Melanie Stern is Section Editor of Families in Business magazine.
With absolute return in alternative investment derived from manager skill, finding the right individual from the huge pool of candidates is a time-consuming but essential task. Melanie Stern investigates
Forbes' 2003 Rich List, published this September, provides a great starting point on which to illustrate the importance of a great alternative investment manager. Out of 400 American constituents, five individuals made their fortunes in hedge funds. Their collective wealth came to US$11.1 billion – 1.16% of the total list wealth. As hedge fund managers' compensation is linked to the performance of their fund, one can assume that these managers have made their clients very rich (or richer).
Performance, however, is not the sole driver of the money alternative managers make (to clarify, a 'manager' in this article pertains to the individual and not the fund or group managing a fund.) The cardinal aim of the alternative investment market, and its main attraction for family offices, is absolute return, when high and stable returns are gained from a low correlation to traditional markets; the only way this can truly be achieved is through 'Alpha' – investment return derived directly from individual manager skill.
As the definition of 'skill' or 'talent' is somewhat intangible, finding Alpha is a big challenge. While stocks and shares fell from grace in recent years, the number of hedge fund or other alternative investment products ballooned, and the number of people within this market proliferated equally. Finding the right manager is now a bit like finding the right mortgage or the right credit card, requiring a lot of shopping around and application of thorough product analysis. Additionally, the market is young and a great deal of the incumbent managers that have migrated from related parts of the financial markets offer little or no track record in alternatives to measure performance; topped with a lack of regulatory framework and understanding of hedge funds, the marketplace is a minefield of less than ideal individuals. The danger in selecting the wrong one is underlined by the many stories of huge client losses and hedge fund securities fraud, which in this marketplace can be attributed as much to unscrupulous opportunists as it can be to lack of specific skills or experience in alternatives.
For this reason there is a number of consultants that specialise in helping family offices locate the right candidates. Mailesh Shah, head of manager selection at Mercer Investment Consulting in London, explains the challenge: "If you are a family office looking for a best-of-breed manager, there is a wide choice. There are managers that are pretty visible in the market, but also good managers that are not visible because their reputation and contacts are such that they can raise enough money without having to market themselves aggressively."
The work of these consultants is more difficult by the intangibility of qualities that constitute a good manager. The lack of quantitative data available on individual managers' performance means that evaluation is largely qualitative, paring down everything from investment philosophy to personality in a painstaking due diligence process. "In many cases, a hedge fund manager does not have any relevant track record, so we assess their skills on what they tell us about their experiences so far," says Pictet's head of Manager Selection services, Nicholas Campiche. "We can't just crunch numbers because there are no numbers to crunch. We're not in the business of assessing companies as an equity analyst would, using a balance sheet – this is a people-based business."
Because alternative asset managers have a relatively low life span compared to traditional asset managers, and can exit the market in their droves in a short space of time, aggregate data sets can often give a far more positive picture of the market than what is reality. This is known as 'survivorship bias' and is another reason that those selecting managers pay much closer attention to aspects of personality and 'gut feel' than to statistical information.
With that in mind, the issue of track record is a thorny one. While those selecting managers acknowledge that the lack of such data exists, they are at pains to say that they would not hire someone with no track record. Then they concur that past performance is no guide to the future anyhow. So the first risk in alternative investment is the process in which one assesses potential managers. Pictet's Campiche explains how the qualitative sway this lends to his job does not just have a complicating effect, but also facilitates the identification of future star managers. "All our core positions are with established managers both in terms of assets and reputation. But when we look for new investment opportunities we often meet a manager at a very early stage, with only $20 million or $50 million under management, and at that point there is just no data. We occasionally invest with these managers, by placing a small amount with them and increasing it over time of they prove themselves." Mercer's Shah agrees: "Looking for good quality asset managers is about looking at what insights they can bring to the field, which doesn't always need 20 years of experience to demonstrate."
Six stages of selection
There are generally six stages to the manager selection process:
- Assessing client needs. Risk appetite profiling and appropriate strategies for those who need them set up;
- Candidate indentification. Compilation of a list of individuals deemed to initially matchclient needs;
- Client/candidate match. Interviewing candidates to assess the closeness of the client/candidate match and preparing a final list;
- Family office shortlist of candidates. Involving the client to assess the candidates, often involving them interviewing candidates themselves;
- Selection and mandate. Family office and manager selection professionals working together to select the right individual(s) and allocating them funds.
The process usually takes a minimum of two months and can involve the manager selection professionals to travel internationally as they evaluate and personally assess individuals, before taking the list to his client who may choose to complete the whole process again independently. Throughout the process, manager selection professionals will look to understand all aspects of risk taken on – market, individual, financial, product-based – and understand how a manager works to mitigate them to fend their client's money from erosion while achieving Alpha.
Alpha vs Beta
Something that manager selection professionals are careful to distinguish is whether an individual manager's data reflects genuine Alpha, or indeed returns from market risk rather than skill, or Beta. Both are added value to the client's portfolio, but the difference is the amount of risk the family office seeks, and therefore value of the individual (Alpha is more highly valued and therefore those bringing Alpha to the table will be more highly compensated). Additionally, the popularity of the long/short strategy in alternatives as opposed to traditional buy and hold managers – when managers are permitted to sell a stock they do not own and that they believe is over-valued, and then buy it back when the price is lower and hold it in the portfolio – provides another smokescreen through which those selecting managers must see. Long/short is supposedly a market neutral strategy and thus ideal for achieving high returns unaffected by underlying markets, but some believe the strategy under some managers can have a long bias of as much as 60 or 70%. "Within the scope of managers adding value, you do find hedge fund managers who, from the outside are supposedly adding value, but once you've analysed the figures, you find some or all of that added value is coming from Beta," Mercer's Shah points out. "One needs to examine carefully to what extent you are paying a manager just to take on market risk for you. Family offices in particular are looking to add value without taking on too much risk."
Once a suitable manager is mandated, family offices are not left to fend for themselves. The selection consultant usually remains involved in monitoring the progress of the placement. "The nature of this business is such that, a week after you've placed the client's funds with a manager, the whole arrangement could change; perhaps two or three key people in a fund could leave, in which case the confidence you have in that fund reduces," says Mercer's Shah, pointing out a common occupational hazard.
To prevent repercussions to the portfolio if a manager exits the market, or indeed if the family office decides to terminate a manager, the client must make adequate provisions in-house to mitigate as many of the risks alpha-based investment as possible. Professionals advise family offices to set up a strong governance structure for everyone involved, setting in place responsibilities and decision-making channels, and defining what input external family members will have. They also like to see the technological setup in place before funds are allocated. All of this serves to ensure that manager skill is facilitated fully in the quest for Alpha.
"Achieving Alpha is about taking something away from other managers in your marketplace, and to do this is not easy," Shah concludes. "The only way is if you have some kind of edge, like being able to interpret data in a better of quicker way that allows a manager to do something no other manager has thought of, for instance. Adding value through skill is what alternative investment is all about."