Episode #05. featuring. Chris Solarz, Adam Duncan, and Freeman Wood

Transcription

1 Episode #05 featuring Chris Solarz, Adam Duncan, and Freeman Wood

2 Introduction Welcome to CME Group's podcast series on managed futures. My name is Niels Kaastrup-Larsen, and I'm the host of the podcast Top Traders Unplugged. Today I'm delighted to welcome you to a series of short conversations with industry leaders in managed futures. On this episode my guests are Chris Solarz, Managing Director, Global Macro Hedge Fund Strategies at Cliffwater, Adam Duncan, Managing Director at Cambridge Associates as well as Freeman Wood, who is a Partner and Head of North America, at Mercer. 1

3 Niels: Today's all about consultants and the role they play in the alternative investment industry, and I'm joined by some of the best in the business. I'm pleased to welcome Chris Solarz, managing director of global macro hedge fund strategies at Cliffwater; Adam Duncan, managing director at Cambridge Associates; as well as Freeman Wood, who's a partner and head of North America at Mercer. First of all welcome and thank you for joining me today for this conversation about managed futures and alternative investments. In general, before we jump into today's conversation let's share with our listeners a short version of your investment journey and how you got to where you are today. Now since we have among us a Guinness World Record Holder, I thought I would come to you first, Chris. Tell us about your journey and please don't leave out why you, today, can call yourself a Guinness World Recorder Holder. Chris: OK. Well, thank you for having me. I got started in the hedge fund industry in A couple of years prior I was doing investment banking, out of college. I started at a fund-the-funds for about eight years, and I joined Cliffwater in I'm the manager of research. So, over these years, I've seen over 2000 different hedge funds. Earlier in my career, I was more of a generalist, but for the past ten years (almost) I have been focused on global macro strategies; and today, at Cliffwater, discretionary global macro strategies and systematic global macro strategies. I also have a pretty good grasp of all the relative value strategies as well. There's a lot of overlap on the discretionary side with the arbitrage managers as well. On the Guinness record side, I'm lucky enough to have broken eight Guinness records for long distance running, for treadmill running, for beer drinking, for stair climbing, and subway riding. Niels: Fantastic. That's awesome. 2

4 Niels: Adam, I noticed that you were trading liability in the early part of your career. I'm not totally sure what that really means but it sounds exciting. Tell us about that and how you moved on from there. Adam: I started out as a Fed funds trader at PNC Bank in Pittsburgh. It was a great place to "cut your teeth and learn how markets work and how trading desks function, and I met my future wife there. She was a brilliant short-term interest rate trader. From there the progression started. After Business School, I went to JP Morgan where I did interest rate and FX derivatives for a long time. I was into structuring, and I traded structure and did sales there. It was a good experience. Then I spent a couple of years at Credit Swiss doing FX option structuring. Then after that, I left, and sort of stumbled into Cambridge Associates. It was a very serendipitous kind of thing. I was one of these conferences, and my old boss said, "Hey, you should talk to this guy Adam." I was literally on my way to another interview, and he said, "I know this is crazy but would you like to come to Boston?" I had wanted to get into research, and one thing led to another, and I ended up in a very similar position as Chris: looking at systematic strategies, discretionary macro, and all those quant related strategies and that's been an amazing experience. Now, I run the quant research at Cambridge Associates, which is trying to get us into the predictive modelling business and see if there are ways we can be more efficient about our decision making. Niels: Great, fantastic. How about you, Freeman? As far as I recall you have a very interesting path to where you are today which includes trading on the floor in Chicago. Share with us the road that led you to us. Freeman: Sure, it's been a long road with many different things. I started, as you said, as a floor trader and market maker and CBOE in early So, built up a nice long position with short volatility positioned right into the crash. I got to experience market volatility at a very interesting time. That really formed my career path. 3

