Dear Hedgie:

As a relatively new Tweeter (Twitterer?), I sometimes get questions from followers on a host of topics. In case you were also wondering, here are a few recent answers: Yes, there are almost always song lyrics hidden in my blogs. Actually, my hair is naturally large & no outside intervention is required. And yes, creating this much snark and sarcasm is exhausting.

Last week, I got the following question Tweeted in my general direction:

And while I can’t guarantee maximized profits, dear Tweeter, I can offer a few suggestions to enhance your first foray into alternative investments:

1. Take The Red Pill – The press loves, loves, loves them some alternative investments. And by loves, loves, loves I mean loathes, loathes, loathes. You’ve probably seen articles talking about excessive fees, billion dollar salaries, poor performance, insider trading, Ponzi schemes and other shenanigans and, I’m here to tell you, just because someone scribbled it on newsprint or online, doesn’t make it true. 

Take hedge funds, for example - they aren’t all gypsies, tramps and thieves, whatever you may have read. Fees are closer to 1.5% and 18% than to 2% & 20%. The vast majority of hedge fund managers make nowhere near the $11.3 billion that the 25 largest funds rake in, and are much more sensitive to reductions in fee income than you may think (see also http://www.aboutmjones.com/mjblog/2015/6/29/hedge-fund-truth-series-hedge-fund-fees). Insider trading happens, but is remarkably consistent at about 50 enforcement actions per year (across all miscreants, not just hedge funds). Ponzi schemes have happened but rarely at serious scale (and no, Madoff was not a hedge fund). Average performance of hedge funds has been lackluster but the top performers (who I’m pretty sure are the folks you want to invest with anyway) have generated some outstanding returns, even in the last few years. Don’t believe me? See the distribution of return graphics from Preqin’s latest study. 

Finally, there is no proof that hedge funds cause cancer, despite what the Hedge Clippers may say.

2.   Get a good data sample – One of the key mistakes I see from new investors in alternative investments, especially hedge funds, is the lack of a good data sample. The thing about hedge fund data is there is no requirement for any fund to report any information to any commercial hedge fund database. Period. As a result, the data is fragmented and incomplete. The only incentive for a fund to report to a database is to pursue assets. If a fund isn’t in asset raising mode, has a hearty network of prospective investors, or if the performance of fund is unlikely to attract assets, many funds simply won’t report. In addition, many funds report to only 1 or 2 databases, and if those don’t happen to be the ones to which you have access, well, that’s just tough cookies. The moral of the story? Invest in data. Buy data and gather information on your own by networking, going to conferences and talking to other investors about what and who they like. The only way to ensure you make the best investment decisions is to know what your options are in the first place.
 

3.   Think about what risk means to you – All too often, we try to boil risk down to a single data point. Whether it’s drawdown or standard deviation, we attempt to quantify risk because we feel like what we can quantify we can understand and control, right? Wrong. Risk means different things to different people and each investor will maximize different aspects of risks. For example, one investor may feel their biggest risk is not achieving a certain minimum acceptable return. Another may feel their biggest risk is losing a substantial amount of their investment. Yet another may feel headline risk is their biggest concern. And still another may worry about liquidity. The list is endless. The important thing for investors is to think about their personal (or organizational) definition of risk before making an investment, then identify the risks in any investment strategy as thoroughly as possible and finally determine if the potential upside is worth taking those risks. All investments involve risk. Period. Deciding whether the risk you’re taking is worth taking is up to you.

4.   Get your nose out of your DDQ – Get to know a manager and his or her team not just by grilling them with a long due diligence questionnaire, but by having a real conversation. If you know what’s important to a manager, what drives them, what keeps them up at night, how they got to where they are, what influences them, and how THEY perceive risk you have a much better chance of developing the rapport and trust that is necessary to any successful investment.

5.    Look ahead, not behind – If you’re chasing returns, you are already behind.

6.   Watch out for dry powder and Unicorpses – There is an awful lot of money flowing into private equity and venture capital and a finite number of reasonably priced deals, great management teams and fantastic business plans. Ensure any GP you plan to LP has the DL on deal flow.

7.   There is no I in TEAM – Actually, there is – it’s in the “A” holes. But I digress. My point is there is a lot of work associated with finding and doing due diligence and ongoing monitoring on alternative investments. If you don’t have a robust team, it’s ok to go to folks for help. Funds of funds, outsourced due diligence, OCIO, multi-family offices, operational due diligence firms, and other providers can be a lifesaver to a new or small investor in alternatives. It may not be cheap, but neither is recruiting, training and providing salary, bonus and benefits for an entire specialized team. Weigh what you can do in house against what you can easily outsource and spend the most effort on the voodoo that you do so well and money on the stuff that isn’t the best use of your time or expertise.

So there you have it: A small list of tips to help with first (or continued) forays into alternatives. Got a tip of your own? Put them in the comments section below.

(Humorous) Perspective on the Due Diligence Process

After spending some quality time with managers and investors recently, I've come to realize that, while they have a lot of respect for one another, they also have a lot of frustration with one another's due diligence processes. Here's their thoughts about each other's due diligence in a (somewhat sarcastic) nutshell. 

