Ideal Investment Fund Terms

[CPTrader]

Quote from heech:

Can you give a little more color on this? What's driving that demand? Is it transparency due to Madoff, or something else?

I have had a couple funds tell me they can only allocate to CTAs via managed account, since regulation for true fund of funds is different. Not sure how common that is.

The above statement I think is just a misleading statement made by FoF because they know futures strategies lend themselves easily to managed accounts. They want MAs so they claim they can only invest in MAs...meanwhile they are invested in other Fund vehicles for the most illiquid, exotic strategies without missing a step.

Personally, I would almost never offer a MA...it gives the investor excessive control and insights into the strategy, especially for an automated quant strategy in this era where hi-tech tools for monitoring, mirroring, replicating, reverse engineering abound.

Whatever fidicuiary controls, security issues an investor wants addressed can be addressed in a Fund with a reputable/reliable Fund Administrator, Prime Broker, Bank/Custodian, and auditor.

 

[CPTrader]

Quote from heech:

Oh I disagree, re: 3-5 yr track record. I think it's hugely significant.

There are a very large number of funds being founded every year... for the sake of argument, let's say 500 (new funds ranging from $10k to $100mm). Let's say all of these fund managers are actually poo-flinging monkeys, making buy/sale decisions based on where their poo lands on a target.

Just statistically speaking, assuming i.i.d. , 250 monkeys will out-perform the market... 13 of them will look like poo-flinging geniuses, out-performing the market by two standard deviations! Is my fund really great, or am I just lucky? Stay tuned.

If an investor is going to look at track record at all, they should absolutely wait at least 3 years. I personally wouldn't invest a large amount of money in an "emerging" fund on the basis of a 1 year track record, either.

My humble opinion;

A 3-5 yr , even a 10 year track record proves nothing unless:

1. The track reord reflets a consisten stargey that s stilbeing used n dwillbe used inth efuture wthotu chage

2. The track record reflect sall psisbel market regimes an denvironments.

Thes etwo conditions are rearley ever presnet. Funds are cosntly chnagig stageso, adding stargeis, allocating Fnds to outside managers/trding advsiors, etc. Ina didton veyr few track reocrd shave encomassed multiple market regimes. How many fund todya eixsted during the 1994 bond debacle and teh 1997-1998 russian emerging market/LTCM cirsis an dteh 2000-2002 dot com bust an d9/111 and the bul market and the 2007-2009 rela estae idnuced crash and the 2009-2010 HFT indced flash crash and flash squeez.

Teh answer i svery few.a.dn ebven those fundsthat have be around fo rteh past 16 years like Tudor & caxton & sors ..ahve chnage dvery much from tehri eigns 9which is not a bad thin per se0.

What I cnsider a san ainvetsro:

1. Does the strategy make sense. Some strategies to me do not make intellectual sense (or present excessive risk that will prove difficult if not impossible to contain/manage in real time). Other strategies have such inherent weaknesses I would never invest in them

2. Most importantly, how does the Manager define risk, mitigate risk and manage risk. Can the Manager prove by providing historical examples their risk mgmt process valid. If a manager cannot show me how he manages risk every day for the past 3 months, why do I need to wait 3 years to see that he can't mange risk or to see that he is supposedly managing risk (by virtue of "good returns" that are probably due to luck and/or excessive risk taking) If you can prove to me how you managed your risk yesterday or 3 months ago and how you intend to manage future risk ..that for me is enough.

3. Does the manager have the character & discipline to implement the risk process in point 2.

Most mangers do not have a through risk management process, and you can screen this out after one meeting or even after just reading their marketing docs. Once a manager can prove they understand risk and have a process to manage risk and they have a strategy that makes sense...all other things being equal, I could invest with them very early on. Very early on...

 

[1prometheus]

Then you run into the problem where after 3-5 years, a manager with a great record will have grown assets to the extent the forward returns will not be wonderful.

They diversify, become more conservative, start new managed account types (and shut the ones that do badly). etc.