5 I spent most of my career in risk management rules, trading corporate risk management for Ford Motor Company for several years, with the Federal Reserve for six years, on Wall Street with BNP Paribas for several years I was trading risk management. Then I ended up at a hedge fund-the-funds, and Mercer most recently. I've been with Mercer for about eight years now, and I head up a group that's a bit different than my colleagues here. It focuses on the operational aspects, the transactional cost, the control structure and governance structure of investment managers. So, when you think about the function of trying to generate alpha and all the great work that consultants do to help clients think about, we focus on the alpha protection side or minimizing that erosion from operational transaction. Niels: Fantastic, great. Thank you for sharing that. Freeman: One more thing, I'm now an inspiring, beer drinking record holder. I didn't know there's a record for that. (laughter) Niels: Excellent. It's nice to have big goals! (laughter) Now today we will cover a number of different topics that I think many investors and managers have to deal with in their day-to-day world; to find out how investors can benefit from your services; but also how managers need to understand your role and how they should interact with you. Maybe to kick it off I could come to you, Freeman, first. Maybe you can describe the role of the consultant in today's world, and how you interact with investors on one side, and managers on the other side. Freeman: That is a great question. I think that it's changed quite a bit over the last few years. It's more of a partnership, I would say, with clients and managers. I think understanding the various managers and what's important to them, their strategies, their approaches, and how they structure themselves and deliver value to clients is as important as understanding your clients, as well, and the changing needs of those. 4

6 So, I think the consultant role has changed. I think it focuses on bringing those two constituents together in the most effective way possible. There's the proliferation of the different types of strategies, different approaches that managers take and how client demand has changed over the last 10 or 15 years really has required a knowledge of both sides, and trying to fit those pieces together in the most effective way. Niels: Sure, absolutely. While we're on this theme, Adam, what are the classic challenges that you meet in your world when dealing with institutional investors? Adam: I think there are lots of challenges. It depends on the type of institution. Lots of folks are under tremendous pressure from all different sources. These pressures are real and quite salient to the clients. They're often difficult barriers to cross when you're trying to make good decisions about portfolios. There's education that needs to be done; there's sometimes differences in time horizon where people would like to be long-term investors and act like long-term investors, but the realities and pressures that are put on them by various committees and constituents makes it a much shorter game. This can confound the kinds of things that you're trying to do for the portfolio. Part of a consultant s role is to understand that and try to keep things as closely aligned as possible to the longer-term view, but still recognize that there are these near-term pressures. That is the most difficult thing - some of the behavioural biases that creep in. The actual, raw, nuts and bolts of the portfolio and the managers, a lot of that stuff is (in my view) much easier than resolving some of the behavioural issues that we encounter. Niels: That's a great point. 5

7 Niels: Now, before we move on to some of the more specific parts, Chris, perhaps you could talk a little bit about how the role of the consultant may have changed now that there are so many more institutional investors coming into this space compared to maybe ten years ago. Also, as a result of the financial crisis, how did that impact how they use consultants, and the amount or the level that they use consultants? Chris: At Cliffwater we are an alternative investment consultant. So, we have hedge fund advisory, private equity advisory, and real asset advisory. I work on the hedge fund advisory side. I think the real service that we can provide is we are an extension of our client's research department, because a lot of them hire us because they simply don't have time to come do the MFA, and contacts, and have dozens of meetings. So, this week I have 64 meetings, and in the big picture there are 10,000 hedge funds, but only hundreds that are, perhaps, institutional quality that the biggest public pension plans could realistically invest in. So, our job, on the research side... and we divide the world into five different hedge fund strategies: we have long-term equity, long/short credit, ev. My job, as well as the other sector heads, is to be on top of the whole world of global macro. We strive to find the very best in breed. We find the up-and-comers, and we find the ones that, perhaps, need a little more seasoning. Then we present to our clients which we think are the very best and we can save their time ent driven, relative value multi-strategy, and global macro - which is my group. In that sense, we're an extension of their research. Niels: Sure, absolutely. Freeman: Just a comment on that. I think that's a great point. The spectrum of services that consultants provide has really changed quite a bit. It used to be providing a bias for helping to select managers, for example. Now it's everything from tools (for investors to use on their own) all the way through to delegated or outsourced CIO (where the consultants are taking on the government structure and the positioning for it). I think consultants now must span that whole spectrum and provide an array of services that adds value no matter where the client wants to be on the spectrum. 6

