Newport Capital Advisers

HEDGE FUND OBSERVATIONS AND QUESTIONS

Hedge funds are not homogeneous. The only factors that they tend to have in common are the legal structure and compensation arrangement. The spread of returns among nominally similar hedge fund strategies has been much wider than for those of unhedged investment strategies. Therefore, manager selection is far more important with hedge funds than with unhedged managers.

Hedge fund managers typically have very wide latitude in their deployment of assets. They have two primary ways to make—and to lose—money. They can own securities (long positions) that they believe will increase in price and they can borrow them and sell them short (short positions) that they believe will decline in price. They can also use margin (leverage) to increase the amount of capital for investment. Obviously, leverage can be very profitable or very unprofitable; it is not asymmetric and must be used with the utmost care, if at all.

Perhaps one of the most important aspects of hedge funds is that they are partnerships. It is remarkable that many investors in hedge funds are so mesmerized by the prospect of asymmetrical risk—that they can make money with relatively little risk of loss—that they invest without ever meeting the general partner(s). When one enters a partnership, whether in legal form or on informal terms, one certainly wants to have a full measure of one’s partner and confidence in that person’s ethical and intellectual integrity. In our view, such knowledge is the primary risk management factor for a hedge fund investor.

Manager selection is a complex process. One must know the general partner(s) well. Secondly, the world is a far more random place than most successful people assume; thus diversification among hedge funds, or any other investments, is one’s only true friend. Yes, concentrating one’s investments can lead to outsized returns, but also to outsized losses. Additionally, among the profitable experiences of investing in hedge funds for over 15 years by Newport Capital Advisers is the observation that growth of assets under management can often have a significant, adverse impact on investment returns. Of course, a five year or greater performance record can deliver comfort to a prospective investor, but such records must be viewed in the context of a number of variables, including assets under management and the individuals responsible, for as those two factors change the validity of the past performance is also likely to change, perhaps significantly. The use of quantitative analysis to gauge the effectiveness of a manager can be very helpful, but may also mask risk due to potential changes in qualitative factors.

Hedge fund selection is highly subjective and requires a multi-faceted approach. An investor should seek to identify competitive advantages in their hedge fund selections. Examples include industry sector specialists, as their focus provides an informational advantage, managers who limit assets under management to preserve investment flexibility relative to their universe of potential investments, firms that take great care with personnel growth, funds that are selective in their admission of limited partners, funds with a clear focus on incentive compensation, funds not dependent upon leverage, managers who do not make low conviction investments, managers who do not attempt to time broad stock market movement, but that base their decisions on specific fundamental factors for each security, and funds that operate in securities sectors less likely to be adversely impacted by technical factors such as limited liquidity. Specific advantages primarily relate to investment research acumen.

Are there more liquid vehicles available to access funds that invest both long and short?

Yes, there are a growing number of mutual funds that invest in a variety of hedged strategies. The growth of such offerings has increased since the financial panic of late 2008 when investors wanted to liquidate assets to prevent further losses. The desire for liquidity since the financial panic of 2008 has caused many hedge funds to modify their liquidity terms and allow more frequent redemptions, although the daily liquidity offered by mutual funds offers much more frequent liquidity opportunities. Of course, one must also consider the impact of highly liquid fund strategies on investment returns. Stable capital not likely to flee on a daily basis is far more desirable from an investment perspective, as most fundamental investors have an investment horizon greater than one day or even one month.

Although several private partnerships have converted to mutual funds (“1940 Act” investment companies), the universe of private offerings available only to accredited investors and qualified purchasers is far larger currently. One must remain cognizant of organizations designed to gather assets in contrast to those who focus on investment returns. It remains to be seen if the mutual fund versions of hedge funds can produce rates of return for a given level of risk the same as or greater than private hedge fund offerings.

Is long-term equity investing dead?

Very probably it is not, although it has very few advocates in today’s especially uncertain economic environment. The desire for nearly instant profits from a risky investment such as equity has heightened interest in strategies that may engage in rapid trading as investors seek to earn profits daily in what has become a highly volatile equity market with relatively limited liquidity against the economic backdrop that has many structural problems with very uncertain growth prospects. This very near-term focus may be one reason that equity valuations appear to be low and why the highest quality corporations that require no external financing have dividend yields on their common stock that exceed the yield-to-maturity of ten year US Treasury Notes. The fact that the S&P 500 has produced a loss for a decade has reinforced the aversion to stocks, if the mutual fund outflow from equity funds and into the perceived safety of fixed income funds or cash equivalents in the two years since the financial panic of 2008 can be used as evidence.

Are Exchange-Traded Funds (“ETF’s”) the best way to access various sectors of financial markets, including equity sectors and indices, fixed income securities and other sectors including gold and commodities?

ETF’s have become more popular to access market sectors because they offer diversification and relatively high liquidity. ETF’s are generally more tax-efficient than mutual funds. The sponsors of ETF’s charge fees that investors should understand. As with any investment, one should understand the risks associated with ETF’s. Sector selection is very important and ETF’s offer a wide variety of sectors. Of course, there are mutual funds that have performed better than their respective sector or index after all fees, but selection risk is clear, as many do not perform better. An ETF investor must accept the high probability that an ETF will not perform better than the sector it replicates, if for no other reason that it charges a fee. In short, ETF’s offer the investor a vehicle that may well complement and add diversification to a portfolio.

What are the major factors that Newport Capital Advisers considers in investment manager selection?

We look for consistency of decision process, conceptual and practical validation of the process, compelling risk management, and organizational commitment when selecting and retaining managers. We recognize and resist the familiar temptation to simply extrapolate recent trends when we address manager selection or retention. Just as price alone provides insufficient information for most investors in stocks, past performance is only one factor in manager selection. Sophisticated quantitative analysis is best used to manage risk, not to naïvely compare past performance. Firms with greater interest in attracting new assets than in investment performance (an all too common problem but one to which no firm would ever admit) are of no interest to us.

Selecting managers is probably more difficult than selecting stocks and there is no substitute for meetings with decision-makers at investment management firms. We conduct on-site visits with managers when it is practical and necessary. We communicate with an extensive network of investment professionals that we have developed here and abroad to help us surface such research opportunities in addition to screening our manager databases.

We will never recommend a manager to a client without meeting with its principals and developing confidence in its process. Our manager selection approach is based on relative valuation, the willingness to exploit less efficiently priced asset sectors, and the conviction to engage less well-recognized investment managers. Just as one would not base a stock purchase or sale decision solely upon its historical price performance, one should not select investment managers solely, or even primarily, upon performance history. Frequently, recent underperformance may be evidence of an attractively priced portfolio. Recent outperformance may likewise indicate that the manager’s style has had a good run, not that the manager in question is skillful.