Personally I would rather make a strait bet on a manager I trusted when still small and just let the cards fall where they fall. If it blows up well, at least a start up usually has a smaller minimum investment.

Either you can use your judgement at the right time or you get left out. Playing it safe is no safety at all, as typically all that is left at that point is the churn and frictional costs, the manager has succeeded in capturing any surplus return.

 

[heech]

Quote from 1prometheus:

Personally I would rather make a strait bet on a manager I trusted when still small and just let the cards fall where they fall. If it blows up well, at least a start up usually has a smaller minimum investment.

Either you can use your judgement at the right time or you get left out. Playing it safe is no safety at all, as typically all that is left at that point is the churn and frictional costs, the manager has succeeded in capturing any surplus return.

I agree with much of what you said... but obviously, the challenge all allocators/investors are facing is the same: how do you decide whether you should "trust" someone with your investment?

By the firmness of their handshake? By the twinkle in their eye? By their own self-serving, rough description of their strategy? It's not a trivial task.

Historical returns is the only objective tool available for measuring a manager against her promises. It should only be *one* tool in the toolkit for the sophisticated investor, but I (personally) see it as a critical measure.

 

[CPTrader]

Quote from heech:

I agree with much of what you said... but obviously, the challenge all allocators/investors are facing is the same: how do you decide whether you should "trust" someone with your investment?

By the firmness of their handshake? By the twinkle in their eye? By their own self-serving, rough description of their strategy? It's not a trivial task.

Historical returns is the only objective tool available for measuring a manager against her promises. It should only be *one* tool in the toolkit for the sophisticated investor, but I (personally) see it as a critical measure.

A lot of allocators/investors...at least the smart ones will confide in you that they know that historical returns are to a great extent meaningless for reasons I've listed earlier...but investing in an established manager with a track record and maybe a few hundred million gives them an excuse to be wrong...so the requirement for 5 yrs historical track record is more as an insurance policy for their careers (as Allocators, FoF mgrs, etc) than anything else. Easier to explain losing money in Citadel's Kensington fund than in a 28 year old's 6 month old futures fund.

 

[Ghost of Cutten]

Quote from heech:

. If you're trading exchange-listed instruments, and if you're not a billion dollar fund... you really have no excuse for having any sort of extended lock-ups.

I disagree, if you are a value investor for example then extended lockups are essential to stop investors harming themselves by making irrational decisions, such as liquidating at the bottom of a bear market when assets are at their cheapest.

For shorter-term trading then regular liquidity is fine, but for any kind of investing or long-term trading you need at least 1 year and really 2-3 year lockups IMO, just like you have in the venture capital world.

For example, let's say you correctly identified great values in late 2008. If your lockup was anything 6 months or less, good luck not getting liquidated at the bottom there. Or if you were picking the top in the housing market it's the same thing. Most major investments or macro themes take more than one year to move from a valuation extreme to fair value.

Now, most investors wont accept >1 year, and dislike even 6-12 months. Well, that's why investing in actively managed funds is such a tricky thing to do well. Most investors should avoid active funds, basically - they have neither the skills nor psychology to do it properly.

 

[heech]

Quote from Ghost of Cutten:

I disagree, if you are a value investor for example then extended lockups are essential to stop investors harming themselves by making irrational decisions, such as liquidating at the bottom of a bear market when assets are at their cheapest.

For shorter-term trading then regular liquidity is fine, but for any kind of investing or long-term trading you need at least 1 year and really 2-3 year lockups IMO, just like you have in the venture capital world.

And I couldn't disagree more. Speaking as an investor first and manager second... the last thing I want is someone else "protecting" me from making "irrational decisions". The purpose of a lockup should never be to force an investor to suffer through a draw-down, because the manager thinks it's in their interest to do so.

I've been in the angel/VC investing world for years. The sole reason why VC (and to a lesser degree private equity) deals use a lock-up, is because of how difficult it is to get to a liquidity event. If you're forced to liquidate any kind of private investment for cash, you will only do so at a HUGE discount.