8 Niels: Yeah, I think that's a great point Chris: You'll see some of the very biggest institutions might have four or five different consultants: they'll have a general consultant; they'll have a hedge fund specialist; they'll have a private equity loan consultant, etc. Niels: That's very interesting. Let's move on and take a look at the role of the consultant from a manager's point of view. I think a lot of CTAs (since we're doing managed futures this week) are frustrated by two issues in particular: the historically relatively small allocation to managed futures that consultants seem to have had when they make recommendations to institutional investors; and also that consultants seem to have a preference for only the very large managers. Adam, why don't you talk about how you view the role of managed futures in a portfolio when you advise your clients, and what would be a reasonable allocation to this space in your opinion? Adam: That's a good question, and it's something that comes up a lot. Managed futures is a broad brush. There are many, many types of substrategies in managed futures. I think some of those are more useful at the start than others. We try to be careful about how we categorize them. For example, trend following (which is sort of the bedrock of managed futures) is very good and very healthy for a lot of our client's portfolios, particularly heavy equity portfolios and heavy credit portfolios. These things tend to have big left tails and skew benefits of trend following and the divergent nature of trend following. It's something that can have a very quick impact. It's a very good and healthy addition to a portfolio that basically just tries to make the return distribution of the total portfolio a bit more symmetric, which we think is better for certain wealth on wealth compounding. 7

9 So, trend following is a natural first move when you look at the Chess board, which is the portfolio. Beyond that, there are lots of strategies that are just sort of absolute return type strategies: basically, I give you money, and you make money with it. There's no end to the types of strategies, and we find those quite attractive as well. So, when you think about optimal allocations to something like trend, or whatever, you can do simulation with different portfolios, to start with, and you can let the computer decide how much of this does it want? You get some pretty interesting results. The allocations tend to be much higher than what people are doing. So, I always giggle a little bit when people say, "How much of this should we do?" And the answer is, "How much can you do? What you're thinking is probably much lower than what the optimal answer is." So, I always encourage people to do as much as you think that your committee and your constituents can take and try to treat it as a permanent allocation and not obsess about trying to time it. Niels: Where do you normally see the people land, in terms of percentages, when you give them that choice? Adam: I think it goes anywhere from 2.5%, (to just get a toe in the water, which is going to be largely ineffective in times of change of the return distribution) up to as high as 10% of the total. If you think about hedge fund allocations, in total, don't tend to be that large, as far as the total. It's like 25% or less. Some of the more aggressive things could be up to half of that - being in managed futures. Niels: Sure. Chris and Freeman, do you agree with Adam, or do you have a different approach? Chris: We Agree. At Cliffwater we have a 20% allocation to macro, roughly. I think the biggest benefit of managed futures with macro, in general, is that... as Adam mentioned, it's the divergent nature of it. When you look at most hedge fund strategies, 80%, 90%, they're valued by us - whether it's long-term equity or buying low and selling high; whether it's merger or whether it's credit; or it's distressed or buying low. That's the beautiful premise of CTAs and momentum is that it's the exact opposite and it has the positive skew. So it's very, very beneficial, almost sight unseen, with any portfolio. 8

10 I would say you could probably add a high percent of allocation at least to a CTA and it would improve your distribution characteristics including your sharp ratio - not only the numerator but the denominator as well. So, that's the premise, and we all know that. I think the challenge is, then, that the numbers haven't been there since was a great year for CTAs, but we've had nine years now... eight years of underperformance, and that presents a big challenge. We know that, theoretically, the possibility is there. We saw a glimmer of it in 2014, but we've had these runaway bull markets, and we haven't had to hedge, so people haven't felt the need to. That's really the contemporary issue right now with why allocations have been low. Niels: Sure. Freeman: I would agree with you, generally, but it's important to think about what client's needs are. That's really the driver of the decision making. What is the risk appetites, and what portfolio construction is important to them; how much do they value risk-adjusted return versus just chasing return? Each client is different, and I think that drives a lot of the decision making where to put your money. Diversification is an important aspect of good portfolio management, and for those reasons, this asset class makes sense. But, it depends on what a client is searching for. Back to your earlier question of where clients put money (if you think about where large asset pools existed 10 or 15 years ago), they were with large pensions, some large endowment foundations - basically retirement assets. People had a very different view on what was important to invest in, and that drove a lot of decision. That has changed quite an bit in the asset classes like CTAs and others hedge funds is becoming more interesting for all the reasons we talked about. I think the world is changing but the mindset of the big decision makers, the people who have very large pools of assets, is still fairly conservative and I think that needs to change over time. Niels: How do we bridge the gap, then, between what the investors, as you said, can't stand or can allocate and what you, as experts, recommend doing? How do we bridge that gap? 9

