By
We strongly believe in the fundamental-driven, long-term, concentrated, and active investment approach for both private and public strategies. This includes our buyout, venture capital, public long-only equity and absolute return strategies. As pointed out 46 years ago by journalist Carol J. Loomis (known for her writings about and with Warren Buffett), a hedge fund is a scheme to reward a manager based on his performance with few restrictions. In order to maximize benefits, we need to ensure there is an alignment of interests between the manager and investors. We like this performance-driven structure very much and actively seek managers with a shared philosophy.
That written, here are a couple of things to look out for when selecting hedge fund managers:
- Avoid hedge fund and public equity managers who have too many analysts.
Most investors think that it is better for a portfolio manager to have support from many high quality analysts. In our view, this is not true and becomes problematic when a portfolio manager has too many good senior analysts. Based on our experience, the number of positions the fund takes tends to increase as the number of analysts do to a level beyond the benefit of diversification. In order to motivate senior analysts, the portfolio manager has to listen to the analysts’ recommendations and add those positions to the portfolio. Maybe up to 20-30 positions, this relationship could be beneficial. However, beyond that level, we think there will be negative attributes.
We expect a portfolio manager to understand in-and-out of companies they invest in. This becomes quite challenging if a manager has more than 50 positions. Think this way—a manager with 50 names in the portfolio can theoretically spend 5 business days or 40 working hours per position on average. Can he be an expert of each position he owns? We doubt it—the math does not add up. All the idea generation, primary research, and financial modelling are done by someone else—and the portfolio manager’s job is relegated to meeting management and making top-down judgments. Unlike private equity, a hedge fund business should be very simple and efficient. The same calculation can be applied to the number of analysts. If a portfolio manager hires 10 analysts, how many hours can he spend with each analyst? If he spends 2 hours per week to speak with each analyst or to review each analyst’ recommendations, that’s 20 hours a week or half of business working hours. It simply seems implausible.
- Avoid smart managers who think they are smart.
In many cases, they think they are smarter than they actually are. They know how to behave and how to treat investors. Their arguments can be convincing too. However, there are too many uncertainties in this world and even the most skilled manager is bound to make mistakes. Smart managers who think they are smart take more risk than they can handle as they often overestimate their abilities.
“Every great money manager I’ve ever met, all they want to talk about is their mistakes. There’s a great humility there but and then obviously integrity because passion without integrity leads to jail. So, if you want someone who’s absolutely obsessed with the business and obsessed with winning, they’re not in it for the money, they’re in it for winning, you better have somebody with integrity.”
Stan Druckenmiller
*This is an extract from the Star Magnolia Capital Outlook of August 22nd. It has been reproduced with permission. The whole of the Outlook can be read at http://starmagnoliacapital.com/outlook/2016/08/22/farewell-my-hedge-funds/. Star Magnolia Capital is a multifamily office based in Hong Kong.