In the last week, I’ve read the Wharton “Hedge Fund Game” paper (PDF), and commentary on it by All About Alpha, Financial Crookery, Dealbook, and the FT. The debate focuses on one type of manager and fund, and misses the idea that funds and managers are a mixed bag; what matters is WHY THEY WANT YOUR MONEY.
The above paper, and much of the commentary, esp. from Financial Crockery, oops, Crookery, focuses on the talentless (trading-wise, at least) fund manager who runs the fund solely as a means to manage assets and collect fees. This player collects 2/20, or some variant thereof, and essentially makes big leveraged bets, knowing that if they suffer too big a drawdown, they can close the fund and keep the management fees collected thus far. It’s the kind of payout incentive that encourages collecting quarters in front of buses, because when the bus hits, somebody else goes to the ER. Granted, there are quite a few of these guys out there, especially in the hedge fund space, but I don’t think ALL of them are like that. Maybe most, maybe just some. Certainly enough to create the widespread perception. This type of critter isn’t confined to hedge funds, but can be found occasionally in all branches of the industry, apparently even options trading newsletters, where the subscription fee takes the place of fees for assets under management.
The focus of the discussion has been on one aspect of one manager type, to the detriment of the others (however few or numerous they may be). The key point is MOTIVATION, the “WHY” they want your money. The ones discussed above all want to get paid taking flyers on others’ dimes, which is understandable, if immoral.
Now, why else would someone want to manage your money?
Perhaps they have a good idea with increasing returns to scale. There are many strategies, such as long-term trend-following (LTTF) in the commodities futures markets, that benefit to scale (to some degree â it ain’t linear!). Up to a point, more money means a more numerous basket of futures to trade simultaneously, meaning smoother returns and higher Sharpe et al. Booyah! If their macro strategy involves moving a market, perhaps on the order of Soros vs. BOE, then more money improves the chance of success. The “idea with increasing returns to scale” is a very valid reason to want to manage other people’s money.
Lots of good ideas have roughly constant returns to scale. To me, the main motivation to manage other people’s money with a constant-scale return strategy is just to diversify income streams. Hey, strategies have ups and downs, but if you’re managing $90 million at a weighted-average 1% per annum, you’re netting $900K in revenues for the firm, so that’ll keep you in biscuits-n-gravy money even if the fund is having a bad year (provided not too many people pull out). Considering the tendency of “investors” to mis-time their fund allocations, it wouldn’t be surprising if the impact of soliciting funds isn’t similar to blending non-correlated trading strategies … The manager with an idea that has constant returns to scale has a legitimate, ethical reason to seek others’ funds to manage. Matter of fact, it’s a great way for a manager to use the capitalist ideal, and get rich by helping others! If he’s got talent and a few hundred thousand of his own, it’ll be a looooonnnnnnggggg time before he gets rich on 12% annually with 6-8% standard deviations, but if he can get a few accredited investors under his wing, he’ll multiply his personal returns on the idea by many-fold, while helping his customers get richer, at the same time.
There are good ideas with decreasing returns to scale, as well. At the small end, think about momentum trading of microcaps, and at the large end, think about our LTTF example when he’s already full up with capital and managing hundreds of millions of dollars. There are many other examples, but those will do. Past the optimal amount of money, many strategies face declining returns as scale increases, and at this point, the manager doesn’t have (as much) incentive to raise assets to manage. I say “as much” simply because I’ve seen many funds get lookin’ like they’re too brig for their bitches, oops, big for their britches.
I think that’s pretty much the lay of the land. You’ve got talent-less asset hounds (not confined to hedge funds), guys that NEED the money to execute the strategy, and guys that are looking at the money for diversification-of-income purposes, with various levels of desire for it, based on how their idea responds to incremental asset scale.
The latter examples really show that there are legitimate reasons for managers to seek assets under management â they’re not ALL crocks, er, crooks.
3 Comments
Bill,
What would you cite as an example of the “constant returns to scale” category? Can you describe some investment strategies and managers that would fit this style, and explain why? Thanks.
Also, how would you categorize an investment manager who decides to set up a limited partnership in the vein of the Buffett partnership, pre-Berkshire? Would such a partnership be categorized as having decreasing returns to scale if it was focused on value investing?
Most ideas suitable for mutual funds have a fairly constant return to scale; it takes a lot of assets to outgrow the ability to find large-cap value, although BRK/A has done just that, and a retail schlub with a few tens of thousands of dollars can get the same results, if they want them. A tactical asset allocation scheme based on relative strength (like Rotational) is fairly constant to scale, since I can execute it with six figures by using ETFs in a retail account, and could execute it with nine figures through buying the stocks instead of the ETFs, using futures for some positions, and buying the actual bonds or options on bonds. Generally speaking, the strategies that stick with the most liquid, smallest-denominated, and highly-traded instruments have the most scaleability, and those dabbling with microcaps/smallcaps, illiquid bonds such as CDOs, and high-capital requirement assets like actual real estate or private equity, have the least scaleability.
Keep in mind, no returns are perfectly constant to scale. Aside from transactions expenses and other minor concerns, pretty much every strategy has a sweet spot in terms of number of positions, market cap range of targets, etc. Past that point, entry and exit slippage and liquidity are problems, and one has to expand their universe to less effective choices; before that point, there may not be enough assets to execute a diversified strategy.
If memory serves me correctly, at that point W.E.B. was more concerned with special situations, cigar butts, and arbitrage. I would think that type of fund had a relatively tight sweet spot, meaning he needed partners, but I would also think that there wasn’t room for a LOT of partners.
Personally I think that extreme deep-value investing in publicly-traded stocks has decreasing returns to scale, because the “value” in the large-cap space just can’t compare to the broader range of values available. Once you start talking about value through activist investing, the sweet spot is larger and requires more assets to get to that spot where you can diversify the strategy.
Hope that helps.
Yes, thanks Bill. I’ll keep this post saved and refer back to it so the info makes more sense over time as well.
I think you’re right about the Buffett partnership’s need for capital/partners. I’d have to refer back to Lowenstein’s book on Buffett, but I remember that he definitely needed a certain amount of partners at the beginning. Although at one point they seemed to be getting real close to the limit in terms of new money and partners that they were able to take in.