Look Both Ways

Throughout my childhood I owned and rode a bike. In the 70s and 80s, no one gave two figs whether I did so wearing a helmet or not. Seriously, we drank out of the garden hose and trick or treated at houses where we didn’t know people, too. Those were wild and crazy years.

In the 1990’s, however, someone decreed that biking was entirely too dangerous to be attempted without a helmet. I promptly stopped biking. For those of you that have met me, or who have even seen my picture, you probably recall one critical fact about my appearance: I have Big Hair Syndrome.’ And it ain’t fitting under a bike helmet.

Flash forward 20 years and we’re discovering some interesting facts about the bicycle helmet craze. In places where bicycle helmets were required by law, bike trips decreased by 30-40% across all demographic groups and by 80% across secondary school aged girls.

Unfortunately, when people gave up their bikes, they also gave up the health benefits of riding. One study by the Brits suggested that the health benefits (in terms of increased longevity) of riding outweighed the risk of injury by 20:1. A study done in Barcelona put this figure at 77:1. In Australia, they found 16,000 premature deaths caused by lack of physical activity dwarfed the roughly 40 cycling fatalities that occurred each year.

And that’s the curious thing about risk. You can focus on a single risk (in the case of biking, that a head-on collision will occur at 12.5 mph) to the exclusion of all else and actually increase your risk of other types of injury.

This is especially true in investments, where there is no single definition of risk. There are a multitude of risks against which to guard, and most of them have corresponding risks they introduce. For example, if you maximize the risk of illiquidity (the risk that you can’t get to your money when you need it) you may compromise returns. Private equity has been the best performing strategy over the last 10 years, but locks up capital for 5-10 years depending on the fund. Likewise, venture capital, which has been on fire for the last few years, has a 10 plus year lock up.  Requiring high liquidity restricts the types of investments you can make, which can impede diversification. More liquid investment structures can have lower returns than less liquid investments because they allow for people to trade at exactly the wrong times. Don’t you know someone who sold his or her mutual funds or index funds at the exact bottom of the market? In addition, there can also be a lower premium on more liquid instruments.

Or consider headline risk. Remember the Chicago Art Institute and Integral Capital? When Integral blew up and the Art Institute was a large, and the only, institutional investor in the fund, the headlines abounded. Since that time, there’s been an acknowledged risk of being in the headlines for losing money. For this reason, many investors stick to the same small group of funds so that they’re not alone should the ‘fit hit the shan.’ Unfortunately, this leaves a lot of smaller, less-well-known managers in the cold, and can compromise returns as well.  It also increases concentration in a small number of managers, funds and strategies.

And what about fee risks? Being ‘penny wise and pound foolish’ can block access to some of the most successful (read: non-negotiable) managers and funds. It can also cause investors to eschew entire asset classes (private equity, hedge funds) increasing correlations and concentrations and reducing diversification. Or what about the risk of not beating a benchmark like the S&P 500? Chasing returns is not very productive in the long run, and it can cause investors to take unnecessary risks in order to beat a rising benchmark. It’s also difficult to outperform on both the up- and down-side, so targeting outsize bull market returns can lead to bear market catastrophes.

In short, there’s no such thing as a free lunch. Protect yourself single-mindedly from one risk, and you just increase your odds of obtaining a different type of injury.

The Honey Badger

One night last weekend, I was in bed reading when I was distracted by a noise coming from the bookcase in my master bedroom. I heard a thump and then scratching. Convinced it was one of my pets messing with my suitcase, which was out and packed for a trip the next day, I ignored the sounds. Thump, scratch. Thump, scratch. Thump, scratch. Finally I sat up in bed to admonish my cat for being a pest, however I quickly noted that said cat was on the other side of the room. And he was staring intently at the bookcase.

Thump, scratch.

Thump, scratch.

When I got up to look more closely at the bookcase, the door actually opened a little bit. The thump of it shutting was followed immediately by scratching noises. I stared at the door. Thump, scratch. I wondered if I should open it and see what was in there. Thump, scratch. I was pretty convinced it was an animal. Thump, scratch. A squirrel perhaps. Thump, scratch. Maybe even a honey badger.

Thump, scratch.

Whatever it was, I was sure it had rabies.

Thump, scratch.

I called the wildlife removal company and asked if they could come in the morning. They assured me that they would be at my house at 8:00 am, and I went to bed downstairs – after taping the doors shut and barricading the rabid honey badger in the cabinet with an ottoman.

THUMP, SCRATCH!

The wildlife people came to my house after I left for the airport, but called me to report on their findings before my flight took off.

“Ma’am, we’ve contained the situation,” they said.

“Was it a honey badger?” I asked.

“No, ma’am. Your DVD player turned on and was trying to open, which bumped the door. Then it spun and scratched the door, before shutting and trying to open again.”