11 Adam: I think one thing I would want to point out, that Freeman touched on there, I think it's important is that not every investor agrees that diversifying away from certainly equity premium is a good idea. I've run into this situation: of course you want to diversify; of course, you would want to add these things and increase the sharp ratio of the portfolio, and not everybody agrees with that. It's sort of a head scratcher for me, and I'm saying, "Why are people bristling at these things that I thought were just foregone conclusions that every finance person would agree with." It took me awhile to think about, "OK, the portfolios that people are holding are probably an optimal solution, and I just don't understand what the problem is that they solve." Chris: So, when I went back and I think, "What is that portfolio the optimal solution to?" If you think about it, if you view yourself as having permanent capital and an infinite time horizon, that portfolio will give you the highest terminal wealth. To frame a point, I think that's the way a lot of people view themselves. I think the tricky part of that is that when the bullets start flying and the chips are down many people overestimate the extent to which they are in this, what I call, the eternal investor. If you stick to it and don't blink along the way, you will achieve the highest terminal wealth. But if things get bumpy and you blink, you probably would have been better off diversifying and doing some of these other things. Niels: It's funny you say that. It's just that something comes to mind when you say it, because when you look at the manager level, the managers who have actually had the most success in raising assets, and the ones who has diversified have become super smooth and know the risk, are the ones who have actually stayed true to their original strategies, say in trend following, where there is volatility but where we know their actual returns will be the best over time are the ones that actually are making or growing as fast as the other ones. So, it's funny that investors, on one side can think like that but then when they must select the managers they will take the one that looks... 10

12 Adam: I guess my point is that, don't be so quick to conclude that these are crazy portfolios. Those are the optimal solution to a problem that's just slightly different than what you might think. Freeman: It depends on what you're your benchmark is. If your benchmark is the guy next door or the endowment down the road or the other corporate pension plan then their overweighed equities, you look dumb and you don t to look dumb. It's important to understand what the drivers of the decision maker are. When you think about it theoretically, a strong risk-adjusted return is great, but when you're getting beaten handily by overweighted to one asset class, it changes the decision making and maybe not optimally. Adam: These are the real-world pressures that these folks are facing. Peer group performance matters to these folks: their compensation, their careers, and there are lots of those things that don't show up in your model of the portfolio that are important. So yeah, a high sharp ratio is great, subject to staying competitive in the peer group, and subject to all these other constraints. It's a difficult problem. Chris: And each line item is becoming more and more important which is part of the problem of diversification. Diversification truly is the only free lunch in finance, yet when we start to scrutinize weekly return, and we start to scrutinize every line item, I'm surprised to see many managers not being taken up on their 20-ball share class. Ideally, if I'm making a 20-investment portfolio I would choose... everything would be uncorrelated or negatively correlated to each other, have a positive expected value over time, and I would choose the largest share class or the cheapest advice I could get per unit of ball out of 20 ball funds. I think everyone knows that, in their heart, when they studied finance. In practice, we're very concerned because a 20-ball fund or even a 10 ball fund can add down 10 months. That's all within expectations over the long-term time horizon. Now it's focused on weekly and monthly performance. 11

13 It's interesting - when you look back 20 years ago or when you look back 30 years ago, with the macro funds of the day you were lucky to get a quarterly statement. You didn't get monthly letters, and they were able to pursue a purer strategy which was high ball because classic macro maybe has one, or two, or three big moves a year and you make all your money in one week, maybe one day, but certainly one month. So, it would be very, very choppy. I think what's happened in the macro space, and really in the hedge fund space, is that hedge funds themselves are starting to diversify. Every multi-strategy fund started out as a convert-arm fund 20 years ago, and they added on credit, and slowly but surely, they added on everything so that their offering is robust on its own. But, it's not necessarily what we want theoretically, but it is what we want if we're concerned about every line item. So, it's tough. I think everyone is contributing to the problem and I think we, collectively, also have the answers to the solutions to investment problems as well. Niels: Yeah. Chris: But it just takes people to sort through this on an individual bespoke basis Niels: Sure, sure. Maybe we'll come back to that point about transparency, what effect it's had (generally) on volatility, and things like that. In terms of the perception that clients have of managed futures... I remember 26, 27 years ago when I started in this business, trend followers and CTAs in general, it was a black box. Has that perception changed from the institutional investor's point of view? I mean, do they see it differently today, and how do they see it? 12

