Happy 30th anniversary! Three decades ago, we began a whirlwind journey.
The year was 1995. Madonna’s “Take a Bow” and Coolio’s “Gangsta’s Paradise” were topping the charts on the radio (the iPod was years away, not to mention Spotify). Jeff Bezos had just left D.E. Shaw (a well-known hedge fund) to start a then-unknown company named Amazon. We were calling each other from rotary phones, emailing on platforms like Hotmail and Rocketmail (which would later become Yahoo mail) and watching the S&P close above 500 for the first time. The world of hedge funds was in its infancy, 100 times smaller than its current size and unfamiliar to most of the population. Very few understood the impact hedge funds would eventually have on the global investment landscape. Fast-forward to present day and the industry is now over $4.5 trillion in total assets under management and a staple in most investors’ portfolios.
The last three decades were not without adversity, and the industry overcame periods of fragility to emerge even more resilient than it had previously been. We experienced the evolution firsthand as stewards of our clients’ capital. Along the way we uncovered the lessons that are borne out of each mistake, the keys to success and the skills we believe are necessary to persevere. As we celebrate this important milestone, we reflect on these past 30 years and are excited to share the 30 most important investment insights from our journey. The times might have changed, but the wisdom remains the same.
The times might have changed, but the wisdom remains the same.
Taking the road less traveled
The road less traveled is never an easy path, but it’s often less crowded and, when navigated wisely, it can lead to opportunities others overlook. Early on, we made an unconventional decision to invest with short sellers, and it turned out to be one of our more impactful strategies. At the time, critics cited the strategy’s high volatility, risk management challenges and seemingly limited return potential (the market goes up over time) as reasons not to invest. There was merit to the critique of the naysayers, but it missed the point of what could be achieved at the broader portfolio level. While you needed deep conviction in the short sellers to remain invested (the volatility of their return streams wasn’t for the faint of heart), if used correctly in a portfolio, short sellers provided positive convexity during market declines and unlocked an ability to take risk elsewhere.
Two short sellers stand out in our team’s collective memory:
- The first epitomized the unique – and often colorful – personalities of many short sellers. He led the west coast office of a firm focused on finding “frauds, fads and failures” and his detective-style work often felt like watching an episode of “Forensic Files.” He may have been early at times, but his conclusions were seldom wrong. Deep insights combined with straight talk and a proclivity for unconventional indicators set him apart (e.g., screening for CEOs who wore wigs because it implied a willingness to hide reality). Smart, passionate, confident and always entertaining, he’s anything but forgettable. After all, in 30 years there’s only been one time when a manager jokingly chased one of our analysts around the room with a Taser gun!
- The second was JPMAAM’s most successful short seller – perhaps more staid in personality, but no less innovative in investing, she was one of a number of prominent women leading the industry in shorting at the turn of the century. At a time when many focused only on quarterly earnings, her forensic accounting approach to investing was quite novel and yielded tremendous results. Just as importantly, she eschewed ego, emphasized risk management and appreciated the impact of broader market dynamics on her short portfolio. Her strategy was our most lucrative short-selling investment and a material contributor to our strong risk-adjusted returns over the first decade.
Here are 10 often-overlooked insights to help you make better investment decisions:
1. Be a skeptic.
Approach due diligence from the perspective of where does the offering “break”?
2. Volatility isn’t your enemy.
Allocators often focus too much on manager volatility; in a portfolio context, it’s rarely the challenge.
3. Focus on the tail.
Being “uncorrelated” is nice; being uncorrelated in the tail is powerful.
4. Have the courage to make mistakes.
Mitigate unnecessary risks but take calculated bets.
5. Just say no.
You’re more likely to regret making a failed, poorly conceived investment than missing a good one.
6. Basis kills.
Be aware of misalignment between your longs and shorts, as two bets are riskier than one.
7. Don’t be afraid to run into fires.
Some of the greatest investment opportunities and manager access are sourced during dislocation.
8. It’s only a great investment if you can hold it.
Stress test not only the portfolio but also how the business, financing and counterparty risk hold up under material market pressure.