Yes, the wild animal in my house was a vicious DVD player.

Why am I telling you this pretty humorous but somewhat embarrassing story? Because every person to whom I’ve told the story in person asked me the same question: “Why didn’t you open the cabinet door and look?” My answer? At the end of the day, I knew I had two long-term solutions to the problem. Either the wildlife folks would show up in 24 hours and remove the critter, or it would die and I could safely remove it myself with gloves and a shovel. I didn’t need to act right away, and doing so could actually have caused more damage.

The same thing is going on in the markets right now. The thumps and bumps of market volatility have a lot of folks spooked. But some people are checkers – they look at what the market is doing daily and try to develop a short-term solution. They are convinced if they act now, they can save themselves from whatever may be lurking in the dark. Other people are waiters. These folks develop a long-term solution and trust that their plan will work out for them in a defined period of time.  I’ll let you guess who sleeps more soundly through the thumps and scratches.

The key to surviving volatility, hysterical commentators, and even market corrections (which will happen), is to have a long-term plan. To be able to disengage enough from the noises in the night to ask the following questions:

“Would I buy this stock/invest in this manager/choose this strategy today?”

“Has anything fundamentally changed with this stock/manager/strategy or is this purely market movement?”

“Do I need liquidity from this investment now or in the immediate future?”

“What conditions would need to be in place for these undesirable changes to become the new status quo? Are those conditions likely to occur?”

By logically thinking through what might be causing the noise, it is possible to develop and stick to a plan that reduces reactivity and focuses on long-term goals and objectives. After all, in the words of Warren Buffett, “In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.”

 Don’t get me wrong. I am a fan of active investing and I’m not saying, “let it ride no matter what!” I am not, however, a fan of re-active thinking. I believe successful investments require discipline. And while you might jump when you hear noises in the market, you need a plan and conviction to avoid letting the rampaging honey badger into your portfolio.

Earworms and Investing

In 1965, the Byrds released Turn! Turn! Turn! The song’s lyrics were taken almost directly from Ecclesiastes and promises: “to everything there is a season.” After reading that Macro funds made an overdue performance comeback in September 2014, I walked around my office singing that hippie ditty all day. While it was an annoying earworm in less than an hour, after nearly four years of market gains, maybe we could all use a little repetitive reminder that investment strategies fall in and out of favor.

If you look at Hedge Fund Research’s top performing strategies for the last 14 years, for example, you can easily see where investors might have some short-term memory loss when it comes to performance. After all, the S&P 500 has taken top performance honors for the last 3 out of 4 years. If you look at the last decade, however, you can see that Emerging Markets strategies have been at the top of the charts for three years as well. In fact, the S&P 500 and Emerging Markets hedge funds have been as equally likely to lead the pack as to end up in the bottom half of investment strategies over the past decade. And Macro/CTA funds, which have been both maligned and heavily redeemed from in past months, were the number two performing strategy in 2007 and 2008 at the height of the financial crisis. Many investors were extremely happy to have allocations to those strategies at that time, and flows into CTA/Macro surged in the 12 to 18 months that followed the market meltdown. Interestingly enough, however, Macro’s top-notch performance was preceded by, you guessed it, bottom half performance rankings in the years immediately prior to the crisis.

And hedge funds aren’t the only alternative investments to fall into cyclical patterns.  While venture capital is positively on fire now, it has been a long road to recovery in the wake of the tech wreck. According to data from Cambridge Associates, US Venture Capital funds returned 26.1% over 15 years, but only 8.6% over the past 10 years and 7.5% over the past 5 years. Now venture capital is coming back with a vengeance, with a three-year return of 14.4%. There is even talk of a new VC bubble, which was probably pretty unimaginable just a few years ago.

Even private equity, which seems untouchable at this point, has its good and bad performance periods. With a 15-year return of 12.0%, according to Cambridge, a five-year return of 11.0% and a one-year return of a whopping 17.2%, private equity is clearly not immune to some degree of strategy cyclicality.

Why does this matter? We all have a tendency to chase winners and sell losers, whether they are strategies or managers, and even when we know that investment philosophy doesn’t often work. For example, a study by Commonfund Hedge Fund Strategies Group in August 2014 showed that chasing returns was not a long-term strategy for success. The study concluded that “there may be a natural tendency for hedge fund investors to gravitate toward managers that have captured a significant share of the market’s upside. However, since such equity upside capture is not common or persistent among hedge fund strategies, using it as a selection criterion may lead to adverse selection.”

Investing isn’t easy. It can be a fight against your instincts and ingrained behavior. So it’s healthy to take a moment every once and a while to remember that markets change and that strategies come in and out of favor. A relentless chase of returns is not only exhausting, but often suboptimal. And by definition, if you’re chasing returns, you’re already behind. 