14 Adam: There have been some papers, recently, about algorithm aversion, and you can see it in the allocations. There's a clear predisposition to invest in humans rather than machines, and I've thought about this. I've been a quant for my whole life I guess, and that's very strange to me. On the other hand, I stop and think about that. Think about getting into a driverless car - that's a very unnatural thing for me to do, yet I know that that driverless car is highly accurate in its driving, but it still feels incredibly unnatural to me. I just don't know, given the way we've grown up if I'm ready to let go of the wheel. There are lots of examples of this where machines are able to do things better than we can do, yet we still feel this reluctance to do it. Freeman: It's funny that you say that. What you hear with a driverless car is when it fails, right? The failure rate is so much lower than regular drivers, but you hear... remember when we talked about that one fail? Adam: Correct. Freeman: Similarly, when you have flash crash or some problem with a high-frequency trader and you hear about that. You don't hear about all those successes that approach has over time, so people are very sensitive. Niels: Plus when we hear of that accident with an airline, it's usually pilot error. Adam: Exactly. 13

15 Chris: That's it. People never lose confidence in themselves. It's the plight of the human condition. It's that we hold algorithms and computers to a much higher standard. Niels: Yeah. Chris: But that's changing. It's slowly changing. changing. Freeman: I think that's true. I think people are getting much more comfortable, not just in managed futures but broadly, more with complicated asset classes. We're getting more faith in the process, in the technology, the thesis, and the people that run it. So, I think that's Adam: Yeah, I agree. There are all kinds of strange examples of this. People may say, "Oh, that's too complicated." Trend following is, perhaps, the most simplistic algorithm that you can imagine. I look at what's in people's portfolios and I think about some of the private deals that they have, and the sheer complexity of those transactions is just mind numbing. Freeman: That's a good point. When you see the complexity of a private transaction and the lack of transparency, valuation, the people, and all the drivers of value (compared to a futures fund where everything is very transparent where you get daily views in to it, you just start looking at what is more complex: the algorithm or the guy signing the agreement to lend money to somebody you've never seen before? Adam: I agree. I tell them, I say, "Look, if the price today is above where it used to be, we're long; and if it's below we're short." That's pretty much it. The rest is just all sort of... 14

16 Niels: How do we improve this reputation, or perception, or whatever we call it? How do we help? Chris: I think it's slowly changing. Twenty-five years ago, it was a black box because people didn't want to talk about the 10 day over 100 day moving average. Today the pendulum has swung, with the rise of risk premium and the low fee trend. It's always been a commoditized product: we know this is what you get, this is how you capture the momentum premium, and it's cheap. So, I think people are understanding the properties more, but I think that's why we see the rise in low fee trend following. Niels: Yeah, we'll come back and talk more about that. Let's move on to one of the other big questions that is on many manager's minds when it comes to consultants, and that is this perceived preference for very large managers. I'm going to start by saying that I'm not going to suggest that "big is bad" and that "small is good." After all, in life we want big opportunities rather than small, and smaller problems instead of big problems. So, there's no fixed rule here. However, we do have some evidence of big being the preference of consultants and institutions. That is according to hedge fund research: 6% of all hedge funds control 68% of global assets, which is, in fact, up from 61% in In fairness, I don't know what each of your manager's selection criteria is when it comes to CTAs. So, why don't we start by sharing what's the smallest manager that you would allocate to? What does that look like? You can talk whether it's managed futures or other strategies, but give us some perspective on this. Adam: There are obviously some lower bounds. It's hard to put your finger on it exactly. We've been very early on a couple of ideas that are very large funds now, but at the time they were mostly just partner capital, 100 million dollars (around there). It varies. I think it's a little more complicated than to just put a hard number. It's a more complicated assessment process than just say, "Oh, 50 million? Forget it." I think the preference for large funds has some practical implications: for one, if the fund is only going to be 500 million dollars, we could easily end up being a larger percentage of that, and that makes us sort of uncomfortable being such a larger percentage of assets. 15