9. The opposite of a long isn’t a short.
Great short sellers are wired differently; don’t expect success on the long side to necessarily translate to a successful short book.
10. Don’t make logical decisions based on flawed information.
Take the time to ensure quality inputs and appreciate the flood of biased information during market extremes.
Sometimes, it’s the simple things that matter
Analyzing a hedge fund – properly – can be time consuming and require a detailed understanding of markets, strategies, financing, operations and business management. It’s not a light lift, and many strategies require specialized skills, training and experience in markets trading similar strategies. While that’s all critically important, sometimes it’s the simple things that matter most – like references.
References are a hugely important part of the diligence process, but not all allocators run them – and even fewer run them correctly. There’s a lot that can be gained from a thoughtful allocator’s conversations with a manager, but it’s only one side of the story. In those settings, the manager owns the messaging around how their firm is branded. Talking to others in the manager’s ecosystem can add layers and depth to the diligence process. That means talking to former employees, counterparties, companies and whoever else may have firsthand insight on how a firm operates, what they do well and, equally importantly, what they don’t do as well. Not only is it important to have these conversations and pull at threads, but also it’s critical to start doing so early in the diligence process (and continuing throughout your time as an investor) so it can guide where you spend your diligence time. When references happen late in the process as a “check-the-box” exercise, it ends up being more about confirming existing views than trying to uncover the truth about a firm, its people and its process.
Ultimately, you’re building a mosaic and not relying on any one reference, but there are some conversations that can really shape where you go with an investment. One example is talking to former employees about how the process actually works at a firm. What kind of work is being done? How are decisions made? Who is involved? In doing a reference on a well-known firm with a co-PM structure, a former employee told us how “A and B haven’t spoken with each other in a year; they are co-PMs but trade their own books independently without any scrutiny or collaboration.” That was not the message that was being communicated by the manager to investors. By peeling back that layer, we were able to get a fuller, more accurate picture of the firm. Although this reference helped us avoid a mistake, references can also help shape a more positive opinion of a hedge fund, motivating you to spend more time or size it larger in a portfolio.
Here are 10 simple but powerful aspects of due diligence that can help you avoid mistakes and focus on the prize:
11. References matter.
Too often, references are too few, too late and too superficial.
12. Culture is king.
The road to failure is paved with poor cultures.
13. The truth is out there.
Developing a network is important, but building the right one is even more critical.
14. Control the meeting before it controls you.
Every manager believes they are the best and it won’t take long before they tell you…
15. Read between the lines.
Develop techniques to extract maximum information, but recognize that what is not said may be just as important.
16. Don’t buy the portfolio, buy the process.
Stories change and positions are fleeting; a robust investment process should endure.
17. Focus on the prize.
Don’t confuse a poor presenter with a poor investment manager (or vice versa).
18. 1+1 = 1/2.
Co-PM structures rarely work – especially in difficult markets; look for clear ownership of decision making.
19. Avoid casinos – black isn’t “on a roll” and red isn’t “due.”
Very, very few managers add value over time through timing the market (even if it sometimes looks like it). Don’t reward a manager for gambling.
20. There’s a fine line between confidence and hubris.
It’s okay to be wrong as long as you recognize it quickly.
Our success has been directly attributable to our desire to continually evolve both our business and the investment strategies we pursue.
“Skate to where the puck is going.” –Wayne Gretzky
Rumors of the death of the hedge fund solutions provider have been greatly exaggerated. For most of the last 30 years, many have referred to our business model as a melting ice cube whose relevance would soon evaporate. While some competitors have succumbed to stagnancy, those speculations have been far from accurate as it relates to our business. We are currently at peak assets, and we continue to expand and strengthen our client relationships. Our success has been directly attributable to our desire to continually evolve both our business and the investment strategies we pursue. We pride ourselves on moving to where the puck is going and working closely with our clients to ensure they remain ahead of the curve.
