Tuesday, 9 November 2010

Hedge Fund Portfolio - "The Nemesis of Any High-Octane Hedge Fund"

I don't put a blogroll on this site, but that does not mean I don't appreciate the high quality output carried on other hedge fund related blogs. A case in point is the "Hedge Fund Portfolio" written by Kris Chikelue, and which you can find at http://hfpf.blogspot.com. Although I haven't read all of them, I have yet to read a posting there I didn't think was good or excellent.  With his kind permission you can read Kris's latest posting below - Simon Kerr.

If you’re an investor focused on high-octane hedge funds, a high quality problem to have is to find that a small, young hedge fund you invested in has outperformed AND ballooned past $1B after a relatively short period. Believe it or not, even in today’s difficult fundraising environment, more than a few funds have achieved this feat (certainly many in credit-related strategies like MBS, Distressed, and Converts). This “problem” is a high-quality one; nevertheless it is a problem if you demand high-octane performance. Why is it a problem? Size. While this answer isn’t a surprise for most folks, what is an area of contention is the exact number at which size becomes a problem. I won’t weigh in on that debate; instead I will discuss other relevant topics.

First, exactly how can size impede performance? The most obvious is it introduces liquidity constraints on what a manager can trade. There is also a less obvious yet “structural” issue: a large fund has a narrower opportunity set of trades that meet a high-octane bogey. Let’s use a quick example: Imagine Warren Buffett has just $100M to invest; he would likely identify a long list of securities that meet his very strict investment criteria. At $40B, it gets substantially shorter. Finally, there are “soft” obstacles created by size: A large fund will likely have a sizable headcount and, as such, non-trivial managerial demands. A large fund will have a LP base that has diverse demands: some focused on performance while others are watching the fund’s correlation. In contrast, a small fund is more likely to have investors that are uniformly focused on high-octane performance (unless of course, you have family/friends that are there for unconditional support). To be clear, I am not against large funds; being big has its benefits including having access to first-class information on macroeconomic trends, etc. These advantages are important for large funds; yet they have not frequently translated into high-octane returns.

Let’s go back to the original problem – what should you do after a young superstar in your portfolio has outperformed and attracted substantial assets? I’ll be honest – my first instinct is to take some (if not all) chips off the table, particular if the size is greater than >$800 and the strategy is in stock picking or credit. However I think it’s important to diligently investigate a few issues before deciding. In particular, I think it’s relevant to first, determine how important high-octane performance is for you. With your superstar, you have achieved a level of comfort that another fund has to surpass. Is it worth leaving this comfort to search for another fund (and potentially fail in finding such a fund)? It also might help to determine the fund’s new bogey. Ideally your superstar has grasped his new context, (i.e. he has a smaller universe of applicable trades) and has made adjustments to his performance target, among other things. Finally, it might help to understand adjustments to the fund’s coverage format. Ideally your superstar has determined a robust format for covering his opportunity set and the appropriate headcount he needs.

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