as complex as alternative investments, a process driven, checklist approach to investing, leads to mediocrity.

How To Invest In Hedge Funds:

Understand the Risks.

One cannot manage in ignorance. Understanding risk involves understanding the operational , fraud , regulatory , liquidity , market , funding , political , and manager risks. It involves understanding which risks are acceptable and which are not. Risk management goes beyond having a big matrix inversion, Monte Carlo machine or VaR system spitting out numbers. That’s just market risk and even then its just the surface. Risk measurement and quantification is not risk management. Risk is a multi faceted issue that needs a multi faceted approach. The operational infrastructure and processes are often intimately linked to the investment strategy. High frequency traders need different infrastructure to longer term buy and hold strategies. Multi asset strategies have different needs than predominantly single asset strategies.

In the area of operational and fraud risk, there is no substitute for being sceptical and leaning on principal agent theory. In the area of operational integrity, motive is sufficient for suspicion. An independent administrator, independent control over assets, are necessary conditions. If there is fraud, the impact is not just on capital but on reputation, on confidence, on career. The position and situation of the risk taker within their organization also impacts judgment. The type of ultimate clients or investors will impact decision making also. One is constrained not only by the enemy but by their generals and even the people they serve.

Understand the philosophy.

One cannot manage in ignorance. To understand fully the risks, one has to understand in quite a lot of detail, the investment strategy. Underlying most strategies is a philosophy. It doesn’t always have to be the case, but most of the time, a good strategy is built on a good underlying principle. Understanding the underlying principles allows one to make a better judgment if the flexibility that a manager will almost surely employ should be construed as style drift or a genuine and considered foray into a new area based on existing and related experience. The underlying principles of a strategy also frame the strategy. The investor who takes the time to understand will also be able to infer strategies independently of the investment manager, providing a basis for independent triangulation on the logic and rigour of the manager’s investment strategy.

Understand the strategy.

It is simply inconceivable that anyone would invest in a strategy they didn’t understand. So the question really is, how well does one have to understand a strategy before they are happy to invest in it? This will vary from investor to investor. The key is to understand the strategy to ones’ own satisfaction, and realize how much one understands, and how much one doesn’t understand and invest with that self knowledge. Guessing is probably the worst sin against understanding because it extrapolates where there might be treacherous or worse, interesting, twists and turns. Without a proper understanding of the strategy it becomes very difficult to understand what operational support and infrastructure is needed by the strategy, what service providers are adequate, what exposures and instruments to expect, what environments are detrimental or constructive, what kind of personalities of managers are suitable. It becomes hard to understand the factors that influence the performance of the fund and makes attribution impossible. It leads to inconsistent decision making when it comes to investing or redeeming from a fund.

Understand the Manager.

When one invests in a fund, one is really hiring the investment manager for the duration of the investment. When one hires someone, what are the considerations? Character and integrity, skill and technical expertise as evidenced by prior experience and by formal training, judgment, ability to manage people as much as investments, personality, are all considerations. Character and integrity can be checked with the use of professional background investigative services, court searches, regulatory registers, etc.

The value of reference checking is over estimated in hedge fund due diligence. All one gets is an opinion on whether someone is liked or disliked by the referee. References provided by the manager should carry little or no weight. In fact, the noise that that information brings can be so confusing one could argue that it should not even be sought. The analogous situation is a portfolio that is marked by the manager. If one will not accept that, don’t take a reference supplied by the manager. The exception is references sought to corroborate and collect factual information. But this is a mechanical exercise that can be outsourced or delegated.

This implies that all the information and impression regarding the manager or hire as the case may be, has to be from primary sources. Is it practical? Yes, but only at the expense of scale and cost efficiency. The personality of the manager is paramount. Manager’s fail when they fail emotionally. What does a manager do on a winning streak? Is the manager a psychotic risk taker? Are they ego maniacs? What does a manager do on a losing streak? What do they do when they hit a big loss in a short time? Or a long drawn run of small losses? Are they patient? Does patience help their strategy? Are they self aware? What is their built in risk appetite? What is the investment process, the one written in their heads, not on the Powerpoint presentations? How does one go about compiling these impressions?

Talking, to their friends, counterparties, colleagues, ex colleagues, bosses, hires, employees, peers, competitors, etc etc. But the lines of questioning must not take the form of the usual reference checking format, for then the answers will be to the wrong questions.

