Tuesday, 10 November 2009

Galleon Edge Illegal, But Information Flows to Hedge Funds Can Be Important

The information that hedge fund groups use is a topic that comes into and out of focus. Recently it has been in the spotlight because of the Galleon-related indictments, but it has been a live issue as far back as Ivan Boesky's advanced receipt of deal-flow information in the mid 1980's. Over the years the buy-side has decreased its reliance on traditional sell-side research, partly because of Regulation FD. Also the reliance has been downplayed to put marketing emphasis on the prowess of in-house efforts in research - it is widely marketed as a differentiating factor in asset management pitches. These concepts apply even more so to the hedge fund business.

To a great extent, and particularly in America, hedge fund managers are paid their large fees to be experts in a particular area. As America is home to so many hedge funds and has a deep and broad range of stocks and industries it is natural that there are hedge funds that specialise in particular fields such as healthcare and energy. Investors pay their managers to be the best informed participants in their sector.

This concept applied in different ways to two of the dominant firms of the early to mid 1990s. Michael Steinhardt in his pomp was well known to have the highest commission bill and commission rate on the Street. His thinking was that if he paid the highest rate he would be first call from an analyst or block trader. Given the turnover in his funds and assets under management it is easy to see how he became the biggest client of the brokerage community. And it worked – he was the first call for the sell-side. Steinhardt both traded and invested. So he liked to be in the flow of trading in a stock, and he knew where the axe was in any particular stock. There are many modern era equivalents – if you are a trader-style hedge fund manager you have to have a feel for the flows, and have finely-tuned antennae for the change of ownership in stocks and sectors. This is said to be how some hedge fund operations have grown within the context of institutional investment firms. The transaction flow information from the dealing desks (monitoring institutional and hedge fund flows) feeds the information requirements of the faster-moving hedge fund managers under the same roof.

Steinhardt was an investor as well as a trader. Although he was known for calling the turn in bonds in 1983, he was essentially an analytical investor rather than a macro manager. His background was as an equity analyst, but his trading around long term positions left the impression on the Street that he was what we would think of today as an SAC-style trader. He was not (only or just). Something similar has happened to the perception of what Julian Robertson's Tiger was about. Yes the firm engaged in macro trading, but the core activity was relative value investing within sectors (and in the mature period, markets). The ultimate arbiter was Robertson, but there were analysts dedicated to sectors. Analysts had to defend their views on the sector they covered, and the analysts were expected have profound knowledge of their sectors. In the later stages analysts ran portfolios in their sectors, and so gained the experience that would set them up to become the Tiger cubs that grew out of the firm. But the core competency was depth of knowledge of a sector.

Managers have to have an edge. It is requirement that they are able to answer well the standard question "what is it that makes you unique?" Further, the question had better be answered with reference to repeatable elements. The question becomes "what are you going to be able to continue doing that will give you a persistent edge in your trading/investing in future?" In this regard, it is much less satisfactory to investors to infer that the manager is going to do the same as other people running hedge funds, but do the same things better to deliver superior returns. If the manager happens to be better at using the same information flows as others – better at interpretation or quicker at understanding –that is not as sound a commercial response as declaring possession of an information edge, an unusual source of data. It could well be that money management is the key skill in driving the returns of hedge fund manager. Money management is the change of position size at the stock, sector and market levels. Indeed I have worked closely with a manager who had little edge in information flow, or even in understanding of companies through analysis, but had such good money management and risk understanding that he is an above-median hedge fund manager largely through that ability alone. But money management would not sell as well as a marketing point as an information edge. Rather, investors in hedge funds express strong biases towards managers with information or understanding edges in relation to company fundamentals.

Very often investors will state explicitly that they only invest in fundamentally driven hedge funds. A good example of the latter is the DB Equilibria Japan Fund run by James Pulsford at Deutsche Bank. Using the HOLT system, the approach of Pulsford's team rank return-potential based on RoE, cashflow and other fundamental metrics. Because they match long and short positions in pairs and stay market-neutral they can make good absolute returns using an investing time-frame (multi-month holding period). The DB Equilibria Japan Fund made money last year and this year for its investors. Somehow this sort of investment process is superior in the minds of investors to a manager that uses non-fundamental information to select stocks, or manage the position size.

In my mind the institutionalisation of the hedge fund industry is a factor in this behavioural bias towards fundamentally-driven strategies. They are much more easily explicable, even though there is increasing attention paid to behavioural aspects of finance and investing. And this bias to fundamental styles of investing reinforces the need to demonstrate an information edge. For a manager just using sell-side research it is difficult to claim that they have an edge. Interpretation is not sufficient. So other initiatives have to be taken to have an edge and demonstrate it to potential investors.