The only consideration that should be involved in deciding whether a lockup makes sense: does it protect the interests of the *remaining* investors. (This is also why firms dealing in illiquid OTC instruments, fixed income, etc... might have an argument as to why they have to use a lockup as well.)

 

[Hydroblunt]

Quote from Ghost of Cutten:

I disagree, if you are a value investor for example then extended lockups are essential to stop investors harming themselves by making irrational decisions, such as liquidating at the bottom of a bear market when assets are at their cheapest.

For shorter-term trading then regular liquidity is fine, but for any kind of investing or long-term trading you need at least 1 year and really 2-3 year lockups IMO, just like you have in the venture capital world.

For example, let's say you correctly identified great values in late 2008. If your lockup was anything 6 months or less, good luck not getting liquidated at the bottom there. Or if you were picking the top in the housing market it's the same thing. Most major investments or macro themes take more than one year to move from a valuation extreme to fair value.

Now, most investors wont accept >1 year, and dislike even 6-12 months. Well, that's why investing in actively managed funds is such a tricky thing to do well. Most investors should avoid active funds, basically - they have neither the skills nor psychology to do it properly.

Investors want liquidity when investing in hedge funds. It is actually an important factor in their decision. Offering liquidity as a fund manager, even if it hurts your potential returns is one of the best features you can create.

Your viewpoint is shortsighted. It's really not up to the fund manager to judge whether the investor should pull out their funds in the middle of the drawdown. They may be cutting their losses or they may have lost confidence in the fund manager. But more than likely, they are experiencing a liquidity event. You can look to 2007-2008 as an example. Many of them experienced serious liquidity events due credit contraction and failing real estate projects. So whether they were withdrawing funds from a hedge fund at the worst possible time is not a primary concern. The fact that they can withdraw the funds quickly is more valuable than the missed upside.

 

[CPTrader]

Quote from heech:

If you're forced to liquidate any kind of private investment for cash, you will only do so at a HUGE discount.

The key word above is "forced to liquidate". GoCutten's point and my point also is that if a manager is forced to liquidate a position for any reason other than risk management or trade strategy this is done at a disadvantage to the investor, other Fund investors, the manager. As GoC indicated, this forced liquidation many times is done at a discount

A trader/Fund Manager buys what he feels is undervalued..sometimes the market "discounts' this asset further...if this market discount does not violate your risk mgmt rules you don't liquidate at the market discount but if an investor forces you to liquidate you have done so at a "HUGE discount"; which is exactly equivalent to the VC/PE scenario you say is a legitimate one.

So using your argument , I do not see why lockups are acceptable for PE & VC and not for Hedge Funds

 

[CPTrader]

Quote from Hydroblunt:

Investors want liquidity when investing in hedge funds. It is actually an important factor in their decision. Offering liquidity as a fund manager, even if it hurts your potential returns is one of the best features you can create.

Your viewpoint is shortsighted. It's really not up to the fund manager to judge whether the investor should pull out their funds in the middle of the drawdown. They may be cutting their losses or they may have lost confidence in the fund manager. But more than likely, they are experiencing a liquidity event. You can look to 2007-2008 as an example. Many of them experienced serious liquidity events due credit contraction and failing real estate projects. So whether they were withdrawing funds from a hedge fund at the worst possible time is not a primary concern. The fact that they can withdraw the funds quickly is more valuable than the missed upside.

Sure, investors want weekly liquidity, even daily liquidity with zero lockups. In 3 years I predict they'll want hourly liquidity. So yes, I loose liquidity terms is a marketing feature that will help the manager raise assets..but it certainly does not necessarily help performance.


Managers have to determine what is most important...superior performance by managing the investment portfolio or "managing" investors and meeting their every myopic whim? There is no "right' answer here, every manager has to determine what's best for him and what kind of investors he wants.

My initial post was asking the question where is a balance point between investor desires and manager desires. I still do not know the answer.