P2.T8. Risk Management & Investment Management

Transcription

1 P2.T8. Risk Management & Investment Management Mirabile, Hedge Fund Investing: A Practical Approach to Understanding Investor Motivation, Manager Profits, and Fund Performance Bionic Turtle FRM Study Notes By David Harper, CFA FRM CIPM

2 Mirabile, Chapter 11: Performing Due Diligence on Specific Managers and Funds IDENTIFY REASONS FOR THE FAILURES OF FUNDS IN THE PAST EXPLAIN ELEMENTS OF THE DUE DILIGENCE PROCESS USED TO ASSESS INVESTMENT MANAGERS IDENTIFY THEMES AND QUESTIONS INVESTORS CAN CONSIDER WHEN EVALUATING A MANAGER

3 Mirabile, Chapter 11: Performing Due Diligence on Specific Managers and Funds Identify reasons for the failures of funds in the past. Explain elements of the due diligence process used to assess investment managers. Identify themes and questions investors can consider when evaluating a manager. Describe criteria that can be evaluated in assessing a fund s risk management process. Explain how due diligence can be performed on a fund s operational environment. Explain how a fund s business model risk and its fraud risk can be assessed. Describe elements that can be included as part of a due diligence questionnaire. Due diligence is the term used to describe the process of evaluation and analysis that an investor follows to get comfortable with a strategy, a manager, and a fund prior to making an investment. It includes: All the steps that are needed to get to know why and how a fund came into being; The skills its founders or current partners claim to have mastered; The evaluation of the timeliness, accuracy, and consistency of manager and fund information; The reliability and independence of service providers; and far more. Identify reasons for the failures of funds in the past. Investors should remind themselves of the reasons funds have failed in the past and seek answers in the strategy they are considering as part of the due diligence process. Funds can fail as a result of bad investment decisions. Funds can make several compounded bad decisions or just a few concentrated calls on the markets or individual securities that perform very poorly. Funds can fail due to all sorts of frauds, including accounting frauds, valuation frauds, or misappropriation of funds. Funds can fail due to excessive leverage, improbable probabilities, unexpected events, and tail risk. Funds can fail due to a flood of unanticipated withdrawals of capital at the least opportune time. Funds can get caught in squeezes by the street or by other hedge funds. Funds can fail as a result of a lack of supervision or compliance controls related to insider trading. Funds can fail because of their own actions or the acts of others. A prime broker like Lehman or MF Global can go bankrupt and take a fund with it. Funds can fail when liquidity dries up, and they can't meet redemptions and must sell into a market that no longer exists, at least at that moment. 3

4 Investors need to evaluate each strategy and each manager with open eyes and take great care not to be blinded by the past success of any one person or strategy. The more an investor assumes things can and will go wrong, the better the due diligence process and the more likely it is that an investor will uncover problems and/or ensure that attractive opportunities have a higher probability of success. If It Looks Too Good To Be True, It Probably Is The individual employees who are performing investment due diligence should always remember to trust their own judgment. If it looks too good to be true, it probably is. Too often, firms make allocation decisions by committee. In this setting, it is easy for one voice, perhaps one's boss, to direct the decisions of the team. Individuals may feel too intimidated to speak out or to communicate details that may reflect negatively on a manager who is well known to the firm or who has established a high-level relationship with the CIO or other members of the organization. It is essential that people who come across facts, figures, opinions, references, or any other relevant information uncovered during their work escalate their concerns. It has been identified that the most notorious frauds and funds that were behaving badly were quite obvious to those in direct contact with the manager. If something in a manager's track record, background, or pedigree comes into question, analysts must raise their hands and speak their minds. Often only in retrospect is everyone able to see what should have been obvious to all. In the end, no matter how uncomfortable, escalation of questionable information will benefit the organization and will be appreciated. If things don't feel right or just don't pass the smell test, then they should be voiced within the research team before ever getting to the investment committee for allocation decisions or approval. Explain elements of the due diligence process used to assess investment managers. The due diligence process today is different than it was in the past. In the past, manager reputation and performance were the most important factors. Investors did little digging into the how and why of performance and the safeguards in place to protect assets. This was due in part to the lack of leverage that individual investors had with the managers. They were often considered "lucky" just to have gotten into a well-known fund with limited capacity. Institutions had relative small exposures to hedge funds at the beginning and need to have a high return to have the investment matter to the portfolio. Managers were rather selective and if you asked too many questions you would simply be told to go elsewhere. As the industry matured and as more institutions came into the market, not to mention some very high profile frauds, the due diligence process expanded. Today, both managers and investors spend a great deal of time trying to learn where a manager's 'edge" is coming from and that their investment is safeguarded and properly valued. 4

