The point being that alpha is worth paying for because it comes from the expertise and intellectual capital of the portfolio manager, whereas beta should be relatively cheap. It’s the same concept for alternative beta, where returns are generated via exposure to risk factors specific to alternative investment strategies, including long-short equity. Alternative beta strategies tend to have lower fees and provide greater transparency and, when combined with alpha strategies, have the potential to generate very attractive net-returns.
Other strategies we see coming across our desk, ones that aren’t necessarily a good fit for Discovery, but are gaining traction generally are low-volatility strategies. These strategies, like minimum-variance investing, which uses quantitative tools, fell out of favor over the past several years as equity markets marched higher, but as short-term volatility increases, they may become more popular.
Hortz: What do you look for in your due diligence process on hedge fund firms to determine firms that are “better suited to the changing investment environments as we go forward”?
Togher: What we find most compelling is that the willingness to embrace such changes tends to be part of the firms overall culture. It really comes down to the individual management team and their views on the need to change. Getting to know the manager and the organization is the most important thing you can do in the due diligence process. If a manager has a specific skill set: How is the organization organized around getting consistent returns? Is the compensation system aligned to garner those returns? How thoughtful has the manager been in setting up the business? Transparency, what is appropriate given a manager’s strategy? At the end of the day, returns are just the proof of the organization being set up the right way and a function of their overall culture.
Hortz: What is all the debate about on the issue of crowded hedge fund names and what does an investor do to address this issue?
Togher: A very significant issue for the hedge fund industry today, perhaps more than others, is this concept of crowded hedge fund names. That has moved to the forefront in the past couple of years as a real key driver in identifying quality hedge fund managers that can differentiate themselves.
Crowded trading refers to a situation where a large number of investors, in this example, hedge fund managers, all go long (buy) or short the same stock at around the same time. The end result is that a lot of hedge funds hold the same stock(s) at the same time. Obviously, crowding can be of considerable benefit when everyone is buying, which will drive the price of the stock up – which is a good thing. The problem occurs when sell pressure for a particular stock develops and increases over time and everyone tries to sell their positions at or around the same time. The crowding effect can cause higher, short-term performance volatility for fundamental, bottom-up stock pickers, who rely on valuation for stock selection and portfolio construction.
As an investor, transparency into the underlying holdings of your hedge fund managers is one key to identifying and managing position crowding. It also requires that we have a capability in-house to aggregate such information so that we are aware of the overlap we have within our own portfolios. Goldman Sachs actually produces a list of the most crowded names based on how hedge fund names are trading. Interestingly, many of the hedge funds we speak with and like are aware of crowding and a significant number will take into consideration the ownership of a stock as they decide how to size it in their portfolio and what risk parameters to put around the position.
Hortz: Through your experience in this area of the market, what have you learned about how to construct a portfolio of Long/Short hedge fund mgrs? How do you go about building a smoother path for your investors?
Togher: We begin our portfolio construction process by targeting a volatility range, which is usually about 50% of the S&P 500. We then focus on diversifying our portfolio across Long/Short Equity sub-strategies, including generalist, sector focused, event driven and activist with analysis centered on correlations, concentration, use of leverage and portfolio overlap. For our flagship fund we focus on only what we consider to be the very best, well established hedge funds with innovative cultures in the industry. For our Discovery fund, we look for smaller, newer, and lesser known hedge funds.