In addition to accessing the right alternative strategies, investors must also focus on accessing the right managers within those strategies. While we believe certain strategies can fit into a mutual fund format, several major questions remain for the investor such as: How good are the managers and will they be successful going forward? What is their edge and how repeatable and sustainable is that edge? How do they successfully implement ideas into a portfolio construct?
Given the large dispersion of returns among managers of hedge funds and other alternative strategies, we believe that manager selection is critical in alternative investing. Because traditional hedge fund vehicles offer managers greater flexibility in portfolio implementation, this arena typically attracts the industry’s highest quality managers.
As a result, this can lead to negative selection bias among hedge fund managers who choose to manage liquid mutual funds. Certainly, there are high-quality managers who run liquid vehicles, but the concentration of these managers is likely to be considerably lower than in the traditional hedge fund space.
In addition to offering more attractive compensation, traditional hedge fund structures also provide greater leeway for portfolio managers. Besides the liquidity requirements, mutual fund managers are also subject to strict restrictions on the use of leverage. This places significant limits on the manager’s ability to structure trades by using options and other derivatives. In our experience, skilled managers do not want to deal with the distractions of managing for liquidity or leverage levels. These managers often prefer to be unconstrained in their pursuit of the highest risk-adjusted returns.
Thinking about this in another way: Imagine you’re an accomplished architect whose achievements and client work have resulted in many industry accolades for creativity and design. Because of this success, you charge a premium for the innovative concepts you deliver that match your clients’ needs. In the past, you’ve worked independently and run a successful business. One day, a large, global architecture firm comes to you and offers you a prominent role within their firm. Before you sign on, the CEO mentions that all of your future designs can utilize only three forms of materials and must get approved by a 30-person committee. Also you will be compensated only on the firm’s ability to sell as many of the designs as possible. Would you sign up for that?
In many ways, this is what a talented manager in the hedge fund industry is faced with when deciding to manage a liquid mutual fund. Many managers that have true skill are not interested in trading their unconstrained ability to manage a portfolio for the opportunity to manage a fund available to all investors. Top-tier managers understand the limitations that liquidity places on them from a portfolio management perspective, and often times, compensation is only generated by the fund’s ability to grow assets under management — not performance. Regulations further limit a manager’s ability to be creative with their trading structures, and fund board oversight places additional limits on the opportunities they can exploit. This leads many of the best managers in the alternatives business to avoid the daily liquid mutual fund business altogether.
Kenneth Meister is the President and Chief Operating Officer for Evanston Capital Management.