Last week I attended a presentation in London by Cédric Kohler, Head of Advisory for alternative asset manager Fundana Asset Manager. Fundana, founded in 1993, is a fund-of-funds with $1bn of assets under management (“AuM”), across its different portfolios. There are thousands of hedge funds with many different strategies, and Fundana has built an impressive track record over its 27 year history illustrating that it is one of the pre-eminent firms in the industry as far as selecting hedge fund managers. The ability for family offices to get exposure in their portfolios to hedge funds as an alternative asset class, and specifically to a diversified portfolio of quality hedge funds vetted by Fundana, is a very attractive proposition. As I was listening to the presentation the other day, it was obvious to me that many of the principles on which Fundana has built its business over the years are applicable beyond the hedge fund community, into other types of investments like individual stocks or bonds, actively-managed stock or bond funds, or even in lending. Cédric covered things like skill vs luck in generating alpha, knowing not only when to hire managers but also when to fire them, and much more. He kindly agreed to let me ask him some questions about the lessons he has learnt by dealing with thousands of different hedge fund managers over the last 27 years, and to post this on my blog.
Me: Let’s start with two background questions. Firstly, can you provide a bit more information about the profile of Fundana, including the genesis of the firm and its size in terms of professionals and AuM.
Cédric: The firm was created in 1993 to advise the Credit Suisse group. At that time, hedge funds were not very well known, there were no databases, the internet did not exist, and the performances of these managers were nothing short of stellar. 27 years later, Fundana – with about $1 bln under management - is completely independent and still focuses on hedge funds. Our team is made up of 15 professionals mostly based in Geneva, Switzerland. Fundana is a boutique and wants to remain one, focusing on its expertise as opposed to responding to fads. As we like to say, we try to spend 99% of our time on performance and 1% of our time on product. Our flagship fund is a $700m Equity Long / Short Fund-of-Hedge Funds which we have managed since 1993.
Me: What has been the performance of Fundana in recent years, and – assuming there is some sort of hedge fund benchmark – how has the return at Fundana compared to the benchmark?
Cédric: If we look at our flagship fund, the Prima Capital Fund, our objective is to generate equity-like returns with considerably less risk (around 50%) than the public equity markets. Since its inception in 1993, the fund has averaged more than 6%/annum with about 7.5% volatility. Last year, we were up +12% and this year we are up +2.2% as of February. In terms of a benchmark, we typically use the MSCI World Equity Index as this is a real alternative for our investors. However, we also provide hedge funds benchmarks comparison with the HFR (X or I) or Eureka Hedge indices. Unfortunately, hedge fund indices in general are subject to significant biases (e.g. survivorship for example), and this makes comparisons difficult. With this caveat, let me give you an idea of our relative performance. The retail class of the Prima Capital Fund has outperformed the HFRIX indices (investible) over the last 10 years and has also outperformed both the HFRI Research Composite Fund-of-Fund Index and the HFRI Research Fund-Weighted Composite Index (both non-investible) over the same period. For reference, the return per annum on the institutional class of the Prima Capital Fund is 80bps / annum better than the retail fund, widening the gap on the Prima Capital Fund’s strong relative performance. As you can see, there is a lot of noise in comparing our performance to these imperfect indices, so we prefer to show our investors peer group analysis as this removes many of the biases.
Me: Now let’s get into the meat of your presentation from last week. You explained during your presentation how to differentiate between skill and luck in evaluating hedge funds managers, which I found extremely interesting. Can you elaborate on this?
Cédric: Sure. Over a short period of time, it is very difficult by just looking at a manager’s track record, to know whether the manager performed thanks to his skills or whether he just got lucky. From a statistical standpoint, you need to wait about 20 years to be 90% confident that a given track record is not the result of pure luck. Unfortunately, we do not have 20 years to wait and / or we do not want to wait for a 20 years track record. So, looking at the outcome is not enough. You need to look at the manager’s process and at the return drivers. This is fundamental. How much of the returns are coming from each stock, from alpha vs beta, from longs vs shorts, from factors vs idiosyncratic risks, from market timing, etc. Only then can you check that there is a repeatable process, i.e. skill.
Me: How many hedge funds have you looked at over the years, and for context, do you know about how many hedge funds exist these days?