Conference Savvy for Investment Managers

As part of my series on fund marketing, I thought I’d take a moment to talk about conferences. You can’t swing a dead cat without hitting a conference these days. There are events at least weekly, if not more often, all vying for your conference dollars and even more precious time. To maximize your conference experience, consider the following:

DO – Be choosy about conferences. Ask to see attendee lists (current or past, with contact info redacted if the organizer is touchy about sharing). Ensure that the audience matches your target demographic. Sometimes the only family office you will see at a conference is in the title of the event. Also, be aware of how many conferences you attend in a year. It was always a due diligence red flag for me if I saw a manager at too many events during a year, both from the perspective of expense management and time away from investments.

DO – Approach conferences with a battle plan. You should work an event like Sherman marching through Georgia. Make sure you get the conference attendee list with your paid sponsorship or registration and schedule meetings BEFORE the event. Have a target list of people you’d like to see in addition to your scheduled meetings. Bring your pitch book and one pager (if applicable) and plenty of business cards. If you are planning a dinner or lunch or golf outing, have the invites out at least 3 weeks in advance for maximum attendance.

DON’T – Stalk people. While this may seem counter to targeting attendees, there is a difference between seeking people out or asking mutual contacts for introductions and tailing people through an event. Once upon a time, there was a conference that offered homing devices to all attendees. It was not unusual to see an investor darting through the exhibit hall with 10 asset managers hard on their heels. It’s like Wild Kingdom - No one wants to be the antelope at the watering hole. Don’t approach people in bathrooms or lie in wait for them outside of lunches or other conference activities.

DO – Practice your elevator speech in advance. You need to be able to clearly articulate your value proposition in a NON-SALESY way. Rehearse a 2-minute and a 5-minute version. Role play with your colleagues how to seamlessly move from talk about a lunch speaker/panel/weather/golf outing into a quick summary of what you do.

DO – Ask questions when talking to your prospects. No one wants to hear a monologue about you or your firm. When practicing your elevator pitch, think of some questions to ask attendees to make the conversation more interactive. If you’ve done your homework on the attendees in advance this should be easy. Search Google for news or their website for RFPs and other information prior to the event.

DON’T – Commandeer your speaker spot (panel or standalone) to talk about your fund. Seriously. People will pass notes or text each other about you in the audience if you do this. Others may walk out. You’ll be known as “that speaker.” If you are lucky enough to get a speaking slot, think about how you can educate the audience. What is happening in the markets? What makes a particular investment strategy interesting? What is the outlook for a strategy? Always educate, never sell. Exception to the rule? Meet the manager, speed dating type of pitch events.

 DON’T – Sit behind your exhibit table if you have one. Stand up and move around in front of your exhibit so you can engage with people. If you sit, the only people that come up will be people that either know you or who want to have a serious conversation. You can miss more casual opportunities if you’re sitting down.

DO – Delegate effectively. If you aren’t a good public speaker and you have one in the firm, select him or her for speaking roles. If someone is better at marketing or capital raising, put them at cocktail parties or at the booth. There shouldn’t be a lot of ego involved in conferences – it’s a job function just like any other. Select the best person for roles to generate the most interest and effectively raise assets.

DO - Agree to follow ups during your conversations. The goal is to move the ball forward and have a plan (and buy in) to send follow-up emails including pitch books, monthly updates, commentary, white papers or other information. If you don't have a plan to continue forward momentum, you might as well not have gone to the conference at all. 

Stay tuned in November for more unsolicited fund raising advice!

The Truth About Hedge Fund Correlations

There are high correlations all around us. For example, there is a very high correlation between the per capital consumption of cheese and the number of people who are killed by their bedsheets each year. Hedge funds currently have historically high correlations to the indices. Is this a tragedy waiting to happen? Time will tell, but it's really too early to call.

Alternative Investment Good News/Bad News

Good News

According to HFR, emerging managers performed best during last 12 months, gaining 11.3% through 1H2014.

Diversity funds (women and minoirites have outperformed the HF universe at large during the last 12 months, gaining 11.1% through 1H2014

Marco/CTA funds led performance in August 2014. The beginning of a comeback?

Pattern recognition helps PE and VC firms recognize successful investments?

Seven high quality hedge fund start ups launching in London

CALPERS sticking with Private Equity despite "complexity and fees."

Companies founded by women yeild 12% more for their VCs and use 1/3 less capital

IFK will welcome two women to the stage in 2014, Nehal Chopra and Nancy Prial.

Hedge fund liquidations declined in 2Q2014 according to HFR.

Skill is back? Fed says "moderately active" outperforms passive investments.

NY Common's equity hedge managers exhibit "above averages stock selection skill.

Bad News

The largest, most established U.S. based hedge funds control more assets than ever before, with $1.8 trillion as of July 2014.