5 The due diligence process involves two separate but closely related evaluations. Both are considered almost equally important and are often interrelated. 1. One evaluation is of the firm's investment process and related risk controls. 2. The other is related to the fund's operations and business model. Identify themes and questions investors can consider when evaluating a manager. Most, if not all, of the questions related to a fund's investment process should be done in person with as many people of mixed seniority as possible. The goal is to find out what is really going on at the fund and not just have a pitch book recitation by the investor relations staff. Hearing it directly from the firm's founder and lieutenants is always best, but getting the same message from a diverse number of people who perform certain tasks on a day-to-day basis or should be familiar with them is also quite useful. What is Your Strategy, and How does it Work? Investors who are evaluating a manager often start with high-level questions that provide them with some context about the firm, its investment strategy, and how it works. 1. What is the manager's self-described style, and how does it fit within a particular classification scheme? 2. What are the current themes included in the portfolio, and what are the fund's highest convictions or most concentrated positions? 3. How has the portfolio evolved over the past several quarters, and what is the outlook for any changes, given current market conditions? 4. Does the firm manage the fund to specific gross and net exposure targets, and if so, where does the fund stand today versus those targets and why? 5. What is the portfolio turnover and number of days to liquidate, and what are the triggers that result in a reversal and a sell or buy to cover or exit a position? Are the triggers hard coded into the risk management process of just guidelines? 6. How are stop losses used to manage risk? Are they used at the position level, portfolio level, or both? Are they always executed or are there exceptions? 7. How quantitative is the investment process, and how much does the firm rely upon proprietary models? If so, what are they based on, and how are they developed, back-tested, and allocated capital, or decommissioned when failing to perform? 8. How are short sales used as hedges, alpha generators, or both? Has the firm ever been hurt by a short squeeze, recall, or buy-in on borrowed shares? 9. How are listed or OTC derivatives used in the portfolio? 10. How is trading organized? Does the firm have a central trading desk for all external order flow? 11. Is the strategy capacity constrained? 12. Has the fund ever held private investments, and if so, why and how do they support the core investment strategy? 5

6 13. Is the firm more return oriented, asset growth oriented, or both? 14. How does it manage the conflict between generating returns for existing investors versus growing the assets under management? 15. Has the fund ever been soft or hard closed or returned capital to investors? Once this initial set of questions has been answered, the investor can begin to ask more specific questions about the firm and the process followed to manage investing. How is Equity Ownership Allocated among the Portfolio Management, Trading, and Research Teams? Understanding the firm's ownership structure and how things get done is critical. The participation of the investment team in some form of ownership is a critical area of differentiation among firms. o Some firms do not share equity ownership among the portfolio managers or traders in the firm. o Other firms use equity ownership as a key feature of their professional talent retention program and to attract and groom new talent for future leadership positions. One model is not necessarily better than the other. Each has its pros and cons. Investors often have a view one way or another. The key thing is to understand the firm's philosophy and how it impacts performance, talent acquisition, and retention. Is the Track Record Reliable? After an initial set of questions about the firm, an investor will want to dig deeper into the manager's and the specific fund's track record. According to a recent report on hedge fund due diligence performed by the not-forprofit organization the Greenwich Roundtable, investors should inquire whether the track record is comparable to similar strategies, has been audited, and is long enough for statistical evaluation and inference, whether returns were impacted by fund size, and if the team that produced the historical track record is still in place today. Additional questions about the track record should include how it performed during periods of market stress and how it relates to the portfolio manager's experience at previous firms, if applicable. Who are the Principals, and are They Trustworthy? Investors who are thinking about a particular manager need to allocate resources to both references and background checks. Newer managers are trickier than established ones. New managers need to have references from previous hedge funds or banks verified, both those that are on the manager's reference list and those that the investor can obtain independently. Established managers won't need to be interrogated about previous firms or employers from the distant past. When interviewing established managers or talking to their references, focus the dialogue more on the manager's motivation, behavior during crisis or stress periods, ability to communicate to investors, and experiences other investors have had, including both positive and negative over the life of the fund. 6

7 The ability to verify a new manager's prior employment is just the beginning. Did they do what they described? Were they the trigger puller or acting in a support role? Did they generate ideas or implement ideas? Did they operate individually or within a group? Often, the best way to find out is to ask former colleagues, partners, managers, clients, or other independent parties. Investors performing reference checks can think of the process as a 360-degree review of what a person has claimed about the past or about their current skill set. If enough people are saying the same thing about a person or a firm, then an investor can take some comfort. If significant differences of opinion about a person or a manager are uncovered, they should be thoroughly vetted and then discussed directly with the manager. Most often, there is a good explanation but not always! Hedge fund scandals and blowouts over the past 10 years have changed the way investors need to think about the people they are entrusting with their assets. The high-profile blowups of several hedge funds, including Bayou Management and Madoff, have raised important questions about what can be done to uncover fraud in advance of getting hurt. Background checks can be obtained. More depth requires more money, but in some cases, it may be worth it. Very often there is information just below the surface that can be used to discover managers who have had trouble in the past. In many hedge fund frauds, investors could have searched public databases and found litigation, criminal accusations, or civil disputes that may have been used to raise questions about the manager's integrity or past deeds. Many frauds simply go undetected because of a lack of proper due diligence. After the fact, it is easy to point to indicators that something may have been wrong. Investors should always consider calling former employers, track down credit reports, and contact auditors, administrators, and prime brokers to verify what a manager is representing in fund documents or through verbal communication. An investor should include searches of websites maintained by the SEC and read the manager's Form ADV in detail before deciding to invest. Information about bankruptcy, federal or appeals court records, or other sources to uncover information about a manager are readily available. Investors should always look for related party activity when doing background searches. Does the manager of the principal own other business activities that do business with the fund? Funds that use affiliate broker or dealers of administrators can lead to real problems, especially if the manager did not disclose it in advance. Investors need to make sure they have access to the people at the top of the firm. It is also important that investors deal directly with the actual risk takers and decision makers and not just investor relations, salespeople, or junior staff at the fund. 7