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4th FERI Hedge Funds Investment Day

10 September 2015
Panel discussion Mag. Georg-Viktor Dax, Member of the Board, Valida Pension AG, Vienna; Markus Hammer, Partner, Head Asset Management, PWC, Frankfurt; Frank Neidig, Assistent Director Alternative Investments, Bankhaus Lampe, Düsseldorf; Moderator: Uwe Lill, Managing Partner, GFD - Gesellschaft für Finanzkommunikation mbH, Frankfurt.

Hedge Fund Selection

Computers and gut feeling both matter

Marcus Storr, Head of Hedge Funds, FERI

We all know that Germany is waking up to hedge funds. Some people started investing, a lot of people are talking about it, but at the end of the day for us it’s important that we have people like you who are interested in learning more about it or who are even at that stage that they are invested and that they want to get an additional insight to what’s going on.

We already indicated that today’s event has to be educational but also provocative. Yes, absolutely, it might be even provocative for some of the managers because when we talk about Alpha we probably have different opinions to some of the gentlemen in the room.

We started with a title for my presentation in German and translated this into, “Forget the numbers, trust your gut feeling.” What I’m going to do is aggregate a couple of anecdotes with regards to what do we do when we are not calculating, not crunching numbers, looking at statistics, returns, etc.? What do we face? What do we need? What do we receive and what do we get out of it? So talking about track records, whenever you see a track record you feel like this is either good or it’s bad. We call this lower-left to upper-right, this is what you see most of the time in meetings because most of the managers are presenting you with good returns.

Alpha does not exist

What you can see however, from an academic perspective and in practice, – and we’re seeing 300 managers each year – is that Alpha in a perfect statistical way is virtually non-existing. When statistical techniques cannot show that this return series is explainable, that’s when we call it Alpha. So long story short, in general, we don’t think that Alpha exists. Do some managers bring Alpha from time to time? Yes, but this is very rare.

The second point is coming back to the track record; you usually get to see track records that have survived for a long-term, which in itself is a certain bias. You do not get to see the dead ones, hence bad track records. There is a very strong bias that the good track records are certainly the majority of what you see. You will never see a manager coming up to say, “Look at this performance, it’s utterly bad over the last three years but I promise it’s good next year.”

So this bias is consistent in our day-to-day work and what we try to do is to stay away from that, but it’s hard. History very often reverses the future. Again, looking at statistics and looking at academic research is important as there is a good sponge of academic research out there.

Separating beta from alpha

Beta in manager returns is pretty consistent. You will never have a manager sitting in front of you saying, “You know what? I’ll bring you some Beta. It’s only 0.3 to the S&P but there is no way around it.” The easiest way for manager is to say S&P performed 15%, I performed 20%, and hence I delivered 5% of Alpha. No it’s not Alpha. That’s not the case because there are certain statistical techniques where you can show that if the 5% are statistically explainable at that point in time, they vanish from the Alpha pot into the Beta pot. Long story short, Beta is a good indication for the future, Alpha is not because Alpha is not stable. This is not only our belief, you can see this in the academic world.

Diversifiers can be unstable

For hedge fund strategies, the same thing applies. You have a lot of investors but also you have hedge funds with their dedicated strategies saying that this is a consistent diversifying strategy, and here we have just one example which is managed futures.

We all know what happened in 2008, the only strategy which survived and which was top of the post was managed futures. A large number of CTAs performed extraordinarily strongly during the financial crisis. Then over the next five years, approximately 60% of all new assets flew into the CTAs space. Was this a prudent move? No, it was not, because over the next five years the strategy on average did not perform that well. When we talk about this we talk about indices, we talk about average, yes, there are CTAs who performed very strongly in this period, absolutely, but in general that was not the case.

If you build portfolios or if you believe in any strategy consistently over a time horizon, you might be wrong, and this is another element which we and every investor should keep themselves aware of, and obviously just the day-to-day work when it comes to analysing strategies that this is a variety which makes it for an investor in particular in Germany rather complex.

Hidden beta exposures

Track records. A lot of managers tell you in the beginning we do this and that. At the end of the period, call it the calendar year, you do certain statistical analysis and you sometimes find beta exposure, which you ask yourself: where is that from?

What helps is if you do the Beta analysis, you can judge if they’ve done what they say with regards to their exposure. A lot of people will say, “Wait a minute, Beta is market risk, right? And risk in the markets you have to follow closely.” Absolutely right, we’d rather look at factor exposure so we want to see, even if you manage a market-neutral long/short portfolio, you might find some Beta exposure that nobody was aware of, at least not the manager.

Incentivization and alignment

Very interesting topic, particularly in Germany where everybody says hedge fund managers are too rich, they make too much money, they don’t pay back to society.

For us the most important element is that there’s an alignment of interest, so no asymmetric incentivization. There is performance fee for the manager, which in itself has an optionality character. The higher the volatility of the manager returns, the higher the likelihood that the manager performs great, performance fee, thanks very much, done. Obviously that’s not the way these guys think but some biased investors could put it that way.

So what we think is important is that this is aligned, which means, we need substantial net wealth of the manger being invested in the fund. Why? We always say it in a very provocative way. The guys get hit first because of bad performance, then it’s us and then we turn to our clients. So this kind of alignment of interest is important for us and this is something which you can’t quantify, you have to analyse, you have to ask and you have to try to get proof.

Assets and diminishing returns

In the traditional word everybody’s feeling confident investing with AGI, Blackrock etc. that’s the same in the hedge fund industry. If you name the big guys out there managing 10 billion plus, everybody feels safe investing because you have a good operational setup, you can allocate money, and nothing will go wrong because they have six compliance officers, they have 20 risk officers and they all will know in advance if something goes wrong.

For us the point is academic research again, which we look at a lot. It shows that there is certain dependency of performance to assets. We have databases where we follow the strategy and the AUM accordingly. Between half a billion and a billion is the sweet spot of a managers size. There are other managers which are larger but nevertheless, research and our own experience shows that from a certain slope onwards – and it depends on the strategy – the risk of being too big, the risk of becoming inflexible is struggling to produce expected returns, and that’s something which you can’t really quantify.

This is academic research in general but for a single hedge fund, it’s almost impossible to create something like this, so there is the gut feeling again: is this fund too big? So you check on a couple of trades they’ve done, you check on a couple of stocks they hold and try to feel if there is a mismatch of liquidity and you have to judge it yourself.

Background checks

Background checks. Every manager in the room is aware that background checks are an important element. We spend up to $10,000 on a fund before we invest, but the point is, what do you get? You don’t get numbers, which you can crunch into an Excel sheet. Do I need to know where these guys spend their time outside of work, which golf clubs do they own, etc.? No. Does it help judging the manager sometimes? Yes.

On-site due diligence

Why is on-site due diligence absolutely key, in particular when it comes to checking on the research capabilities? It’s somehow different with systematic managers but when it comes to fundamental managers, merger arbitrage or distressed credit manager, we want to understand how the research is done. In every manager meeting you receive prepared research examples. That’s not enough you have to check the entire research process on-site.

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