The New Year starts with a litany of top ten predictions on the hedge fund industry. I find these lists interesting on the surface but broadly unhelpful as they rarely offer clear, actionable recommendations for improvement to benefit from these prognostications.
For the vast majority of hedge funds, 2016 was a year to forget. Outside of the usual flows to the mega managers, it was tough for the majority of the industry. Additionally, over $1 trillion left active management in 2016, offering a significant macro headwind. 2017 is a new year and offers the real possibility for an increase of attention and capital to small and mid-sized hedge funds. Whether these managers capture this opportunity will depend on performance, investor appetite and the specific actions they take – or how they “Control the Controllables” – will put them in a position to succeed.
Here are the Top 10 Action Items managers must do to increase their probability of success in 2017:
1. Get on the Same Page: All organizations larger than 1 person have points of disagreement that distract from the core mission, which in the case of the hedge fund industry is to produce returns for investors. The New Year offers an opportunity to perform a top-down review of all aspects of the organization to identify sources of friction that would detract from the core mission of the firm. Frequent areas of internal conflict involve compensation, titles, office locations, work life balance and strategic plans for 2017. There is simply too much competition for a performance drag due to operational or organizational inefficiency.
Action: Conduct top-down audit to ensure that your team is 100% focused and aligned on common goals.
2. Institute a No Blame Rule: The asymmetry of skill and blame on Wall Street has always puzzled me. When performance is up, managers are smart. When performance is down, it was the market. It’s time for this to STOP. Investors are increasingly intolerant of excuses and blame wherever directed. It’s as simple as that. It is much better to stay positive and own the mistake – in process, in judgement, in macro shock value, in Brexit, in Trump what-have-you – than ascribe responsibility to forces outside of your control. Investors in hedge funds are fighting their own rear-guard actions with their constituencies defending industry performance and fees – the last thing they want to do is defend behavior.
Action: Own your performance – both positive and negative – and offer insight to investors on how and why decisions were made.
3. Incorporate Technology in a More Significant Way: I am confident that we will look back on 2016 as the inflection point of technology’s influence on the alternative investment industry. In 2016 the business of investment management had to grapple with numerous Fintech start-ups, Robo-advisors, big data applications, AI/machine learning strategies all while multi-billion $ quant funds continue to deliver stellar returns. In a case of massive catch-up, the major fundamentally driven firms started investing heavily in quant tools and incorporating them into their process. While it is possible that some of these trends may turn out to be noise, and regardless of which inning we’re in, make no mistake – the game has started. At this point Investors I speak with have programming talent on staff or access to powerful portfolio analytical tools which are integrated into their research and due diligence processes. The net result is tremendous efficiency increase of their investment process and improvement in their decision-making capability. They will expect that managers are at the same level if not more advanced. It’s gone from “nice to have” to “need to have.” Managers ignore this emerging trend and stick dogmatically to their “analog” process at their peril.
Action: Assess your strengths and weaknesses. Leverage technology to scale the former and fix the latter.
4. Know Your Peers: At one point in the evolution of the hedge fund universe it was ok to claim uniqueness. It is absolutely necessary now to consider your strategy and performance attributes vis-à-vis a peer group so that you can help investors make smarter and more efficient portfolio decisions. Investors have access to better technology and resources to identify your peers – don’t let them create your peers comps. The rapid growth of cloud based performance analytics systems offers investors the opportunity to immediately compare a hedge fund manager’s return profile against a range of different funds and strategies. However, hedge fund investing remains a people-focused business, so when asked to compare a strategy vs. that of a competitor, it is an excellent opportunity to demonstrate sector and peer knowledge and distinguish the difference in process, in risk tolerance or investor composition. Understanding the peer group is even more necessary as hedge fund portfolios become more concentrated and the task is generally one of replacement vs. allocating new capital. You need to know how you are different/better than what the investor already has in the portfolio, especially as the “bucket” that hedge funds fit into is constantly changing. Some investors have an alternatives allocation, some an opportunistic allocation and some fold hedge funds into asset class allocations.
Action: Identify your peer group, understand their strategy objectives, attributes, and weaknesses and how you compare.
5. Prepare for a New Round of Flexibility on Fees: Investors are and will be increasingly vocal on the fee structure and LP/GP alignment. The cohort of funds demanding a pure 2/20 structure is shrinking. Dogmatic adherence to one fee model in the face of growing pressure for investor alignments presents a tremendous obstacle to growth. Firms must adopt a new level of perspective and flexibility on the traditional management/performance fee structure. Managers that demonstrate open-mindedness and the creativity to consider, articulate and implement flexible fee structures will succeed.
Action: Be dogmatic on integrity, ethics, compliance, investor relations and the investment process – not fees.