17 I think there are also some of these behavioral factors that get into it. So, it's much easier to fail conventionally. If we all own this one, and it goes down, well, we all own the big one. So, there's sort of a herding effect that happens around certain managers, which is this, "If I fail in this tiny fund, that's going to be worse for me than if I fail and everybody else was in with me." So, these things all, sort of, conspire. There are other things that show up when we test this in data, which is that it's not... Some of the stories about size and performance are very convenient, coherent mental models that aren t consistent with how the data shows up. I've talked to several people about the size versus performance aspect of things, and some people find an effect, some people find no effect. I find, in certain strategy types, that size is beneficial to performance, and that the larger funds do slightly better. There are reasonable reasons to think about that. So, I think you should be careful about not falling prey to a convenient mental model about size. But, I think that these things are there. Freeman: I think that's correct. I'm not so sure it's so clear that small or large managers are better. I think you can find great small managers, but you can also find very good larger managers as well. I think that one of the problems is that we've got a very large universe of managers. Where are you going to spend your time as an investor or as a consultant? Typically, you want to spend your time on something that's going to sustain you over time. Smaller managers? Not necessarily is the universe that is going to be sustained. Some of them will succeed, some of them will fail. Medium sized managers, larger managers, tend to be more stable. So, you tend to invest a little more time there, which drives that effect a little bit. We do the operational reviews, operation due diligence, on a wide spectrum of managers: from a one to two person shop all the way to 10, 20, 30 billion dollar shops. We see that spectrum, and it's always interesting to see that the smaller managers... I think investors are afraid that they're not institutional, they're not safe, they won't have the safeguards that a large one does. However, we see several small managers who are well structured. They take that very seriously. They've instituted a level of controls that you would expect of a much larger manager, either through outsourcing arrangements or structurally. That transparency, that level of control really gives institutional investors a lot of comfort to invest with a smaller manager, and that makes a big difference. 16

18 Niels: What do you see, Chris? Chris: I agree the survivorship bias is very, very real. I think that is one reason we often hear the story that smaller managers aren't performing, but in practice, I haven't necessarily seen it. But, we look at the whole spectrum. At Cliffwater about a quarter of our mangers, that are approved are under a billion dollars. We've done a lot of "day one" investments, we look at a lot of smaller managers, and we hope to start a relationship to grow with them as they get bigger. So, we've really looked at the spectrum. I think that we have very mature portfolios now, today, in So, the hurdle rate for a smaller manager, to be that much better than a big manager that's already in a portfolio, is very great. There are not that many programs, now, that are looking to completely expand and double. In 2006, I think, we were at 1.5 trillion dollars, and in the hedge fund industry, today we're at 3. By the end of the year, I think we'll, perhaps, grow a little bit, but we're not going to be doubling at that type of exponential rate. So, I think the hurdle rate becomes that much harder for smaller managers because a lot of these guys got in the game very early - 10 years ago, 20 years ago when there was a big ramp up in hedge fund assets. Niels: Sure, sure? Adam: I would just add to that, I think it's absolutely right: when you think about what is the edge in the manager's process or whatever they're doing? In a lot of these cases, the edge is the multiple years of technology spent that they've accumulated. If you're spending 10, 50 million dollars a year, whatever it is, for 10 years, the quality and integrity of your systems will be much larger than what a start-up can do, or what a new fund can do. That's part of your edge. You can't just put up your shingle and compete with people who have 10 or 15 years of a 100 million dollar a year tech investment. That's not going to happen. 17

19 Freeman: That's a really good point. You look at a different industry and you think of a transition managers, transition assets for clients, the edge comes from execution efficiency. They spend a lot of money and a lot of time being very efficient at execution. They've done that over a long period of time. You can use that same analogy to smaller managers investing to any asset class. Execution efficiency doesn't necessarily mean technology, but it can. It's how quickly they execute their ideas or get out of their ideas can be the edge. That comes, often times, in time, and spending money, and getting that expertise. Chris: One more point on this, if your edge is in fundamental stock picking, I think you can make an argument that you are smarter than everyone else. You and your two research analysts are just simply just so good at stock picking and fundamental analysis. I think it's nearly impossible for two guys to say that their systems are better when we have such high barriers of entry. R&D has been built up over years, and years, and years. Execution costs play into it, and the trend following model is so mature that it's very, very difficult to come in and say, "I have a better long-term trend following model than these guys that have 25 years of experience." I think you can add an edge with short term models, with more high-frequency trading models, with different types of models, but I think with the mature industry it's a lot tougher to break in. Niels: Sure, sure. Chris: Especially when Sharpe ratios are where they are. Niels: We talked a little bit on the AUM side and that there are more filters that you would use in order to get the universe down. What are some of the other main things that you look for when trying to get your universe narrowed down? 18