Another way is to talk about the trading history, examples of interesting trades, difficult periods, great periods. Track record is a useful starting point as context for discussing in more detail the actions and tactics that generated the returns. Talking about prospective trades is also useful, especially if you are proposing trades to the manager. Their responses and assessments of your trade proposals give invaluable clues to how they manage. One should of course propose as many poor trades as good ones as a control to the experiment. The risk with discussing only good trades is that it can be gamed by the manager attempting to build relationship for future exploitation. The ability to accept criticism on one’s own part is crucial in the effectiveness of this strategy. It is useful to realize that one’s assessment of one’s own prospective trades may be biased and poor.

Team dynamics are also important. A fund is often managed by a team. Is there a top dog? Is this a good thing? Is there groupthink? Is decision making by consensus? Is this a good thing? Its all strategy and situation dependent. It depends on the personalities of the individuals in the team. The compensation and ownership has to work with the personalities of the individuals. It gets complicated.

Understand Yourself.

Investing is as much art as science. The science is the easy bit. The art is all about being inconsistent, inspired, qualitative, arbitrary, and still coming up with good judgment. The path to good judgment is experience. The source of experience is of course bad judgment. Too much faith in one’s own judgment is a bad thing. Too little is also a bad thing. In understanding the risks, the philosophy, the strategy and the manager, very often, one will reach a point where there is no checklist of criteria to qualify or disqualify a manager, a point where judgment has to be exercised. Judgment consists of the accumulated biases and prejudices of one’s own experiences.

An example: I am a mathematician by training. I have built CTAs to aid my own discretionary trading, although I have never traded mechanically on their signals. To date, I have not invested in any CTA’s or systematic macro funds. Why? I demand more transparency than any manager is willing to give. Basically, because of my experience in this strategy, I am too pig headed and egotistical and think I’m too smart. There are a number of things I can do. I can carry on thinking I am God’s gift to CTA investing and invest that way, and will probably pay for my over confidence and inflexibility of mind. I can avoid the area altogether realizing that my experience will colour my judgment. Or, I can outsource or delegate the activity to someone else. There is no right way as long as all avenues have been considered and all the consequences and rewards are understood.

What Not To Do:

Don’t rely on track record. It is history and is the confluence of skill and luck and the attribution is very often unclear.

Don’t believe too much in reference checks. Use references to establish facts, not opinions. People are rarely objective about people they like or hate so the only objective opinion you are likely to get is from someone who doesn’t know the subject well enough to like or dislike them.

Don’t try to time strategies. You can talk about the opportunity set for a strategy but often in hedge fund investing the opportunity for profit is also the opportunity for loss.

Don’t try to be smarter than the manager. They do it for a living. You allocate to them for a living. Don’t confuse the two.

If you have a boss or investor or trustee who doesn’t understand what you are doing or doesn’t understand what the underlying strategies and risks are about, you are up the creek without a paddle. If they will not learn, you should decline the mandate.

Don’t be in a hurry. If a fund wants to close and you’re not going to be able to complete your due diligence, there are other funds.

Don’t procrastinate. It takes time to do due diligence and it is prudent to follow a fund for a few months, 6 to 12 is a good ballpark, to see how they do before you invest. Start early. Plan ahead.

Don’t listen to other investors. Use them to establish facts, not opinions. They are not going to underwrite your losses.

Don’t have any preconceptions. Examples are: shorting through indices is a bad thing, short volatility is a bad thing, nepotism is a bad thing, a history of gating is a bad thing… Everything is relevant in context.

Don’t like or dislike. Especially in the first few interviews. Its not time to like or dislike. Its still time to discover and understand.

The Luxury of the Right Structure:

Few professional investors will have the time to operate along the principles recommended above. Most of the time we are rushed, influenced by others, are too cowardly to demonstrate our ignorance, have not the right sophistication of end investor, don’t have the appropriate stability of capital, have inadequate scale, are either too big or too small, or are too emotional. Perhaps the answer is not to go after the best funds or managers. Perhaps there is no best. Or the cost of attempting to find the best is too high, in making mistakes, in becoming hostage to our own weaknesses. Perhaps the answer is to find what is suitable, to find what is necessary for the objective. Perhaps there is no best, or perhaps best is sometimes just not good enough and perhaps just good is better.

Imagine you ran a business in an industry that is mildly competitive but not overly so. Your balance sheet is stretched, your debt service is stretched and your bond spreads have widened. Let’s assume that you are solvent and likely to remain a going concern. Also, capital markets are open to you so that default is not an issue.

What do you do on the business front? Cut prices or raise them? If your industry is competitive, demand is likely to be elastic. If you are a monopoly, almost surely you are producing where demand is elastic. If you weren’t marginal revenue would be negative. (This is a feature of monopolies.)