Many women and minority led hedge funds continue to struggle with AUM, and therefore face the same fund flow problems as other emerging funds.

156 trend following CTAs liquidated, the first decline in the number of CTAs since 2005.

But keeps VCs from hiring women & minority staff and investing in diverse founders?

Not a single female manager listed among them.

CALPERS decision to exit hedge funds used as a club in the fee war.

Women run companies received just $1.5b out of a possible $50.8 billion from VC firms

In the previous five years, only one woman, Meredity Whitney, had been included.

Trailing 12 month liquidiations was still the highest it has been since 2009.

Blackrock research shows "alpha trades" don't work.

Articles on HFs still act as if beating the S&P 500 is relevant.

Mi Alpha Pi – A Look At The Sources of Alpha

While at the Grosvenor Small and Emerging Managers Conference last week in Chicago, I started thinking about alpha. Despite all of the naysayers out there quick to announce the death of alpha, I would actually suggest that alpha is alive and well and living in many portfolios. I think maybe investors, quick to flock to a very concentrated handful of extremely large funds, have forgotten where alpha lives and what drives alpha. 

For that reason, I’d like to announce the formation of a new co-ed fraternity. A fellowship, if you will, called Mi Alpha Pi. Mi Alphas have no dues and no secret handshake. We are merely called upon to remember that alpha comes in different size funds, diverse managers, life cycle investing and from innovators. 

MI ALPHA PI

WHERE DOES ALPHA COME FROM?

Skill – Obviously, this is what we want in all of our hedge fund managers: the ability to find and make the most of investment opportunities. Skill comes from a variety of sources. Intelligence, experience, intuition, emotional awareness and other factors contribute to manager skill. Skill is long-term and must be judged in a variety of market environments, good and bad. And in Mi Alpha Pi, we don’t believe that short-term losses necessarily are indicative of loss of strategic acumen. We even have special hazing for investors that think that way.

Cognitive Alpha – Cognitive alpha comes from being able to think about the markets and investing differently than your investing peers. Instead of looking at Apple and AIG along with every other large hedge fund, these managers look outside the box. Many investors have a tendency to be heavily influenced by market news and earnings and, over time, buying attention-grabbing stocks has a tendency to diminish returns. How do you find cognitive alpha? Look to contrarians, women and minority run funds for less homogenized thinking.

Structural Alpha – There has been a plethora of research, including my own at PerTrac, that suggests smaller, emerging managers outperform larger, older funds. One of the reasons why this may occur is what I will call “structural alpha.” When a fund is small it can take advantage of niche plays and club-sized deals that larger funds may ignore. They also may have fewer issues with liquidity, volume and short-squeezes. As a result, emerging funds may be able to exploit their smaller structures to produce outsized gains.

Behavioral Alpha – Although it’s difficult to separate behavioral alpha from cognitive alpha, I think it is an important distinction. Cognition is how you think about the world, while behavior is what you do with that information. Behavioral alpha may be created by less frequent trading, less inopportune trading and infrequent return chasing. Young funds and women and minority owned funds may be fertile grounds for behavioral alpha.

Luck/Chance – It is difficult to admit that sometimes what we think is alpha is really just luck or chance at work. For example, in the late 1990’s when I first began researching hedge funds, there were a number of funds that had no real shorting skills but that, at the time at least, didn’t need those skills. The rising tide of the bull market lifted all ships, so to speak. However, when the markets broke during the tech wreck, it was quickly evident which hedge fund managers were wearing no clothes, luckily figuratively and not literally. This is why it’s always critical to ascertain whether a manager is riding a good strategy or a good market.

It’s time to look a little further than the 500 largest hedge funds to find excess returns. Finding alpha isn’t always easy, but the 2014 pledge class of Mi Alpha Pi is looking forward to welcoming you. 

Pay What!?!?

In recent weeks, there have been a number of articles lamenting how much hedge fund managers get paid.

“Most Hedge-Fund Managers Are Overpaid, Big Investor Says”

“Everyone Knows Hedge Funds Are A Rip-off”

“Hedge Fund Moguls Pay Has The 1% Looking Up”

Most of the assertions are, once again, predicated on the assumption that hedge funds all look alike. After all, if Forbes runs an article highlighting the top 25 hedge fund earners and a manager that raked in $280 million in 2013 takes the number 24 spot, all hedge fund managers must be making serious bank, right?

Wrong.

Most of these articles point to two sources of hedge fund manager income: the management fee and the incentive allocation. It seems that the management fee causes the most ire for investors and pundits. This flat fee is charged on the assets under management, or AUM, of the fund. If a fund manages $2 billion for investors and has a 2% management fee, the manager makes $40 million in base salary. Right? Well, maybe.

But let’s think about this logically.