Cédric: There are between 8,000 and 10,000 hedge fund managers globally depending on which database you look at. These days, we have about 175 meetings per year which means that we probably have met more than 4,500 managers over the last 27 years. However, there were less managers to meet than in the early 90s. But the reality is that we do not meet that many managers per year because we are very specific about what we want.
Me: Can you give me an overview then of the major things you consider when evaluating hedge fund managers?
Cédric: We focus on a few but critical elements. We need to understand each manager’s background so we can have an idea what to expect in terms of investing style and focus. This also enables us to do some serious referencing. We have actually built a tool internally, HedgeIn, to help us systematize this. On the operational front, we then focus only on funds which have a top tier set-up in terms of counterparties (Prime Broker, Auditor, Administrator and Legal). This reduces a great deal of operational risks. This is such an important function for us that we have decided to internalise it. Some private equity investors are starting to realize its importance as they discover negative surprises. From an investment perspective, we also want to have a strategy that corresponds to what we are looking for. For example, for Long / Short Equity managers, we are looking for bottom-up stock pickers with AuM between $200m and $2bln, leverage below 200%, a simple organisation (i.e. one fund, one team, one incentive) and managers with significant investment in their own funds, in other words skin in the game. In a nutshell, we prefer simple structures that promote accountability.
This approach has enabled us to survive for 27 years and to weather several financial crises. For example, during the Great Recession of 2007-2008, the funds advised by Fundana (meaning our investors and advisory clients) experienced no gates, no suspensions of redemptions and no Madoff exposure.
Me: You discussed the dispersion of hedge fund returns, which I recall being very wide compared to some other types of asset strategies. What did you mean by this?
Cédric: The difference between the best and the worst hedge fund managers is on average 47% per year. This dispersion if more than twice that of some traditional asset classes like US large cap funds at 15%, or US small cap funds at 20%. In addition, the dispersion is not stable through time and increases during and after crisis periods, so picking the manager that might have had a good return last year doesn’t mean that the fund manager will generate a good return this year. In other words, even if your index finishes up in a given year, your portfolio could generate negative performance simply due to poor manager selection.
Me: You also mentioned that investors should carefully evaluate track records of the managers, because many track records might not be as good as they might seem. I think this has parallels into general investment manager evaluation, and I could not help but think – given my background – about the many pro forma adjustments that characterise the EBITDA in most high yield bonds. Can you explain what you meant by this track record comment as far as hedge funds?
Cédric: We always pay careful attention to any footnotes and any pro forma adjustments to return data, because these generally tell the real story. Managers naturally want to tell as a good of a story as possible, but often, they go too far. This means that one of the major areas on which we focus at Fundana is assessing the actual past returns, putting aside adjustments that might mask the true performance.
Me: I know that a lot of your business is choosing the best hedge fund managers, but what leads you to fire a hedge fund manager?
Cédric: Well, you are correct in saying that we are always prepared to - and often do - fire hedge fund managers. Other than performance, we look for and act on the following:
manager(s) change
there is “style drift
fund terms change
there is pending legal action that might be justified
concentration rates become too high
We also focus on other criteria such as change of focus (launch of several products for example), rapid AuM growth and a portfolio liquidity profile that deteriorates. The quality of returns you can get with a $500m manager can disappear over time because of these elements. As a selector, you need to constantly monitor and be cognisant of these factors.
Me: What about performance? How can you tell how a hedge fund is doing between reports, or perhaps more importantly, how you ensure that a hedge fund is sticking to its strategy?
Cédric: We systematically set up and run a synthetic portfolio mimicking each hedge fund’s strategy, so we have something to which we can compare the fund’s actual performance. This importantly provides a warning signal if the fund’s performance drifts too far from what it should be based on the fund’s stated strategy. Even a performance that is too good vis-à-vis our model could mean that the manager has changed its investment strategy. In fact, the old adage “if it’s too good to be true then it probably is”, is very applicable in the world of hedge funds.
Me: Do you have any closing comments, Cédric?
Cédric: The best investing talents in the world can be found in hedge funds. However, they represent may be 2% or 3% of the entire universe, and it takes a great deal of work and care to scout and monitor them. Since 2008, many investors have gone direct, meaning that they selected hedge funds managers themselves. After negative surprises in 2018, we see a new trend with investors again using advisors that have a demonstrated value-added via their track record. This is important. Investors need to diversify by investing in alternatives assets in general, and hedge funds in particular. However, doing it alone can be tricky.