Either way, cutting prices and trying to increase cash flow takes priority over turning a profit, especially for a stressed company.

Now imagine you are a country. Your balance sheet is stretched, so is debt service, your bond spreads have widened. What do you do? Raise taxes? Or lower them?

Before globalization took hold the above argument would not hold. Under increased labour and capital mobility, demand for domicile has become elastic.

Capitalism is bad at fiscal policy. Capitalism is also bad at monetary policy but that’s less apparent. You cannot hear a loud hum but you can hear a small bang.

I often wonder how effective central bank policy is at maintaining economic stability and price stability. Unfortunately I cannot observe comparable economies of size and complexity which do not have central banks actively managing inflation. Central banks who do not target inflation by and large manage dirty floats which import developed world monetary policy often to address mismatched sets of problems.

Perhaps it is a good idea for policy to be active only when price changes falls outside accepted bands, say +8% inflation to -3% deflation. Perhaps policy has no impact when price changes are within the range 0 to 5%. Perhaps policy is not necessary in the neighbourhood of this range. This is speculation that is hard to test.

The money multiplier measures the ability of the fractional reserve banking system to take a buck of real money and turn it into 8 or 9 bucks of … real money. Central banks control over this multiplier is via a required reserve ratio. It tells banks how much of each buck of cash deposit they can lend out. If the ratio is X, then the multiplier is 1/X. The proof is simple. Bank 1 lends out X which is deposited in bank 2 which can lend out X^2 and so on. The sum of this series is 1/X in the limit. But here is the problem that we face today. It requires that for every 1 buck, there is X bucks demand for credit. The appetite for credit just isn’t very robust. Companies have just come out of an acute recession. Individuals have been over levered and over spending and now need to save. If the savings rate is increasing, the marginal propensity to consume must be falling and demand for personal credit must be falling. Even as central banks are expanding their balance sheets, banks just aren’t. The actual money multiplier is shrinking.

The pessimist is worried that monetary policy is not working and that the disconnect between M0 and M2 is storing up future inflationary pressures of dangerous proportions. The optimist is happy that the printing of money has not had immediate inflationary effects and that households have increased their savings rates as they should to address the imbalances between East and West that had built up to the crisis of 2008. These, however, are the dynamics of household credit. What about corporate credit?

A low interest rate presents a low hurdle rate for investment. Corporate demand for credit will be dependent on product demand which is dependent on domestic and export demand. Domestic demand is a function of household propensity to consume. Export demand is dependent on a whole bunch of exogenous factors. It is sensitive to the terms of trade and thus exchange rate and inflation. As global growth recovers from the recession of 2008 and it becomes apparent that growth either is less robust than expected or less robust than necessary for tax receipts to pay down public debt, desperation often leads to beggar-thy-neighbour exports policies.

On the consumption side, one of the imbalances leading up to the crisis was a negative savings rate of the US consumer and a generally low savings rate in developed countries. Economists at the time prescribed prudent financial management and raising the savings rate. At the same time, they prescribed lowering savings rates in emerging economies like China as a means of correcting trade imbalances. The credit crisis had an instantaneous effect of reversing the direction of trade imbalances and addressing the domestic savings rates. Faced with lack of credit, US and rich world consumers had no choice but to increase savings rates. In addition, sudden risk aversion and uncertainty over investment portfolios, performance of pensions and employment prospects helped to raise savings rates. This manifests in a reduced marginal propensity to consume. What is individually rational collectively self defeating and detrimental to aggregate demand in what is known as the paradox of thrift. The paradox of thrift has several well known counterarguments.

–          Slack demand leads to lower prices spurring demand.

–          Savings are loanable funds representing an increase in potential lending. Consumer spending is offset by institutional lending.

–          Assumes a closed economy. Savings may be invested abroad.

The problem faced today is that:

–          Quantitative easing is balancing deflationary pressures. Moreover, price inflation is more prevalent in asset prices (claims on future goods) than in goods (current goods).

–          Savings are loanable but its not just individuals who are hoarding money, institutions are hoarding money as well, as evidenced by the reduced multiplier. The expansion of central bank balance sheets has not found an analogous or proportional expansion of commercial bank balance sheets.

–          The paradox of thrift actually holds for closed systems and the World is a closed system. In addition, trying to break the paradox at the domestic level leads to a beggar thy neighbour approach towards trade policy.

So the paradox of thrift is a real issue and likely to mean weaker real growth and less inflationary pressure.

