Wednesday, May 23, 2018

Are Smaller Hedge Funds Worth It?

Thomas Franck of CNBC reports, If you want to run a hedge fund that beats the market, keep it small:
Successful hedge fund managers should do something unusual if they want to stay that way: Say no to new investors.

The bigger a hedge fund gets, the worst it tends to perform, according to a new academic study.

Holding other features constant, a 10 percent increase in fund size results­­­ in a decrease of 13 basis points per month (or 1.53 percent per year) in raw returns on average and a decrease of 10 basis points per month (or 1.21 percent per year) in style-adjusted returns, according to the paper from Purdue University.

"A key implication of our findings for investors is that performance persistence is achievable when funds maintain a small size," researchers Chao Gao, Tim Haight and Chengdong Yin wrote. "Fund performance declines with fund age and that declining performance is not significantly related to a variety of fund and family-level characteristics, nor is it significantly related to young funds assuming higher downside risk."

The paper clarifies prior literature that found that hedge fund performance peaks during the first few years of a fund's life, but declines thereafter at an average rate of 42 basis points per year.

The decline in performance, according to the Purdue researchers, appears to be due to managers taking their eye of the ball and focusing more on asset gathering (and the steady fees that come with them) rather than investing.

Other studies hold that historical compensation contracts in the hedge fund industry, such as 2 percent management and 20 percent performance fees, is not effective at aligning managers' incentives with investors' interests.

Yin's 2016 study, for example, demonstrates that the management fee comprises a larger portion of total compensation when funds grow large and thus a fund's optimal size, from a compensation perspective, exceeds the size that is optimal for performance.

The research comes amid an ongoing move by funds to offer more competitive fee structures amid lackluster performance, declining revenues and rapidly evaporating investor patience.

"When funds grow large, fund managers may have less incentive to improve fund performance because most of their compensation comes from the asset-based management fee," the researchers concluded. "Thus, investing in small funds, regardless of age, may provide for superior and sustainable returns."
Ah, the old large versus small hedge fund debate. A few years ago, Barron's had a similar comment on how small hedge funds outperform bigger rivals but CNBC then responded by stating bigger is better.

Let me cut to the chase and give you my quick takeaways:
  • No doubt, smaller hedge funds that survive their first year in operation are by definition hungrier for performance and much more focused on performance. Why? Because in order to survive, they need to perform and raise their assets under management to a decent level over the first three years.
  • What is the critical threshold for assets under management? It depends on the strategy but some say it's $300 million, some $500 million and some over $1 billion to survive and deal with all the regulatory, compliance and institutional demands.
  • Large hedge funds are able to address all these demands. They also have a lot of money to pay their people well which allows them to attract the best talent. So, it's not true that all large hedge funds are lazy asset gatherers who stopped focusing on performance. Many are but there are plenty very much still focused on performance and if they weren't, they'd be out of business
  • I can also tell you there are A LOT of crappy small funds which is why most investors don't bother with them, preferring to focus on the 'best of breed' large funds which are scalable and offer them peace of mind (if they blow up, less career risk since other large institutions also invested in them).  
Anyway, I had lunch with Andrew Claerhout, the former head of Infrastructure and Natural Resources at Ontario Teachers' Pension Plan and Greg Doyle, Vice-President of Pension Investments at Kruger.

It was actually the second day in a row I met up with Andrew for lunch and it was a pleasure meeting him in person in Montreal where he was visiting for a couple of days.

I've said this before and I'll say it again, Teachers' screwed up big time letting go of such outstanding talent. Andrew should have been the next CEO of Ontario Teachers', he's very intelligent, super nice and an outstanding leader (following his departure, the CIO "resigned" and there were a couple of senior managing directors that left Teachers' Private Capital to start their own PE fund).

Anyway, Andrew, Greg and I had a great lunch, we enjoyed the nice weather and I enjoyed listening to them talk private equity, infrastructure, renewable energy and more. Greg was especially chatty and he's a bright guy, reminds me a lot of Mike Keenan over at Bimcor (BCE's pension plan).

Andrew really knows his stuff too, said there was a value creation plan behind every investment and "no investment was made unless we figured out a way to improve operations and unlock value".

Honestly, the guy should write a book or a guest blog comment because he spent 13 years at Ontario Teachers' first working in private equity (Mark Wiseman hired him) and then heading up infrastructure and natural resources over the last four years. He's seen a lot and he's no passive investor, he enjoys getting into the operational weeds.

We talked about the climate for fundraising. Earlier today, I sent Andrew a Bloomberg article on how Carlyle's co-founder David Rubenstein sees more money flowing into private equity than at any time in his three-decade career.

Rubenstein is a master at raising funds. Greg Doyle has met him (and plenty of other big shots) but he remembers him saying: "It takes six months to launch an IPO and 18 months on average to raise money and close a private equity fund."

You see, even in private equity, the fundraising might be great for the large, well-known funds, but it's no cake walk and it's brutal for smaller funds, many of which are struggling to survive.

Still, just like in hedge funds, there are some excellent small or medium-sized private equity funds (I can think of one excellent medium-sized PE fund in Canada, Searchlight Capital, founded by Erol Uzumeri who used to work at Teachers' Private Capital, Eric Zinderhofer from Apollo and Oliver Harmann from KKR).

Many institutional investors love private equity, it's their best asset class and they like it even if it's illiquid because the alignment of interests are there and so is long-term performance.

My last comment was all about how CalPERS is bringing private equity in-house, trying to emulate what Canada's large pensions are doing through fund investments and co-investments on larger transactions (a form of direct investing which lowers overall fees but it’s not pure direct investing).