• There are only about 500 funds (out of 10,000 or more funds) that manage more than $1 billion;
• The average management fee is actually closer to 1.5% than 2%.(around 1.64% by my last calculation);
• So yes, there are some hedge fund managers that can earn millions without investing a penny.

Hedge funds getting rich off their management fee are the exception, not the rule.

According to Hedge Fund Research, 56% of hedge funds managed less than $10 million at the end of 2013. That’s right, I said roughly 5,600 hedge funds have ten large or less under management. Those managers’ management fee payout? $200,000. And that’s if they are a solo operation. If they have to pay additional traders, administrative or back office staff, that number only decreases.

Another roughly 21% of funds managed less than $100 million according to HFR. Their total team base pay? $2 million bucks assuming a (not average) management fee of 2%. If you have a team of even five professionals, that’s $400,000 per person. More labor-intensive strategies split the money amongst more people.

Sure that’s more than a kindergarten teachers makes, but it’s not out of the realm of normalcy in business. Even small business owners with ten years of experience earn more than $105,000 while small business owners in New York can top $125,000 per annum according to Chron. In comparison, kindergarten teachers earn between $39,000 and $77,000.

And that’s just small business owners. Most CEO’s of Fortune 500 companies make up to $1 million in base salary per year. In 2010, the median bonus for Fortune 500 CEOs was $2.15 million. And in case you think that the bonus equates to an incentive or “pay for performance” fee in hedge funds, research in 2011 showed 97% of companies paid bonuses. Bonuses in corporate America have become pretty much ubiquitous.

I get that hedge funds have become in many ways the poster children for economic inequality, and I do think that perhaps it’s time to think of a sliding management fee scale based on AUM. However, I find it difficult to tar all hedge funds managers with the same "fat cat" brush.

As for the incentive fee, since managers only receive this if the fund performs, I have heard less pushback on that front. I guess it’s hard to argue with making money for, well, making money.

Ten Commandments for Pitch Book Salvation

Last month I launched a blog series on capital raising with a diatribe about why money managers actually need a pitch book. I got several emails afterwards asking if I had any advice about what should go in an effective pitch book. Do I have any advice? Silly question!

As a result of those inquiries, I came up with my Ten Commandments for Pitch Book Salvation. Follow them or be eternally damned to limited AUM.

FIRST COMMANDMENT – Thou shalt not create a pitch book longer than 25 pages or shorter than 17 pages. If a pitch book is too long, you’ve probably gone too far into details that may not be pertinent during a first meeting. The goal of a good pitch book is to get you to a second date, not to show everything you’ve got on your first meeting. If, on the other hand, your pitch book is too short, you risk leaving out critical information that investors expect to get in a first meeting.

SECOND COMMANDMENT – Thou shalt include your contact information. There are a lot of sinners out there on this one and you know who you are. I’d call you to let you know for sure, but I can’t find your contact information.

THIRD COMMANDMENT – If thou can say the same thing about other funds, it doesn’t belong in your first five slides. Your first five slides are about you. What makes you unique? What makes this the right opportunity and the right team? When you include phrases like “Our goal is to generate superior risk-adjusted returns” or “The principal’s have their own money invested in the fund” my reaction is, “Yeah, and…?” Ubiquitous and obvious phrases don’t help you communicate your unique value proposition

FOURTH COMMANDMENT – Thou shalt remember Miller’s Law. Investors (and really anyone for that matter) can only absorb about five facts at a time. When you get more than seven bullet points on a slide, you run the risk of overwhelming investors with information. Plus no one really has the time (or the desire) to read all that.

FIFTH COMMANDMENT – Thou shalt learn to use the slide master in PowerPoint so thy slides are uniform. Nitpicky, yes. But there are investors out there who are crazier about uniformity and attention to detail than I am. Have someone who is good with spelling and grammar check it over, too. 

SIXTH COMMANDMENT – Thou shalt include sample positions if thy legal counsel permits it. Most of the information in the pitch book is theoretical. Sample trades let me see what you do in practice.

SEVENTH COMMANDMENT – Thou shalt have slides on position/portfolio risk management AND operational risk management/infrastructure. Because portfolio risk is only one part of the risk equation.

EIGHTH COMMANDMENT – Thou shalt have thy pages numbered. If an investor skips ahead and asks a question that is answered later in your deck, you should be able to tell them what page to turn to while you discuss the answer.

NINTH COMMANDMENT – Thou shalt ensure you articulate the following: who you are, what you do, why it’s a good opportunity, why you’re good at what you do, who you work with (staff, outsourced services and basic service providers), what your terms are, how you manage risk, and how you perform. You are trying to establish your value and uniqueness. Leaving out any of this information makes it hard to learn to love your fund.

