Due Diligence as an Alpha Generator
“People, process and product”
-Marcus Lemonis, host of CNBC’s “The Profit”
In my last post I discussed some of the hazards of assigning numerical measures to hedge fund performance and suggested that keeping things simple might be the most robust approach. Here I’m going to write about evaluating the business side of a fund.
In his business turnaround TV show, Marcus Lemonis is fond of saying that he evaluates a business based on people, process and product; his “three p’s”. I’m going to use the same framework but add one more as well. I must list these in some order, but that doesn’t reflect any degree of importance.
Everything a fund does is because of the people running it. You are not investing in a fund. You are investing with people. It is important to know who the managers are, their backgrounds, their experiences, their levels of involvement and the amount, both professionally and financially, they have invested. Do they treat your money even more respectfully than they treat their own? For that matter, do they have a significant amount of their net worth invested in the fund? Is the fund overly dependent on one person, or can they operate even with the loss of important individuals?
The philosophy defines the theoretical framework of the strategy, and the processes responsible for the implementation of the strategy. The managers should be able to confidently explain what they do and why they expect it to be successful. They need to be able to give a rationale beyond “it works”. Also, it is essential that all the partners give essentially the same answer.
Hedge funds are either focused on performance or asset gathering. Clearly investors want performance, and questions about philosophy are the best way to figure out the true motive of a firm. Also, asset gatherers will tend to have higher management fees while performance-oriented funds will have higher performance fees.
Finally, be aware that as funds age they will often become more risk averse as the partners accumulate wealth. Beginning managers want to get rich. Established managers want to stay rich.
A manager goes from philosophy to performance by way of process.
Harvesting a risk premium (beta) is easy. Passive exposure will do it. But alpha is something that needs to be made. It requires active management. And, just as in any other manufacturing industry, this requires a well-defined, efficient, repeatable process. Short term results can never be certain, but a good process can be. A great process implementing a mediocre philosophy is better than a great strategy supported by a terrible process.
Process represents the implementation of the investment philosophy. An investment process typically has three distinct parts. These are idea generation, portfolio construction and risk management.
Idea generation ranges from the complicated and varying (a global macro fund that invests in almost anything) to the simple and static (an index option overlay). But in any case, the researcher uses various pieces of information to find the opportunities that are most attractive. Then models are built, tested and moved into production.
Next the manager must decide how best to incorporate this new strategy into their existing portfolio. This might not be a portfolio in the traditional sense, consisting of many different products. It is likely to instead consist of only a few products but many strategies. Nonetheless, there needs to be a defined method for allocating to each strategy.
Finally comes risk management. Actually “finally” is a deceptive word because good risk management should be incorporated into the strategy at both an intrinsic level (e.g. a stop) and the portfolio level.
It is a good idea to press a manager about process. If they can’t immediately and clearly state their process it is likely that they don’t have a well-defined one.
A fund you are pitched is likely to have good returns. If the returns weren’t there they wouldn’t be marketing it. So, look for a reason why the returns might not continue to be good. And this needs to go beyond looking at the historical numbers. What does the fund actually do? Is that opportunity going to persist? For example, buying distressed debt might be good in a deep recession but might not be as attractive in good times. Perhaps that is what you want, but you still need to know.
Lastly, research has shown that funds with higher performance fees have higher returns. Look at net returns and don’t worry about the gross. Paying lower performance fees is often a false economy.
Go through the numbers. Go through them as deeply and carefully as you can. But the people also matter. There is no quantitative model for evaluating people, but if you don’t have total trust in the management team’s honesty and competence you shouldn’t invest.