Hedge Fund Armageddon
December 16, 2018
2018 Year End Review
December 26, 2018

The Hedge Fund Manager’s Dilemma…

My most recent article has generated an unusual quantity of feedback from friends in the hedge fund industry, so I thought I’d expand upon it and address this article to all my hedge fund brethren.

As you are well aware, despite outwards appearances, most of us struggle internally with the duality of our desire to produce long-term, risk-adjusted absolute returns vs. the business reality of needing to produce repeated, short term, volatility dampened, monthly outperformance. Before we dive in, I might as well note that this discussion only applies to discretionary stock pickers (like myself). If you run a VC or PE fund, god bless your mark-to-fantasy model. If you are a macro investor, good luck trying to guess what Trump tweets next and if you’re a HFT or Quant fund, you’ve already gone through my prior articles and built a model to front-run my future investments for a basis point each—congrats!!

As discretionary stock pickers, we all know what produces the best long-term outperformance—an un-hedged, concentrated portfolio of 7 to 15 uncorrelated positions. Such a portfolio has statistically been proven to give you enough diversification if you guess wrong about a position or two—while not so much diversification that you are effectively mirroring the overall market. This is the “Alpha Model.” What sort of companies do you choose for your 7 to 15 names? Everyone has a specialty; value, growth, event driven, turn-around, restructuring, etc. It doesn’t really matter. Do what you feel most comfortable with—or blend multiple strategies. Everyone has a skill set—go with what you’re good at.

Since Warren Buffett has been analyzed to death, let’s dwell on him a second—especially as most investors want to emulate him. What did he do so well? He selected a small basket (7 to 15) great businesses, with strong moats and high returns on invested capital—he bought them, leveraged them with non MTM insurance float and held them for decades, while completely ignoring short term fluctuations. This worked amazingly well since, statistically speaking, it didn’t particularly matter what price he paid for a great business (within reason) as over time, his overall returns from owning the business converged with the business’ return on invested capital adjusted for balance sheet leverage. (If you don’t believe me, plug a 25% return on capital into a model and see how little your annualized returns change if you pay 15 or 30 times earnings after 20 years).

Sure, it’s highly unlikely that any of us will own anything for 20 years, but is quarterly turnover ideal either? Let’s face it, taxes and frictional costs rapidly detract from returns—particularly if you’re trying to move large quantities of capital around. Besides, as a PM, you’re ultimately in the asset aggregation business. Do you want to be spending your time constantly recycling your portfolio? Or focused on raising additional capital to buy more of the same stocks you already love? Owning a long-term basket of 7 to 15 high return on capital businesses is an amazing model (both for long-term out-performance and capital raising). It makes you wonder why so many PMs spend so much time quoting Buffett and then doing the exact opposite of his model—particularly as Buffett was so successful with it.

Here’s why; if you intend to own something for 20 years, what are the odds that it appreciates in the first year you own it? The first quarter? The first month? Starting and maintaining a hedge fund costs money. You need AUM to feed the beast—heck, you need fees just to afford groceries for your family. How do you gather AUM if you don’t stand out? What if you under-perform? Do you want to bet that your 7 to 15 stocks will appreciate next month? It’s a coin toss at best. Where are interest rates going? What will the overall market do next month? There’s always some piece of esoteric bad news that could suddenly matter to one of your positions. Do you want to take on the risk that one of your positions declines and ruins your chances of raising capital this quarter? Do you want to show volatility to investors? Of course not—so you’re forced to diversify to the point that no one position can swamp the ship. You set hedges which cost you Alpha. You try to trade around your book and sell positions when they start moving against you, in order to reduce potential losses. You basically diverge from what is best for long-term returns, while trying to generate monthly or even daily Alpha. In the process, you find yourself trading a whole lot of stock, paying taxes and commissions and likely giving away Alpha along the way. Owning 7 to 15 stocks like Buffett isn’t particularly difficult to do in your personal account—it’s nearly impossible to do in a hedge fund. Besides, shouldn’t you be focusing your energy on raising capital instead?

One wonders if Buffett’s concentrated portfolio would even gather AUM in today’s world. I can think of dozens of friends with great records and minimal capital as investors don’t want to invest in volatile funds. Just imagine what the monthly volatility of a micro-cap portfolio was in the 1950s? Would Buffett get redeemed during his first drawdown and end up stuck with a bunch of illiquid filing positions that other hedge funds are shorting against? “Bid wanted; 70% control block of Dempster Mill.” He would be in the same position as all the current forced sellers with 4 trading days left to liquidate their portfolios.  No wonder he gave up on the hedge fund world and built a permanent capital vehicle—the hedge fund model almost by definition, detracts from your ability to generate returns.

 

So, what is the solution? Our industry has been fighting this battle almost since inception. I say that long term performance wins out. Be yourself and manage your book like you’d manage your personal account. Capital will come in and capital will go out. If the performance numbers are good—you’ll pick up capital over time. Ignore volatility—hedges only cost you money. A book that’s 120% long and 100% short may only be 20% net long—or it may be 220% exposed to some move where all your positions go against you. Once every decade, there’s an awful drawdown in the market—accept that it will happen (probably while you are trying to raise capital). Your only defenses are to hold excess cash or be willing to add to positions on margin. If you try to time the next drawdown, you will almost certainly end up underinvested while the market continues to rally.

One trade-off of running a concentrated book, focused on performance, is that as your fund grows, you need to move into more liquid companies—it may even mean that you need to cap your overall capital base. If you have redemptions, you need to be able to meet those redemptions without swamping your positions with sell orders. Not every strategy can (or should) manage billions.

We all talk about only taking investors who are long-term focused, but we’re an industry of prostitutes who will take anyone’s capital. If you sleep with dogs, you end up with fleas—same applies to investors. 90% of future redemptions can be avoided if you stop to understand the needs of your investors and turn away those who don’t fit into your fund’s objectives. Yes, this will slow your ability to grow your capital base—trust me, it’s worth it. Bad investors don’t just hurt your business—they hurt your other investors as well.

Trying to make 50bps more than the S&P without having a down month is an impossible business model. If you’ve convinced your clients that it’s possible—you’ve lied. Stock prices themselves are just random numbers on the screen. When there are forced sellers, those numbers are even more random. If you are following one of the sectors that’s getting liquidated, this is your chance to be a hero. Either you can take advantage of these bargains or you’re part of what’s causing the bargains.

This quarter’s round of redemptions is forcing a lot of people to re-evaluate what it means to be a hedge fund manager. I’m stunned at how many friends with outstanding records are suddenly doubting their sanity. Yes, once every few years, you get a chance to make some really smart decisions and buy a great business at a huge discount to fair value—then probably learn you were 25% too early. If you aren’t mentally set up for that, if your clients aren’t prepared for that, if a drawdown like that threatens the future viability of your hedge fund business, then you need to take a step back and reassess how you are running your fund. What’s happening right now with redemptions is proof that a lot of fund managers made a lot of mistakes over the past few years. It is also a gift for those who prepared right. Which side of the trade do you want to be on?

 

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