TENTH COMMANDMENT – Thou shalt use graphics periodically to make thy presentation visually interesting. Including VAMI charts on performance, org charts, or graphics to depict the security selection process and/or the portfolio construction process can help make your presentation pop. Also, many people react more strongly to visuals than words, so a VAMI chart in the place of a simple monthly return chart can be quite compelling.

And of course, it goes without saying that you need explanatory notes and bios (preferably with pictures to humanize the presentation) within your presentation. But if you follow these simple rules, you are one step closer to pitch book salvation. 

The Truth About Hedge Fund Performance

There has been a lot of negative rhetoric about hedge fund performance lately, including a rabid fixation on the fact that hedge funds have underperformed the S&P 500. This week's blog looks at the the facts and fiction around hedge fund performance, including:

1) how hedging impacts performance;

2) time window analysis considerations; and,

3) how in hedge fund investing, performance averages can be misleading. 

Labor Day Hiatus

The MJ Alts blog is taking the week off from laboring under our own strong opinions. Watch for a new blog next week. 

Will Accreditation Changes Turn Emerging Managers into Submerging Managers?

Most of my non-industry friends don’t know what I do. They all know that I do research in finance, but to most, my alternative investment research focus is as mysterious as if I was a pre-Snowden NSA operative. This is in part because many of them consider finance to be frightfully dull. However, the primary reason for their lack of knowledge is something called "accreditation."

The SEC restricts data on and investments in hedge and PE funds (as well as other private investments) to those folks that are “accredited investors.” For decades, being an accredited investor has meant either having a million dollar net worth (excluding your primary residence) or an income of $200k/$300k (single/married). These income and net worth standards are used as a proxy for financial savvy. If you have enough in the bank, then you must understand money, the SEC reasons, and therefore you are allowed to take more risks with your cash.

However, even as I type, the Securities and Exchange Commission Investor Advisory Committee is weighing changes to accreditation standards. Some of the considerations on the table include raising the income threshold to $500,000 and the net worth threshold to as much as $5 million. In addition, there has been mention of a financial literacy requirement, such as passing the Chartered Financial Analyst exam. The monetary requirements would wipe out a huge portion of the HNW investor community, while a CFA requirement would take out a significant portion of the rest. For example, increasing the net worth requirement from $1 million to just $2.5 million would reduce the accredited HNW investor base from 8.5 million to 3.4 million people according to some studies. (http://www.cnbc.com/id/101933881)

While I understand the urge to “protect” investors, I happen to think these changes are unwarranted and may potentially have a significantly negative impact on innovation and diversity, and ultimately returns, within the alternative investment industry. And frankly the proposed changes just raise a lot of questions for me.

Why this particular threat?

There are a number of financial arenas in which enhanced knowledge, wealth or sophistication could make a material difference in outcomes. For example, according to one study, 15% of all bankruptcies are caused by credit debt, including credit cards, large mortgages, and car payments (http://assets.clearbankruptcy.com/infographics/leading-causes-of-bankruptcy.jpg).

In 2010, there were nearly 1.6 million bankruptcies. So approximately 240,000 Americans potentially could have avoided bankruptcy if the government controlled how much credit one could obtain, how much creditors could extend, or how well people have to understand credit before taking on such burdens.

Likewise, look at day traders. In order to manage a pattern day trading account, one must maintain a mere $25,000 balance. Yet, one study showed that four out of five day traders lose money, while another determined only one out of every 100 day traders consistently make money. Let’s assume that roughly 10,000 people in the U.S. day trade as their primary job. Of those professional day traders, 100 consistently make money and the other 9,900 consistently lose. Why not regulate this more closely? Maybe require a CFA?

And don’t get me started about gambling or the lottery. According to a Gallup Poll on Gambling, 57% of American adults reported playing the lottery in the last 12 months, with 65% of those falling into the $45,000 to $75,000 income bracket (http://www.naspl.org/index.cfm?fuseaction=content&menuid=14&pageid=1020#LotteryOdds) Your chances of winning the lottery? Less than getting injured by your toilet this year, according to National Geographic. How many folks do you think really understand those odds?

Hell, the average investor can contribute to a Kickstarter campaign for potato salad (over $40,000 raised) or a Chipolte burrito ($1050) which are both completely stupid investments AND utterly unregulated. Or what about Bitcoins? Mt. Gox lost over $409 million for its clients.

In short, there is no end to the ways you can “invest” your money. And any way you slice it, there are plenty of ways that these investments can destroy your wealth. Why doesn’t the federal government care about the “sophistication” required to understand, withstand and mitigate other "investment" risks, particularly ones that have a lot lower chance of success?

Isn’t this a self-limiting problem?

