Business Mind-Set Key to Hedge Fund Management
What does it take to be a successful hedge fund management firm?
Philip Duff, CEO of FrontPoint Partners, thinks he knows. In fact, he thinks heís built one.
Speaking at the SIA hedge fund conference last month, Duff noted that while many hedge funds are created each year, only a few last for more than a few years. He predicted that of the roughly 500 hedge funds that will be launched globally this year, "no more than five of those organizations will end up being sustainable businesses."
Duff said that the "vast majority" of hedge fund organizations are launched by talented investment professionals who say "Iím not getting paid enough." Such a person, he said, is approaching the venture with a very different mind-set from a typical business person. "The mentality of a business person," said Duff, is to analyze a potential market to determine whether there are unmet needs, and then determine whether the businessperson has some unique ability to fulfill those needs.
FrontPoint, said Duff, did just that. His firmís founders determined that there are unique demands from both hedge fund investors as well as from the investment professionals that manage hedge funds.
From the investor side, Duff pointed out the obvious: institutional investors are increasingly turning to hedge funds. While the individual high net worth investors who invested in hedge funds in the 1980ís and 1990ís continue to represent the majority of hedge fund holders, he said, the "vast majority" of new money being invested in hedge funds is coming from large institutions, such as public and private pension plans and endowments, foundations.
The "wants and needs" of those institutional buyers, noted Duff, are "really quite different" from high net worth investors. Specifically, institutional investors are looking for "non-correlated" returns ó positive returns that arenít tied to the performance of equities and bonds the institutions hold elsewhere in their portfolio. Moreover, institutional investors want sustainability and protection from reputational exposure.
In contrast, the typical new hedge fund is "slightly larger than $100 million" and lasts only three and a half year, on average. Itís "three guys with a Bloomberg in a garage," he said. "Take your typical $50 billion pension plan," he said. "What does your typical $100 million hedge fund do for it? Nothing."
There are plenty of small hedge funds. Duff noted that the median launch size of a hedge fund in 2004 was $11 million. "My simple rule of thumb is you need $100 million to cover your fixed costs," he said. The "vast majority" of hedge funds, he said, are operating "at the level of a hobby."
Moreover, reputational risk to be considered. As the recent Bayou scandal has illustrated, when a fiduciary entrusts an organizationís money to a hedge fund manager, it has to be sure it knows who it is dealing with. If the three guys in a garage "end up in column 6 story in a Wall Street Journal ó thatís death," said Duff. "Thatís much worse than losing money." To the institutional investor, he said, "the three guys in a garage just scare the bejesus out of me."
So, he concluded, the market demand from institutional investors is to incorporate the non-correlated returns offered by hedge funds in a scalable, sustainable way, and in a way where the organizationís reputational exposure is minimized.
But thatís only half of the equation.
The other "demand," said Duff, comes from investment personnel. Duff noted that many in the hedge fund industry complain about the dearth of new talent. However, he suggested that rather than looking for the superstars, firms look for solid performers, and provide them an environment where they can focus on their core competency, which is investment. "This isnít the process of going out and looking for that genetic freak who is going to go out and be the next George Soros or Julian Robertson," he said. "We are all subject to the law of large numbers," he explained. Beyond four or five people, he explained, it is difficult for any organization to claim that its staff is extraordinary. Instead, he said, FrontPoint seeks to take "common people and produce uncommon results."
Duff noted that when portfolio managers go out and launch their firms, they spend 90 percent of their waking time during their first year focusing on investment performance. However, he said, by the time the firmís third year rolls around, "at best" no more than 50 percent of the founderís time is spent working on the investment strategy. That diminution in intensity and focus largely explains the falloff in performance experienced by many hedge fund managers, he said.
Portfolio managers that launch a fund find themselves "trying to run a business at the same time they are trying to run a portfolio," he said. The attributes that make an individual a good portfolio manager "are almost the antithesis of what makes someone good at running a business." A portfolio manager has to be quick on his feet in response to negative market movements. In contrast, an entrepreneur has to have a very high tolerance for pain. "Itís a very different kind of mentality."
So, in addition to providing scalability for institutional investment, said Duff, FrontPoint was designed to allow investment personnel to spend 80 or 90 percent of their time focused on portfolio management. To do this, FrontPoint created a centralized business platform, with a multi-strategy, multi-manager structure. But Duff noted that FrontPoint is not a fund of funds nor is it a service provider for independent, stand-alone hedge funds.
Duff advised fellow hedge fund shops to maintain an entrepreneurial atmosphere. To attract and retain good people, allow employees intellectual independence and autonomy, as well as a "degree of control over their personal destiny," he said. With the increasing regulation facing hedge funds, he added, this can be "difficult to achieve." He suggested that firms avoid binding employees down with contracts. "You need to have a partnership of free will," said Duff. He noted that within the securities industry, non-completion agreements and non-solicitation agreements have proliferated, in an effort to "chain people to their desks." In Duffís view, "it is much more effective to use carrots instead of sticks."