20 Adam: Well, one of the things that Freeman mentioned, I spend a lot more time focusing on execution and intelligence than I do spending it on the models or the algorithms or the alpha engine, if you will. I think that the best alpha engine out there can just be swarmed by poor execution and that you get as much or more out of smart execution as you do out of your alpha model. Actually, in my view, quite simple models - very just simple insights - paired with good plumbing and good plumbers, I think is a better bet, often, than betting on an alpha model. Freeman: I think that's right. The plumbing matters, and it matters for a lot of reasons. One from proof of execution capabilities, cost, efficiencies, and also the control structure. A good infrastructure means they're more robust and sustainable. When you are an investor, particularly the types of investors that we deal with - longer term investors, you want sustainability. Sustainability comes from good thesis, but it also comes from a good control structure, a good environment. That's why consultants always spend much more time thinking about the infrastructure even very small managers. How well are they structured and how does that contribute to sustainable returns over time? Chris: I think the key to any business is having a repeatable process. I think consultants and asset allocators are no different. So, when we look at our investment due diligence components, we try to use the same criteria for every single hedge fund across every single strategy. Over time we've built up, what we think, are the keys to looking at these strategies. I would break it broadly into four parts: organizational, investment process, governance, and performance. On the org side, we look at business stability, we look at personnel (we meet everyone who is important in the firm). On the investment process, we are looking for people process: we're looking at their strategy, their portfolio construction, we're looking at risk management. On the governance side, we're looking and fees and expenses, fund liquidity, transparency, different trade-offs. Finally, performance is important but it's only a small part of it. We're looking at alpha versus beta, their peers and different risks imbedded in their performance. I think when we put this all together we come up with a picture for how we feel about that manager and ultimately it's rated. 19

21 Niels: Speaking of that, because obviously there's a lot of aspiring managers listening to our conversation today who are going to be the next one on the recommended list. What's a red flag? Where does it quickly become evident for you that no, we don't have to spend too much time here because there are certain things - they're not ready, or they're not seasoned enough, or whatever it might be? Where do you look for that? Freeman: I think, to what we were just talking about, if you go into a manager and they are really excited about their thesis and their approach but they have no appreciation for the plumbing and that control structure, that's a big red flag. They are so enamoured with their strategy or their approach that they are neglecting pieces, as we talked about, can really contribute to sustainability over time. So that, from our perspective at least, and I m sure my colleagues will say the same, they have to have the bigger picture of how you run a business, not just how to invest directly. Adam: I would agree. I think it's hard to say what the red flag is because sometimes different things come up that give you pause. I tend to like people who have both feet on the ground. It's a little bit nebulous thing to say, but just in talking to them, you can get a sense of that people are comfortable with what the models can do and what they can't do and are just well grounded in terms of what they think they can achieve. I think it's dangerous when people think... There's also a bit of some myopic tendencies where people tend to think that they're the only one doing this, or they're the only one who has discovered this, or this is super unique. In most cases that's probably not the case. In some cases it is, I think it's true. But, those are generally red flags. As I mentioned, the extrapolation of historical experience broadly into the future is a little bit dangerous, in my mind. Market micro structure has evolved so much over the years that, for me, I like to see the people have an appreciation for the way that markets and market micro structure, in particular, have evolved. If you're over-extrapolating experiences that were dependant on a different market structure that's a little bit of a cause for pause for me. 20

22 Niels: Sure, sure. So, now we've talked about the manager and the red flags, but how do you recommend investors should access these managers because, clearly, there could also be some concerns about... In the old days, a managed account was full transparency, little counter party risk, etc., etc. Then came the funds, and they became more popular. There you have certain criteria in terms of how they're structured, service providers, etc., etc. Is there anything there that managers should be aware of when they put together their products to be institutional grade? Freeman: Again, investors are concerned about transparency and how they get to understand what's happening with the manager. So, anything that a manager can do to apply that transparency: to make them comfortable with how they generate alpha, how they control risk is important. I think there's a lot of ways to provide that, either through transparency or the administration of funds, or separately managed accounts, but to keep having that flexibility to deliver what a client wants, what an investor wants, is important. Then, as we talked about before, making sure that investors understand that a manager is institutional in that they've got good controls, good process, and that they've been vetted externally through external providers or types of internal control... 21

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