 If this is aimed specifically at hedge funds and private equity, the issue of high net worth investors putting all of their cash into “risky” investments is somewhat limited by the structure of the funds themselves. With high investment minimums (generally between $250,000 to $1 million), it is unlikely that a “lower level” high net worth investor will be able to make more than one investment, if that. For some who are early stage “friends and family” money, those investment minimums may be waived, but then the potential “damage” is mitigated as well. Most managers don’t want a fund filled with small investors (more work, less capital), so they tend to limit small investments. The market forces alone seem to be pretty efficient at limiting the hedge fund investments of your average millionaire in this case.

Won’t this submerge emerging managers?

 One of the arguments to make these accreditation changes is that no one has really squawked about them yet. Of course, this doesn’t take into account that the funds that have the financial wherewithal to actually make a fuss probably won’t even notice. There are about 500 funds that have more than $1 billion or more under management. There are about 5,000 funds that manage less than $100 million. As you look across this size spectrum of funds, the importance of the high net worth investor decreases as the size of the fund increases. Generally speaking, larger funds tend to be better influencers and squeaky wheels. Its likely HNW investors just aren’t a very important part of a large fund's business model any more.

And for those that say HNW isn’t important to the entire industry, it is true that about 65% of the AUM in the hedge fund industry now comes from institutional investors. It’s also true, however, that virtually none of that is in the emerging fund (small, new, women or minority owned) manager category. The 35% of assets that are controlled by HNW and family offices remains vitally important to this group of fund managers. Without access to a significant pool of HNW capital, and specifically early stage “friends and family” capital, many emerging funds might never, well, emerge.

Why do we care? Smaller managers can produce higher returns. Smaller managers can provide liquidity to parts of the market that are ignored by larger funds. Smaller funds may innovate where larger funds may care-take. Limiting opportunities in the emerging manager space is a key step towards the homogenization of the industry.

Will there be any unintended consequences?

Angel investors who help small businesses launch, fund innovation and create jobs would be swept up in this as well.

Of course, I imagine the SEC cares about as much about my opinion on accreditation as my non-industry friends do. So after today's blog, I'm only talking about beer, boats and BBQ. At least until after Labor Day. Enjoy the long weekend, y'all!

Unsolicited Advice: The Pitch is Back

I've decided to dedicate one blog per month to providing unsolicited capital raising advice. This is the first in the my "Two Cents From The Peanut Gallery" asset raising series. 

Over the past three years, I have had the opportunity to speak with more than 200 emerging managers about their marketing efforts. In my prior life, I was engaged in manager selection for a fund of funds. Needless to say, I’ve seen a lot of pitch in my day. And unlike pop music, for emerging managers there ain’t no auto tune when it comes to finding the perfect pitch.

During the actual pitch or in the midst of a capital raising triage exercise, I often hear the same refrains:

“We haven’t focused on our pitch book.”

“We have a pitch book, but we really don’t use it.”

“No one is going to invest with us because we have a good pitch book.”

And I couldn’t disagree more. A very good, if not great, pitch book isn’t a “like to have.” It is a “need to have.” And here’s why:

1)   Your pitch book helps you refine your message. Many of the managers I worked with who chose not to focus on their pitch book gave disjointed or rambling presentations in person. It wasn’t at all unusual for a manager to get caught up on their bio for example, and skimp on telling me about their secret investing sauce. Thinking through and honing your written pitch establishes a cadence and sequence to your fund raising message. It’s also what helps you refine your message so you can clearly articulate your competitive advantages. Having a pitch book in this case isn’t about taking potential investors on a death march through the deck, it’s about taking the time to think about what you want and need to say to differentiate your fund, while checking all the boxes you know investors care about.

2) Your pitch book helps an organization “sing from the same hymnal.” It’s true that many emerging fund managers may be simultaneously wearing their fund’s money management and marketing hat. It’s also true that lean emerging fund organizations usually draft a variety of players into roles outside of their core competency. I have often seen emerging hedge funds where the portfolio manager(s), IR staff and CFO’s all get into the fund raising game. Having a strong pitch book helps anyone from your organization that finds himself or herself in front of a potential client tell the same story. Otherwise, each individual is likely to spend the entire meeting focused on what they know, and not make the key points that generate investor interest.

3)  Your pitch book works for you when you’re not there. Investors get hundreds of pitches from emerging managers. Sometimes a manager gets a full hour of undivided attention, and sometimes you get a scant 20 minutes at a “meet the managers” event. Often, emerging fund managers may get only a few minutes of distracted attention at a cocktail party or industry luncheon. Whether you get an hour or 90 seconds, the pitch book you provide during or after this meeting is your fund raising proxy. If you have a great deck that clearly articulates your competitive advantages, your performance, your strategy and your organization and operational infrastructure, you will have a much easier time getting future meetings and pushing follow up with an investor. If you don’t, getting back off the slush pile post meeting or conference can be difficult.