6. Communicate from an Investor’s Perspective: Managers need to craft their marketing materials and investor letters with the end-user delivery in mind. Too often, managers don’t push themselves to consider their marketing materials objectively, and can get too granular on elements that don’t necessarily align with what the investors need to know. The landscape is so competitive that if materials are unclear, a fund will immediately be pushed aside. We recommend that you share your materials with an independent, informed market participant – which is different from a counterparty that is incented to say yes and make you happy – and ask if they continue to serve the intended purpose. Too often I find letters and presentations that present as an incoherent – although generally highly intelligent and grammatically correct – series of thoughts on the market, some individual positions, the odd internal update and usually ending with a “thank you for your support.” This is simply not good enough.
Action: Identify the purpose and goals of external communications and make sure that all client facing materials are clear, graphically appealing and most importantly, identify the value proposition for the investor.
7. Understand Market Perception of Your Firm/Fund/Strategy: Because of the historically high degree of confidentiality in the industry, hedge fund managers generally operate with an incomplete and/or blithe disregard to market perception. When was the last time you asked your investors how they thought were you doing and whether there was anything you could be doing better? Have you asked whether there are practices of their peers that you should emulate? How well do you understand your investor’s internal decision making process? Their commitment to your fund, your strategy or the industry in general? It is quite likely that your marketer knows the unvarnished truth – however, do they have a “safe space” to share that feedback? The mutual understanding between client and manager will serve you well during strong years and even more-so during inevitable periods of market/sector weakness or underperformance.
Action: Enlist a third party to conduct un-attributable perception research on your fund and strategy. Share the results and consequent steps taken with your clients.
8. Observe and Selectively Adopt Best Practices of Other Entrepreneurs: Hedge funds are investment vehicles but also small, nimble businesses that must generate their own unique idea flow and brand differentiation. Hedge fund managers will benefit greatly from observing best practices across a range of business management including talent attraction/retention, brand/marketing and sales. We’ve moved well beyond the industry’s closed, clubby Northeast roots to a much more fluid competitive dynamic akin to other industries. As a small business owner, I find tremendous relevance with how tech companies think about scaling their business, optimizing their sales process and how these companies creatively deploy technology to generate operational leverage. The rate of change is dramatic and the way successful entrepreneurs evaluate information and make decisions has helpful relevance to our industry.
Action: Entrepreneurs – in any industry – are your peers. Copy their best practices.
9. Understand the Investor’s Governance Structure: Understandably, managers and marketers focus primarily on the investment analyst teams, senior investment professionals and CIOs etc., but how well do they understand the significant push/pull dynamics that are behind these teams? Recognizing and underwriting the biases inherent in the governance structure is critical to success. My experience is that managers have an incomplete understanding of the investment process, starting with the investment committee – including its composition, past experiences, current preferences and alternatives knowledge base. When it comes to the final decision, it’s critical to understand the governance dynamic in more detail in order to appropriately allocate time, attention and estimate likely outcomes. It starts with asking basic questions. In the case of single family offices, what is the source of the wealth? For endowments and foundations, inquire as to the decision making structure – does the investment team have discretion or does everything go through committee? If the latter, what is the make-up on the committee? Do certain members predominate? Identifying the decision maker and their needs early on is critical.
Action: When approaching an investor understand all the forces that will generate a ‘No’ or lead to ‘Yes’ and it starts with the people and process.
10. Enable Investors to Move Closer to the Trade: Wherever possible or practical, it is important to provide investors the opportunity to get closer to the source of return or Alpha opportunity. The middle layers continue to be stripped from our industry, and the managers that offer investors a clear methodology and opportunity to express a risk view directly are the ones that will succeed. Already present in PE and Real Estate, the hedge fund space is now moving (rapidly) in that direction. It may take the form of managed accounts, best ideas portfolios, SPVs around a specific trade or other dedicated strategies. Offering investors direct access to deal flow and opportunities not only serves to strengthen the relationship and reinforce domain expertise, but is consistent with the larger trend of managers running their books with a core/satellite approach. Increasingly investors are looking for cheap betas or alternative betas to form the core of the portfolio and identifying niche alphas as diversifiers and sources of return as satellites. Looking forward, it is likely that individual trades or highly specific strategies will form that satellite ring.
Action: Through education and access to opportunities, help your clients get closer to the trade.
About Castle Hill Capital Partners, Inc.
Castle Hill offers an innovative and integrated offering centered on “Alpha and Assets.” The firm provides a range of brokerage solutions and strategic marketing and capital raising services for alternative asset managers. Castle Hill works in close partnership with our clients while it advocates and implements a structured marketing process that combines strategic marketing and specific, relevant investor introductions for a small set of differentiated alternative investment clients.
Castle Hill is a licensed broker-dealer, registered with the Securities and Exchange Commission (SEC) and is a member of The Financial Industry Regulatory Authority (FINRA), National Futures Association (NFA) and the Securities Investor Protection Corporation (SIPC). Additional information, including case studies about current client engagements and partner biographies, can be found at www.castlehillcap.com.
Co-Founder and Senior Managing Director
Castle Hill Capital Partners, Inc.