Long PM Health/Short Tums
What do you get when you cross good, thematic long-term investors and stock pickers with quarterly or annual redemptions? Perverse decision-making and style drift. Or a portfolio manager with an ulcer. There is a fundamental mis-alignment of motives in the hedge fund business, and my guess is that it will push truly excellent investors into one of two camps:
- Becoming “institutional,” substantially growing assets, running an overly diversified portfolio in order to dampen volatility by pandering to institutional risk-aversion, and generating mediocre returns in the process; or
- Becoming disenchanted with the focus on quarterly performance and forcing out most outside investors or imposing a super long-term lock-up which will likely have a similar effect.
I’ve spoken to several friends in the fundamental long/short business who are good, really good, and they all get stressed out and irritated by quarterly performance measurement because this is not their investment horizon. Many of the value-oriented funds I know will hold investments for years - whose value naturally oscillates due to both company-specific and market forces - but ultimately the thesis plays out over time. Their approach is more akin to Warren Buffet than it is Jim Simons, and turnover as a rule is quite low. Just look at Berkshire’s stock price; it whipsaws around regardless of the rate at which book value compounds over time. Market sentiment, sector rotation and macroeconomic factors have dramatic effects upon stock prices over short time periods, which may have little to do with the intrinsic value of a business. Quarterly reporting and redemption horizons that are mismatched with investment holding periods exacerbate the problem and lead managers to consider portfolio management decisions that are suboptimal for maximizing long-term returns. Two excellent managers I can think of off the top of my head, David Tepper and John Zwaanstra, run very concentrated, volatile portfolios with dramatic swings in performance year-to-year. And their investors understand this and are willing to take the roller coaster ride. But they are rarities indeed.
So why has this pervasive asymmetry existed? Because hedge fund managers ask for it. If a manager wants a quarterly payout, they have to live by quarterly reporting and performance measurement. Period. And if they complain that their investment horizon is long-term and that they shouldn’t be judged on short-term results, then they shouldn’t get paid that way, either. In a perfect world, managers would collect fees to run the business and attract and retain talent (management fees), but would have both performance fees paid and lock-ups match their investment horizon. So, if a manager had a three-year investment horizon on their thematic portfolio, they should get paid on positions in the book on a rolling three year cycle. This would result in a true melding of the hedge fund and private equity models, where performance fees are paid upon realization, not on period mark-to-market values, and capital is committed for long time periods. The same thing can be said for quantitative managers: stat arbs and other high-frequency strategies with short-term signal horizons should get paid out quarterly - but they should have redemptions quarterly as well. This is akin to the CTA business, and quite frankly it makes a lot of sense.
I believe this is a sensible, rational, and fair way to align manager and investor interests and to let the long-term fundamental manager do what they do best - invest, not trade. People would once again get paid for alpha generation and not simply asset gathering, and portfolio managers would probably have far fewer ulcers. Long portfolio manager health, short Tums.
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COMMENT:
AUTHOR: Jacob N
EMAIL: niburg@kth.se
URL:
DATE: 05/10/2008 06:26:28 AM
Hi Roger, thanks for an excellent blog.
Not all (see bloomberg article below) share your views on hedge fund allocation, which you also expressed in the post on David Tepper, and I get the feeling that the prevailing opinion among investors (perhaps out of laziness?) is that you do not get the most out of hedge funds by allocating between funds (maybe this is where cheap(er) fund-of-funds will have their place in the future?). I would say that allocating (diversifying) between hedge funds on average gives more alpha per unit risk than letting the manager diversify his portfolio himself. Is that something you would agree on?
see http://www.bloomberg.com/apps/news?pid=20601109&sid=a_fgkbImH1BI&refer=home
Regards,
Jacob
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COMMENT:
AUTHOR: George
EMAIL: GSchubert751@gmail.com
URL: http://Thevolatilitysoma.blogspot.com
DATE: 05/15/2008 01:12:35 AM
all of the successful hedge fund managers I know pick their investors as close as they pick their investments. Because if you are long term oriented but have investors looking to crank out a green return every month you are gonna run into problems.
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2 years ago
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