4) Your pitch book forces you to think about your brand. The emerging manager landscape is like the MMA of the investing world. In the hedge fund space alone, industry watcher Preqin has found the 500 largest managers control all but roughly $33 billion of invested capital (as of June 2014). Today, there are more than 5,000 managers with less than $100 million in assets under management, and on average these funds raised less than $500,000 each in 2013. To say the emerging manager landscape is competitive is hyper-hyperbole. While it is true that no glossy pitch book will make up for lackluster performance, craptastic operational controls or an alpha-less strategy, an institutional quality deck can help differentiate your firm and fund. The mistake many managers make is to think their brand is simply their bio, strategy or performance. It’s not. Your brand is not just the data about your fund, but the way in which you present it. Over the past 16 years, I’ve seen clip art, quote overload, typos and other pitch book missteps not just lengthen the capital-raising cycle, but stop it in its tracks. With online graphic design services like www.logomyway.com and www.inkd.com, and with the increased accessibility of professional design services firms, there’s no excuse for not building a strong brand.

Think of it this way, all other things being equal, an emerging manager who is thinking holistically and long-term about growing a business is more likely to get the investment than one who slaps materials together.

In the coming weeks, I'll be talking about how emerging managers can execute a marketing plan like Sherman marching through Georgia.  In the meantime, don’t forget to follow me on Twitter (@MJ_Meredith_J) for news and views on emerging managers and more.   

The Truth Behind Hedge Fund "Failures"

A recent Financial Times article entitled "Most Hedge Funds Fail" got me thinking about hedge fund failure rates and the reasons that hedge funds close. To put some perspective around the topic, I've created a quick video blog that talks about the different kinds of hedge fund "failure" and encourages perhaps a bit more moderation in our choice of terms.

aboutmjones.com blog post - analyzing hedge fund failures from Meredith Jones on Vimeo.

Investing and The Law of Unintended Consequences

In Nashville, we have a weekly paper called “The Contributor” that is sold exclusively by badged homeless individuals on various street corners around town. The paper costs $2, and I make it a point to stop and buy one once a week or so. Now before the bleeding heart liberal accusations start flying, let me explain. “The Contributor” contains some of the world’s best advice couched in its “Hoboscope,” written by one Mr. Mysterio. It’s worth the price of admission every time.

In a recent Hoboscope, Mr. Mysterio provided the following nugget: “Assuming the worst will happen might make you cautious, but it never really makes you safe.” In investing, at least, truer words may never have been spoken.

We all know investors are motivated by fear and greed. I would postulate that our fear wins every time. Maybe it’s the fear of losing money. Perhaps it’s the fear of not keeping up with investing peers. It could be the fear of headline risk, or of paying “too much” for an investment. But our fears feed our investment decision-making, creating cautious investors who somehow remain far from safe.

Take me, for example. For the last several months I have been sniffing disaster on the markets like a dog with his nose out the car window. Having lived through LTCM, the tech wreck and 2008 as a professional investor, my thoughts often fly to all the bad things that can happen to my little nest egg. At the moment, and for much of recent history, I’m primarily in cash. In the meantime, however, I’ve missed significant market gains, which compromises both my current and future earnings. I’m certainly cautious, and I’ve avoided my worst-case scenario, but I haven’t made my financial situation significantly safer due to that particular trade.

Look at the institutional investor community. One of their greatest fears is that of headline risk a la the Art Institute of Chicago and Integral Investments. As a result, many choose to pile their assets into a very small number of large and established managers (the 500 or so that contain 90% plus of the hedge fund AUM).  Studies, including my own from 2006-2011, Preqin and eVestment, have shown that smaller funds tend to outperform their largest counterparts cumulatively and across more time periods, and that new funds have outperformed cumulatively and across all time periods.  However, just like no one ever got fired for buying IBM, it’s unlikely you’ll be fired for investing in Bridgewater or Paulson. But does sub-optimizing returns in a world of growing liabilities truly protect us, or does it just spare us the humiliation and/or hard work of investing in or potentially being wrong about a smaller or newer fund?

And finally, think about the investors that remain all too focused on fees. Overpaying for an investment is a capital crime for a host of investors. They hope to simultaneously optimize returns by saving a few basis points and avoid the headline describing how much they paid their portfolio managers last year. Unfortunately, their fear can result in negative selection bias (only investing with lower cost funds or funds who will cut fees), going direct in an investment arena where they may not have sufficient expertise, or eschewing certain investments altogether. The illusion of safety is created, where their caution may in fact be creating its own set of risks.

Regrettably, I can’t tell you how to solve this conundrum. Let’s face it: I’m no Mr. Mysterio. I can only advise that when we think through our worst case investment scenario, we focus on all of the factors that need to be in place to make us truly “safe.” Not just on the one or two problems that keep us up at night.