Anyway, today I wanted to talk about hedge funds, especially smaller hedge funds.

There are some talented absolute return managers in Canada that are run by excellent managers but for one reason or another, they don't make it on consultants' lists of funds to invest in.

I hate the cookie-cutter approach where you need to check off all the boxes and think it's really worth  meeting managers one by one to understand their strategy, performance and people.

For example, in Montreal, I've already referred to the folks at Crystalline Management, one of the oldest hedge funds in the country which will soon celebrate its 20-year anniversary. Marc Amirault and his team have done a great job running a couple of arbitrage strategies and they have grown their assets very carefully (I think they're way too conservative and have told them so but it's what they're comfortable with).

But there are other emerging managers, some that received mandates from PGEQ. Quite frankly, the biggest problem in Quebec and rest of Canada is we lack a billionaire Bass family like they have in Texas to fund new private equity and hedge funds on a much larger scale.

We desperately need big billionaires with big cojones writing big seed tickets. I'm dead serious about this. The PGEQ is fine but we need something much, much bigger, preferably backed by large family offices since big pension funds aren't into taking big seed risks.

[Note: In March, CPPIB announced it made initial investments of as much as $250 million each in five startups and young hedge funds under its Emerging Managers Program in the past two years. None of these fledgling hedge funds are Canadian. Read details here.]

I see guys like Karl Gauvin and Paul Turcotte at OpenMind Capital trying to get assets under management and offering institutional quality volatility funds. Go see them, kick the tires, talk to them and you'll see they know what they're talking about.

But there are other less well-known players, slowly gathering assets under management, people I've worked with in the past. One of them is Francois Laplante who runs Folco Strategy Partners and is posting outstanding absolute return numbers.

I know Francois from my days at the National Bank going back almost 20 years. He and Philippe Couture were the only traders who survived and are still trading for a living (Philippe trades his own money and doesn't want to manage outside money).

Francois runs a segregated account using Interactive Brokers platform and charges low fees (1.25% management fee and 10% carry) because his costs are low. It's fully transparent, the client owns the account and can get out at any time, and he can run all the trades pari passu through this structure (by the way, OpenMind uses the same IB structure and also charges low fees).

I had lunch with him a couple of weeks ago and asked him to give me a brief description of his strategy/ edge:
Folco Strategy Partners equity long/short seeks to generate annual returns of 10% (net of fees) with a risk target lower than equity markets. We have a contrarian approach and we
focus on REITs and other defensive real asset industries such as renewable energy, rails, energy infrastructures, independent power producers, pipelines, utilities and telcos. The strategy offers a very low correlation to the equity market.

Our unique proprietary top-down and bottom-up investment process uses a combination of fundamental and technical analysis.

We focus on our sectors of expertise and remain disciplined at all times. We believe publicly-traded real asset sectors are occasionally mispriced, and we use these opportunities to our advantage.

We may invest or short securities in other sectors to seize opportunities or minimize downside risk (maximum 20% of AUM). We establish our geographic and segment exposures based on regional growth perspectives, currency impact and supply/demand dynamics The manager has a significant personal investment in the strategy. I am the biggest investor.
I highly suggest you contact him at  Folco Strategy Partners and do your own due diligence. A guy who has traded this long and in size (he ran big ALM desk at Desjardins) really knows his stuff and he's posting incredible numbers (a couple of investors I brought to him didn't believe it but one was so impressed, he already invested with him after visiting his office and kicking the tires).

All this to say, everyone loves big hedge funds, I too track what top funds are buying and selling every quarter, but it's worth keeping your eyes and ears open for smaller hedge funds that aren't brand names but often (not always) offer much better returns and alignment of interests.

In my humble opinion, the best investors positioned to invest in smaller hedge funds are large family offices who aren't afraid to take some smart risks.

Large pension funds can also seed smaller hedge funds through a fund of funds structure or some other structure (like PGEQ) but they move at a very slow pace and there just not interested in allocating risk to such a venture and when they do, it moves at glacial speed.

Let's face it, big pensions looking for scale want to write big tickets to a few big players. That will never change but maybe they need to rethink their approach and allocate some risk to smaller hedge funds.

Below, CNBC's Leslie Picker reports that hedge funds are raking in the money. The big hedge funds are getting bigger but this leads to crowded trades which is why returns are dwindling over time.

Update: Charles Lemay, Vice-President Business Development at Landry Investment Management, shared this with me after reading this comment (added emphasis is mine):
Great article Leo, 100% agree. When interests are aligned and the PM/employees have skin in the game...motivation to perform and succeed is much higher. You find this much more often in smaller shops vs larger ones who have “made it” and can afford to pay the bigger salaries so the PMs/employees get complacent. It’s not always true but like Vital Proulx said at the EMB event a couple weeks ago...graduating from being an emerging manager to above a billion is one thing...you have a sustainable business now...but keeping that drive and motivation to keep performing and growing to your “sweet spot” AUM for you strategy is very important. We need more stories like Hexavest (like your billionaire Bass family) who made it from nothing to $20B and have kept the engine going. Vital doesn’t need to work...but his passion is there, he loves what he does and wants to keep going. And yes PGEQ needs to get bigger...much bigger.
I thank Charles for sending me this and agree with Vital Proulx's wise advice, no matter how big you get, you need to keep the drive and motivation alive and that's been the secret behind Hexavest's success.

And just so you know, Hexavest recently announced it hired Vincent Deslisle as the co-CIO to help Vital and Jean-Pierre Couture, the Chief Economist. Good move, Vincent has a lot of passion for investment research and he's a very nice guy too.

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