Tongue in cheek? Perhaps. But I think there's more than a little truth in those cartoons. 

Maybe we should try to agree to exercise a little more peace, love and understanding about what drives the due diligence process from both sides of the fence. For managers, efficiently (if not perfectly) responding to every investor and due diligence request is paramount, since asset flows for most managers are tight. For investors, who are also resource constrained, eliminating managers quickly that won't 'make the cut' is key, while fiduciary responsibility and headline risk contributes to a high stakes process. I think both sides agree the process is far from perfect, but perhaps there are ways to tweak the process, rather than see the other side as an adversary.

Investing in Portfolios, Performance & People

I realized I was getting a bit long in the investment industry tooth the other day when I actually started a sentence with “Back in my day…” In fact, all I needed was a cane and the ability to shoo kids out of my front yard for a full flashback to the crotchety down-the-street neighbor from my youth.

What aroused this fit of curmudgeonly angst, you may ask? Well, sad to say it was a pitch book.

Many of you know that I spend an inordinate amount of time looking at pitch books. I’ve seen long ones and short ones. Blue, black and green ones. Stapled, bound, slick, fancy or plain, I’ve seen so many pitch books my retinas have paper cuts.

Recently, while looking through a stack of pitch books I noticed a disturbing trend.

Title Page

*flip*

Tiny Print Disclaimers No One Reads

*flip*

Table of Contents

*flip*

Fund Highlights

*flip*

Performance

*flip*

Investment Process

*flip*

Portfolio Construction…

*flip*

Wait. Something is missing. *flip* *flip* *flip*

Hmmmm…*flip* *flip* *flip* *flip*

Oh wait….HERE it is…Firm and Manager Information. At the end? You betcha. Sometimes it was even in the appendix.

Look, don’t get me wrong - I recognize that investors are laser focused on returns. With all the underfunding and under-saving and underperforming, I get it. Returns matter. But they aren’t (or shouldn’t be) the only factor in the investment decision-making process.

Back in my day…

When I started investing in the late 1990s, we had a slightly different modus operandi for choosing hedge funds. Sure, we screened for alternative investment options based on returns (where available), but we didn’t get a lot of elaborate pitch books. Often all we got was a PPM, a conversation and, if we were lucky, some sort of beverage during our meeting. There wasn’t necessarily a formal “pitch” and the meetings generally entailed a lot of Q&A. My write-ups for the rest of the investment committee weren’t limited to number of positions, leverage, and service providers (although those were certainly important), but also included my general impressions of the manager and staff.

After all, we were placing money in a fund, but we were actually entrusting it to a person. And while it’s nice to think about percent returns, alpha, beta and the whole carful of Greeks, the decision of whether we were interested in a fund couldn’t be isolated from how we felt about the people to whom wrote that big freakin’ check.  (Ok, it was a wire, I’m not THAT old).

Unfortunately, I think relationships and trust can get lost in DDQs, tear sheets, check boxes and stress tests, and the proof is in the pitch book pudding. Managers are eschewing bios, org charts, firm details and even grim, blank wall mug shots for pages and pages of data.

And even though my first question has always been “can this person manage money?” it has always been followed by “and can I trust them to do so?”

I mean, you can't just divorce the process & performance from the person. Even in the most quantitative strategies, with the most robust black box systems or rigorous analysis ,a person is at the helm, programming risk levels, making assumptions about the markets and investments & deciding who to trust with that information. In short, people matter & you should know & understand those people as well as you understand the strategy. 

Think of it this way, if you trust your fund managers you sleep better at night. Combined with robust operational controls, you don’t worry that the manager may be running off to Key West to follow Jimmy Buffet with your money and a Coral Reefer tee-shirt. You also communicate better. Chances are the fund manager will engage with you more, and in a more open fashion. Simply put, the relationship and trust you mutually establish makes it easier to keep your mind on your money and your money on your fund managers’ mind. And of course, volatility is easier to stomach. In times of market or strategy volatility, you’re less likely to second guess or panic. If you trust the manager is executing the strategy you hired them to do, and you believe the market opportunity continues to exist, you can handle a loss.

If you think the manager is a lunatic, an a-hole, a loose cannon or in any way resembles Leonardo Dicaprio from Wolf of Wall Street in any way, none of that is possible.

Now, don’t get me wrong – I am not anti-research. Anyone who knows me (or even knows of me) understands that I let my Geek Flag fly. I also am familiar with the growing body of research that shows we have a tendency to make bad decisions when we rely only on our intuition. I’m also not anti-pitch book – I think a great pitch book helps before, during and after a meeting. But I do think we could all use a little reminder that, at the end of the day, we’re investing in people, and those people can ultimately make or break our investment experience.

So managers, put on a clean tie and go stand in front of your conference room wall, get your school picture taken and put it, and information about you and your staff, in your pitch book BEFORE you go too far down the strategy rabbit hole. And investors, look up from the checklist from time to time and think about whether you like, trust and can talk to your fund manager – you’ll both be glad you did.