The first is the employment of analysts. As hedge fund groups have grown, like the rest of the buy-side they have added analysts. In truth, for investor perception, fundamental analysts have to be added to a small hedge fund operation before any other capability in the firm. Say you are going to add an analyst and you get a nod of the head at an investor meeting. Say you are going to add a marketer to a small hedge fund firm before adding an analyst and the manager would be thought the less of. Not that analysts at hedge fund groups don't add a lot of value in some cases - analysts at hedge funds can be award-winning in their understanding of companies they follow – like Charles Evans Lombe at Egerton Capital in capital goods companies, or Robert Donald at GLG building materials, who both gained plaudits in the Extel survey this year.

The second initiative that hedge fund groups have taken that help them demonstrate an information edge is in procuring (primary) research. Leading hedge funds now deploy a wide range of industry experts on an out-sourced basis via consultancies and specialist research houses. It is not uncommon for large US hedge fund groups to retain political consultancies in Washington to get a handle on the probabilities of regulatory change in various industries. Healthcare specialist funds might tap into firms that understand the workings of the FDA, or can interpret clinical trial data to commercial effect.

Leading hedge fund groups have enough capacity in research spending to commission their own research – footfall at malls or in particular chains of shops, interviews on the street with shoppers on particular brands, counting of cars at import terminals, or monitoring iron-ore ship-loads at Australian ports. Sometimes managers at different hedge fund management groups get together to fund such primary research. Student interns are sometimes brought in to carry out bespoke research projects.

A third initiative taken by hedge funds to obtain a demonstrable information edge is the use of expert network providers like Vista, Coleman, and Guidepoint Global. There were seven such firms just over ten years ago, and there are at least 24 operating today. The largest is Gerson Lehrman which is the only expert network company with a global network. It is instructive that Gerson Lehrman was founded (in 1998) by Mark Gerson and Thomas Lehrman who had spent the prior two years at hedge fund Tiger Management.

Of course, many hedge fund managers talk to their companies directly to produce an understanding of the companies in their universe, which can be an edge. Meetings with senior executives can be limited as sources of information, given what the executives feel able to disclose in Western countries. A common tactic to get some useful information from a company meeting is to talk and ask about competitors. It is often seen that investors pair up in company meetings – one staffer to ask the prepared questions and one to observe the body language and reactions of the executives. One manager I know seeks better operational level information by using extensive contacts at the level of divisional heads in the companies in his universe.

If you think about it, investors in distressed securities and activist investors try hard to put themselves in the position of being privileged investors. Distressed managers position themselves to be on the creditor committees which help decide how company financial reorganisations unfold. Activists seek Board representation. Being on the committee/Board puts them in a position of being better informed investors about the securities and companies to which they have exposure.

So a manager has information that he thinks is not priced into the market, even if he thinks several other investors know it too (the efficient market hypothesis being recognised as dead at this point). The information edge then has to be appropriately expressed in the fund's portfolio. This is where conviction and positive reinforcement should come in, but that is a whole other topic and would take us on to the dynamics of position sizing and portfolio construction – topics addressed in my consultancy but not here today.

Going back to when I was an investor in hedge funds at a fund of funds outfit, I used to ask managers of hedge funds in Europe about their information flows. I would only ask the managers in private meetings as this was not a topic for discussion in open forums like a Cap Into event. I don't recall a manager ever saying to me directly in this time (2001-2) that they had special or unique sources of information about stocks or companies. Finding out what the inputs to their process are is part of understanding how a manager operates. What sources they tap (and how frequently) is part of what helps you as an investor understand where the manager is on the spectrums: wholly fundamental through to wholly technical; long holding period investor through to short holding period trader; and where the manager is positioned in breadth versus depth in their universe.

So in conclusion, all hedge fund managers are required by investors to have an edge. Although the edge may theoretically be of different sorts (such as ability to forecast volatility or correlations, or time markets), often investors expect a hedge fund manager to have an information edge in some way. There is a significant bias amongst investors that the investment process of managers should be fundamentally driven, and this reinforces the desire amongst investors for an information edge to be part of the offering. In the pursuit of such an edge managers of hedge funds have made and continue to take significant initiatives to obtain for themselves proprietary information. Deep research and expertise justifies the (externally perceived) steep hedge fund fees. The trends are for hedge funds to devote more resources to acquiring the elusive information edge. Galleon allegedly did it the wrong way, but the information edge is worth persuing with most managers in the due diligence process.


The Posting A difference between long only and hedge has a comment on it.

Do you agree with Doug of London, or was he just talking his own book?

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