As most hedge fund investors will attest, finding managers with a true ‘edge’ is an incredibly challenging task.
There are 13,000 hedge funds in existence, and every one of them claims to have an edge over the others. We can't claim to pinpoint the right combination of skills and experiences needed to generate alpha. We can help eliminate some of the noise however.
With the help of our family office and institutional investor friends, here are the most common ‘edges’ they see that aren’t necessarily edges at all:
7. Our Backtested Results are Phenomenal
Unsurprisingly, backtested results always seem to perform great. One family office told us,
“It’s kind of like buying the winning lottery numbers after the lottery has already ended. It doesn’t make us feel any better about a fund.”
Despite that opinion, some investors use backtested results to demonstrate that the fund has at least learned from the past.
Ultimately, the disclaimer language speaks the truth: “historical results may not be indicative of future results”. While backtesting a strategy may not be harmful, it also does not ensure that the fund has an edge going forward.
6. I am a Tiger Cub
Two years ago, Absolute Return did an excellent breakdown of the lineage of Julian Robertson’s famous Tiger Management Corp. They found 97 funds that claimed to be ‘Tiger Cubs’. (That’s a lot of offspring.)
How many of those managers were close enough to Robertson to absorb the magic? We don't know, but it's not 97.
The point is that while pedigree is important, it’s also important to understand the depth of the pedigree. There is a huge difference between being personally mentored by Julian Robertson and being the portfolio manager who barely knew him (and was later fired for underperformance.)
5. We're Doctors. We Know Biotech
(AKA “We’re geologists. We know mining”, “We’re engineers. We know technology”, etc.)
Understanding the field is the starting point before investing. It’s a critical prerequisite, but it doesn’t necessarily grant an edge over the many other talented participants in an industry.
As one honest pension fund manager put it, “I am a consumer – but I’d probably be an awful consumer discretionary manager.”
4. We Have 30 Years of Experience
This is a picture of Bobby Fischer, the famous chess champion, at age 13. That was the age he played the legendary ‘match of the century’ against an international chess master.
If the average person studied chess for 30 years, would they be able to play at that level?
Bobby Fischer was beating lifelong veterans before he even had facial hair.
There’s always value in experience. However, just because a manager has been alive and employed for 30+ years does not mean they’ve excelled at their work.
Experience is undoubtedly relevant, but not necessarily an edge.
3. We Went to Harvard
Or Columbia, or Yale…
Great schools give students great networking opportunities, and better opportunities to learn from the best.
However, each student takes advantage of those opportunities in different ways. It’s tough to tell just from where someone went to school whether they will truly stand out.
Harvard business school has 900 graduates every year. Some of them go on to be great fund managers, and some of them go on to be great failures. Ray Dalio and John Paulson were graduates of Harvard. The unabomber also went to Harvard.
2. We've Worked Together as a Team for 8 Years
Let’s say the ClaritySpring basketball team is given 8 years to practice together. If we were to play against a team of NBA players that had never worked together and had no coaching, we would lose horribly.
None of us can even dunk.
The picture to the right is an example of a professional team that works together every day and is still absolutely horrible.
Similar to the “we have ‘x’ years of experience” argument, we see a lot of people touting that they’ve worked as a team for ‘x’ years. A great team dynamic is undoubtedly valuable, but it is hard to measure and it doesn’t convey a clear edge over the market.
1. Our Strategy is Uncorrelated
A long-short manager with positive beta recently told a local family office that their strategy was uncorrelated to the market. Bewildered stares followed.
We get it. Investors have asked for uncorrelated strategies, so managers want to deliver them.
However, not every strategy is uncorrelated, nor are they all designed to be. Furthermore, for those that truly want to eliminate beta, historically low correlations do not mean future low correlations. Many investors learned about unforeseen hidden correlations through the events of 2008.
“Correlation does not imply causation.”
Investors need to determine how a strategy is unique, and in what circumstances the edge holds up. Low correlation will be the byproduct of a unique strategy, but it does not explain anything about why an edge exists, nor whether it will persist.
P.S. Correlation is obviously a statistic, and therefore it has the potential to lie. We’ll have a follow up piece about how hedge funds mislead with statistics.
The graphic shows a strategy that has a perfect zero correlation to the benchmark. When the market goes down, the hedge fund goes down, and when the market goes up, the hedge fund goes down.
If you see a manager who is a Tiger Cub, has great backtested results, has 30 years of experience, went to Harvard, is a doctor focused on biotech, worked with his team for 8 years, believes his strategy is completely uncorrelated to the market, and can dunk, will you invest?
We can't answer that question for you, but we hope this piece will elicit some more good questions!
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