In emerging markets, a larger proportion of income is spent on subsistence hence the marginal propensity to consume is not only higher but more stable. In more mature economies where incomes are higher, the proportion of income spent on subsistence is lower and thus the marginal propensity to consume is less stable. As government spending seeks to fill the deficiency, the transmission mechanism, the velocity of money, is a function of the marginal propensity to consume. Much as the fractional reserve system of banking has a multiplier, fiscal policy passes through a spending multiplier. That multiplier has in the current economic climate, been reduced. Where once government spending was multiplied, today it is being saved. Why? Because we can. Because greater uncertainty encourages more saving. Because the reaction to more inflation may perversely encourage cash hoarding. Because people make strategic errors. The result is a realization of the paradox of thrift at a global level.

The loss of the multiplier is not catastrophic as long as it is not counted on. It is therefore crucial that Government therefore directs its fiscal efforts at productive expenditure. If a road is built, it should be a toll road and a profitable one. If a railway needs to be built it has to be a profitable project. Bridges to nowhere lead to nowhere physically and fiscally.

Time is necessary for savings and consumption rates to stabilize and to reflect income and employment prospects and inflation expectations. It takes time for businesses to stabilize their demand for credit, for lenders to stabilize their risk aversion, for the banking system’s multiplier to re-establish itself. In the meantime there is little that capitalist systems can do to steer an economy in the path they wish.

For centrally planned economies the problem is not easy but it is easier. They have better short term control over the path of development of the economy, but over the longer term are hostage to the same noise and uncertainty, perhaps more so, than their capitalist counterparts.

Investing is not for the faint of heart. Neither is it for the psychotic risk taker. Investing requires balance, rationality and a good deal of detached and independent thinking. So don’t listen to me. Figure it out for yourselves. Here are a few common declarations by investors and a few (loaded) questions they should ask.

We will only invest with managers who did well through 2008. Did 2008 represent normal conditions? What is the probability that the liquidity conditions of 2008 repeat themselves? How does one manage around this probability? What is the opportunity cost of assuming a high probability say > 20%?

We will never invest with any manager who suspended or (gated) restricted redemptions in 2008. Would it have been preferable to have a firesale, or an orderly liquidation? Would it have been fair to all investors both those who want out and those who want to remain invested? Was the manager protecting their own franchise or exercising due care in discharging their fiduciary duties?

We were surprised and disappointed at the behaviour of the manager in 2008. Did one understand what the manager was doing prior to crisis? Leading into the crisis? Did one understand what the manager was facing in the midst of the crisis? Coming out of the crisis? To the extent that one is comfortable investing in distress investing funds, does one see some parallels between gating and suspension and the Chapter 11 reorganization process?

We will only invest with liquid funds. Does one need the liquidity? If the only time one needs the liquidity is in a crisis then is seeking partially liquid investments which end up illiquid in a crisis the right strategy? An illiquid strategy or portfolio offering liquid fund terms is usually a failure of asset liability management, but how about a liquid strategy or portfolio with less liquid fund terms? Is it fair for a manager to demand some level of stability of assets for business stability reasons?

We will only invest with managers who have a long and consistent track record. How does one differentiate between skill and luck? Track records are the result of the combination of skill and luck. How many teaspoons of skill were added to how many thimblefuls of luck? See my coin tossing experiment.

We will only invest with managers with a record of making money on the short side. We will not invest with managers who use futures to short. Does it matter how the pasta is made if it is healthy, non toxic, hygienically prepared and tastes good? Or perhaps the diner would like to take a turn as cook?

We will never invest in managers who are short volatility. Is a short volatility portfolio always vulnerable to tail risk?

We always want the manager to have substantially all of his liquid net worth in the fund. Would you put substantially all of your net worth in your portfolio of hedge funds? Is such a manager diversifying their own personal portfolio sufficiently? What does this say about the risk aversion of the manager, their confidence in themselves and their propensity to take risk in the fund?

We will not invest in highly levered funds. In fixed income arbitrage, what level of leverage is acceptable and what is typical? In a futures based portfolio, how do you define leverage? What does margin to equity tell you about sensitivity of the NAV to fluctuations in the underlying markets?

We like to invest in market neutral funds. What market is the portfolio and the underlying positions neutral to? In credit for example, is the spread neutrality matched across the term structure?

We seek a fund with percentage of winning months over 90%, volatility below 3%, average returns of 11-12%, drawdown of no more than 1%, an 18 year track record, assets under management of several billion USD, monthly liquidity and fees of 1 and 20. Does one require an independent custodian and administrator? Does the fund sound familiar?

Investors are still adjusting from the shock of 2008 and the shock of 2009. It will take time. In the meantime, the measure of rationality in the world remains constrained. While it remains so, there are still obvious opportunities.