Manager selection – process of elimination
Many talented stock pickers, analysts, strategists and traders may not have developed all the skills or more importantly an awareness of the skills necessary to run a successful hedge fund. Here is an indicative list of 12 red flags that may lead us to eliminate a manager, especially those that are just starting out, from further consideration.
n Lack of appreciation of the business aspects of managing a hedge fund. Look out for: lack of a strong CFO/COO, who can free the manager up to focus on investing.
n Lack of appreciation of the existence of a denominator, that is, a finite capital base. This is a problem especially with proprietary traders who are used to trading a line of credit. Look out for: imaginative track records and creative ways of defining invested capital.
n Closet longs. There are excellent long-only managers, who do not take a performance fee. Clues: if net long exposure is close to or over 100%. One does not need to pay a 20% incentive fee for leverage.
n Lack of portfolio management skills. This problem is often encountered with former sell-side analysts managing sector-specific funds. Evidence: oversized buy-and-hold positions in household names.
n Lack of experience on the short side. This is a problem especially with former mutual fund managers. Clues: shorts based on valuations alone, oversized positions or an admission from the manager that he or she looks at the short book as insurance, rather than as a profit generator.
n Lack of attention to optimising hedging techniques and reducing their cost. Look out for: small or mid-cap equity managers who hedge their portfolios with S&P or FTSE futures. This is an unintended long mid-cap/ short large-cap bet, rather than a hedge.
n Lack of knowledge of what else is out there, such as competitive products. For example, there is no reason to invest in a private placement unsecured convertible fund, when there are other managers who provide a better risk-reward opportunity by investing in secured debt with warrants.
n Use of third-party money raisers and sponsors, who have bad track records. One should note if too much of the capital comes from the typical “hot money” sources. Observe: whether managers have not met all of their end investors. Also observe if the manager attends a disproportionate number of hedge fund conferences.
n Attempts to create many products, rather than one fund that incorporates the manager’s best ideas. Usually someone else, such as a sponsor or large client, is driving product development.
n Uncompetitive fee structures or liquidity terms, such as lock-ups, that are less favorable than those provided by the new manager’s direct, more established competitors.
n Aggression in the capital raising process. Think twice when: the manager declares that there will be a one-time closing. Funds have a funny way of reopening from time to time, so there is no rush to invest large amounts from the outset.
n Unclear motivations for forming the hedge fund. Some new managers create investment companies because they do not have more attractive employment alternatives, or because they want to slow down rather than speed up. One hint: look out for former institutional salesmen who are suddenly in charge of risk management.