How to Improve the Alternative Asset Management Industry

Another well-know hedge fund manager announced this week that it’s closing shop. Richard Perry, of Perry Capital Management, decided to close the firm’s flagship fund and send the majority of capital back to investors. This was once one of the largest hedge funds in the industry and has been around for almost three decades, so this one was surprising to many.

The firm has hit a rough patch in terms of both performance and client redemptions in recent years (the fund is down nearly 20% since 2013 and assets have been cut in half). Perry shared a few thoughts on some of the reasons for this move (courtesy of Bloomberg):

“Although I continue to believe very strongly in our investments, process and team, the industry and market headwinds against us have been strong, and the timing for success in our positions too unpredictable,” Perry wrote in the letter.

“I had to be realistic, and it hadn’t been working for the last couple of years,” Perry said. “I decided that it would be better not to be in this mark-to-market world, and focus on longer-term investments.”

You never really know why these things happen. At a certain point billionaire hedge fund managers could simply get bored or sick and tired of dealing with their investors. But this does seem to be turning into a trend where many of the pioneers in the hedge fund world are running into trouble or completely shutting down their businesses.

One of the problems is that the entire industry has completely changed since the old school fund managers launched their funds in the 80s and 90s. Back then there was much less competition. There were far fewer institutional clients allocating to the space so there wasn’t as much of a need to staff institutional quality back offices. Regulations have made it so these funds now need large compliance departments. They’ve had to beef up their sales and marketing teams. They have dedicated risk management specialists. Many are now in the public eye whereas before they were reclusive. All of these side aspects to running a business have likely detracted from investment performance in some way, whether the managers admit to it or not.

Right or wrong, this institutionalization of the hedge fund industry has changed the game in a number of ways. There are now many family offices, pensions, wealthy individuals, endowments and foundations who have rushed into this space without the correct knowledge or skill-set to understand how these investments work. Investors have to do a better job on this end, but all of this new money over the past decade or so means the alternative investment industry is eventually going to have to adapt, as well.

The obvious fix is to lower fees and see a lot more of these funds go out of business, but here are a few other areas these fund firms could improve upon to potentially see better results:

Be more selective in who they choose as clients. Investors will always be chasing past performance in this space to some degree by investing in managers following strong performance and rushing to the exits following a period of poor performance. The hot money is typically last-in, first-out. But the money managers themselves need to be more selective about the types of clients they’re willing to accept. It may mean a smaller asset base (and thus lower fee revenue), but choosing to work with the right clients and performing due diligence on the type of investors they are before allowing them to make an investment can save massive headaches down the line. Perry talked about focusing on longer-term investments. The only way to do that is to have the right clients in your fund who have the patience and discipline to see that type of strategy through.

Better educate their clients. For far too long this industry has been built upon a “trust us, we got this” mentality. That may work for the top 1% of funds,  but for everyone else there needs to be a more concerted effort to help clients better understand what they are investing in. Yes, investors and asset allocators have to perform their own due diligence, but fund managers need to take on more responsibility for their investors’ actions. Most people assume that hundreds of millions or even billions of dollars in institutional capital must equate to a sophisticated investor base, but this is not always the case. Fund firms need to do a better job with their communication efforts if they would like their investors to behave better and allow them to do their jobs as money managers.

They need to be more transparent. Most hedge funds are notoriously stingy when discussing their investment positions, but transparency can also be improved in terms of admitting mistakes to their investors instead of coming up with excuses or moving the goalposts. They don’t have to pretend to be masters of the universe at all times. This is something Buffett has perfected better than anyone. He almost always starts his annual shareholder letters by talking about his mistakes and where they went wrong over the past year. It’s a great way to build trust with investors and not enough professional money managers do this.

Set more realistic expectations. Another reason I feel hedge funds have had a rough go at it over the past decade or so is because they’ve been far too reactive to investor demands. As investors fight the last war they are constantly pushing hedge funds to invest in ways that feel safe, but are actually risky based on their timing. Following the Great Financial Crisis institutional investors were all demanding funds with low volatility and downside protection. Hedge funds were more than happy to oblige with these requests and it has subsequently hurt returns.

This one goes right along with communication, education and transparency as ways to get your investors to stick with you or even add money during the tough times. Money managers need to treat their investors like actual long-term partners instead of just seeing them as assets.

Again, investors need to learn how to behave, but these funds need to do a better job of setting realistic expectations and not altering their strategies simply in an effort to attract investor capital. That money is always going to be short-term in nature.

If these funds want to focus on the long-term then they need to start acting like it through their business practices.

Source:
Richard Perry Walks Away, Hoping For a Shot at Vindication (Bloomberg)

Further Reading:
Paul Tudor Jones & The Nature of the Beast

Now here’s the stuff I’ve been reading this week:

 

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