Preference for Dominance in a Narrow Sector

From http://streetid.com and ClaritySpring

There are thousands of hedge funds competing in the marketplace. They come in all shapes and sizes, but all too often they approach investors with the same thesis.

“The things that everyone sees all the time are long/short and global macro, basically people that are saying, ‘We’re gonna be better than the market’ because we’ve got XYZ experience and we’re so smart or we have backtested all our results,” said Nathan Anderson, co-founder and CEO of ClaritySpring, a hedge fund marketing company. “That’s not unique. At this point there are 13,000 hedge funds, so the burden is on the manager to prove that they have something that is focused and unique.”

Before ClaritySpring, Anderson evaluated hedge fund and private equity fund managers for Blue Heron Capital. His experience has led him to prefer hedge funds that have a particular focus over those that promote a generic thesis.

Inefficiency yet to be Exploited by Capital 

“I think the best funds are when someone has found a very specific segment of the market that has an inefficiency that has not been yet exploited by a lot of capital,” said Anderson, providing an example. “There’s this one fund that invests in aircraft-backed securities. It’s a fixed income-type of investment.”

Airlines are a volatile investment. Between bankruptcy expenses, the costs of running the business, and the fluctuating customer base, the airline sector is one of the most challenging industries in the world.

“However, air travel as a transportation medium is not going away,” said Anderson. “Regardless of what happens in and out of bankruptcy court, air travel is here to stay. One of the major expenses for every airline is, of course, the aircraft. In many cases they don’t own the aircraft, they lease them.”

Anderson said that the fund — which he could not name due to regulatory restrictions — has “identified a specific inefficiency within the aircraft security because these are securities that can’t really be run through a quant model too easily because each plane has completely different collateral characteristics, so the quants have kind of stayed on the sidelines.”

“There aren’t a lot of buyers focused on the space because airlines and aircrafts kind of have a negative connotation,” he added. “So a lot of these securities are trading at a very significant discount to the liquidation and loose value of the plane.”

Regardless, Anderson said that planes are “ultimately fundable assets.”

“They can be leased out anywhere in the world, so if a [domestic] airline is doing poorly, but another is booming in China, it might be a Chinese airline that leases the plane,” Anderson explained. “The lease revenue is relatively stable. The resale value is fairly quantifiable.”

Anderson said that he has not dug into this fund too deeply. “But on the surface of it is a very unique investment thesis, and I think it’s potentially compelling,” he said.

Creating An Advantage Through Research

In his quest for other unique hedge fund concepts, Anderson came across a few that specialize in shorting fraudulent Chinese securities.

“In the early 2000s, a lot of Chinese companies would reverse IPO onto U.S. exchanges or came to U.S. exchanges through a reverse merger,” said Anderson. “It turned out that many of these companies were complete frauds. The reason they weren’t listed on the Chinese exchanges is for that reason.”

Anderson said that the punishment for defrauding investors in China is much harsher than the punishment for defrauding investors in the United States. “There’s no extradition and there’s very little recourse, so all these companies produced phony numbers,” Anderson explained. “There are a handful of long/short funds that compare the SEC filings in the U.S. with local filings in China that have investigators that will go to the factory simply to see if they’re empty or operating. They will speak with competitors, and most competitors, if you ask them about a particular company, they will know something about it.”

In cases where the company is a complete fraud, “a lot of times the competitor hasn’t even heard of this company,” Anderson warned. “So if you run into a Chinese company that is claiming to be number-two or number-three in the market, and none of their competition has even heard of them, obviously that’s a red flag.”

In general, Anderson said that these funds are doing “very straightforward, basic research on these companies.”

“When they do find that there’s a fraud, they short the stock, release that information to the market, and then the stock goes down 50% to 100% over the next weeks and months,” said Anderson. He believes that this thesis is far more compelling than a hedge fund that says, “I think Coke is going to outperform Pepsi, so I’m going to short Pepsi and go long Coke.”

Instead, “They’re doing research that says [some Chinese company] is a complete fraud, and their research is moving the markets significantly,” said Anderson. “They are creating their own advantage because they are a catalyst themselves, and that type of stuff is rare. If Goldman Sachs releases a research report that gives a buyer a recommendation to a particular stock, maybe their stock will move three or four percent, which is significant. But if you can provide traders with a report that can move a stock 100%, you’re obviously providing a substantial advantage.”

A Less Crowded Market

If you need further inspiration for starting a hedge fund, Anderson provided one more example of a fund with a unique thesis.

“There’s a fund that focuses on investment-grade wine,” said Anderson. “There’s an exchange for wine, and it’s actually cleared and traded as any other future. These individuals basically buy investment-grade wine at the source — so they’ll buy from the supplier, cut out the middlemen — trade around their positions, hold them if they think it’s going to go up in value over time, and the way they deal with the wine market is to treat it like any other commodity.”

Anderson said that there are “less eyeballs and less people trading the wine market than, say, corn, wheat, and other commodities.” He believes that the players in the wine market are not as profit-motivated “because the other competitors aren’t trading around a position and doing everything they can to find the best wine at the lowest price.”

“A lot of the other participants are really just managing their inventory,” said Anderson. “They’re purchasing futures just so that they can get delivery of the wine in three to six months or whatever, then they buy the futures and forget about it. It’s a unique market. It’s dominated by non-profit-motivated participants, which provides some opportunities to make an excellent return.”

“And, of course, they let their investors drink some of the wine,” Anderson said with a laugh.

“Stuff like that piques my interest. It doesn’t have to be just another fund that figures out whether Apple is going to go up or down. The reality is that there are so many people competing in global macro, there are so many people competing in long/short equity, and when you have a mainstream strategy without a differentiator, it’s a harder road to convince potential investors that you can win in that market. For a strategy like shorting fraudulent Chinese companies, you don’t even have to be the smartest manager in the world. You don’t have to have 200 years of combined experience.”