The need to adapt is nowhere more evident than in quantitative strategies. The best quantitative managers must continually improve their systems to be able to capture inefficiencies as markets evolve. The traditional approach is to employ a large team of analysts to derive, test and implement new statistical approaches based upon an understanding of the markets being traded. Around 25 years ago, computing speed and data storage hit a critical inflection point – using sophisticated algorithms to replace the large teams of analysts became a real possibility and machine learning began to creep into the hedge fund world.
Artificial intelligence may be ubiquitous today, but investors were initially skeptical of these techniques, viewing them as a “black box” with no obvious fundamental or macroeconomic foundation. Our success as an early allocator was therefore reliant on convincing quantitative managers to be extremely transparent – in spite of the fact that these managers, who treated their alpha models as highly classified trade secrets, often hesitated to share more than their names! In one unprecedented case, a manager wrote their core equation on our whiteboard to explain a complex aspect of their process, a move akin to a CIA agent sharing critical mission details… and the insight we needed to get comfortable investing. Today, more than 15 years later, that manager invests nearly $10 billion in machine learning models that have adapted so well to market changes that they bear almost no resemblance to those initially discussed.
Interesting new data continues to be created today at an inconceivable rate. Quantitative and machine learning approaches to digesting data and synthesizing views have become table stakes for successful investing. Within quantitative strategies, we expect the machine learning footprint to continue to improve, grow and eventually dominate the space, forcing perpetual evolution of investing approaches for managers and their investors. As hedge funds must continue evolving to overcome the anticipated alpha decay of their models, allocators must remain front footed to continue sourcing unique and less crowded opportunities.
Below are 10 reminders to help you stay a step ahead:
21. Dinosaurs go extinct.
Innovation must be a constant.
22. Success can be a dangerous achievement.
Complacency, distractions and misalignment can be silent killers.
23. Climb through the side window.
Every problem has a solution if you are sufficiently creative.
24. Don’t sweat the small stuff.
Focus more time on the big allocation decisions and waste less energy on ticking boxes.
25. Write the playbook in advance.
Cycles – and dislocations – may not repeat, but they rhyme; plan sufficiently to afford yourself the time to adjust accordingly.
26. If you’re on time, you’re late.
A willingness to be early investors in new managers and unique strategies is key to delivering differentiated alpha.
27. Understand (and maintain) your competitive edge.
If you can’t measure the bar, you’ll never really know if you’re above it.
28. Gotta be in the “room where it happens, room where it happens…” – Lin-Manuel Miranda
As circumstances change, proper alignment keeps you at the table even when you’re not in the room.
29. “Everyone has a plan until they get punched in the face.” – Mike Tyson
Drawdowns feel like dog years. Remain calm and take a step back before figuring out how to move forward.
30. Learn from other people’s mistakes.
Mistakes will always provide opportunities for growth, but it’s cheaper when they’re not on your dime.
The takeaways
The blueprint for success that we’ve developed over three decades essentially boils down to the importance of thoughtful risk taking, the ability to understand the people behind the numbers and the willingness to continually evolve. It’s impossible to perfectly predict what will happen in the investment industry over the next month, much less the next 30 years, but our experience gives us confidence in a number of truths:
- Appropriately analyzing risk will require increasingly sophisticated knowledge and tools, but the underlying process in evaluating hedge fund investments will remain the same. Always be skeptical (even of what we tell you), but don’t let fear stop you from taking smart risks.
- Future market cycles will be best navigated by teams that have successfully managed through previous market cycles together. Double down on investing in your people and build strong relationships with experienced hedge fund managers and allocators who prioritize culture and longevity.
- The industry will continue to evolve and the approach to investing must evolve with it. Work with allocators who are relentless in pursuing the next source of alpha and aspire to be a leader in customizing portfolios to meet client needs.
We have no doubt that the world of hedge fund investing will continue to educate us, humble us and inspire us in ways we could never expect – but it is our hope that these tenets, and the pearls of wisdom behind each of them, will be the north star that allows us to continue delivering for our clients for decades to come.
Acknowledgements
As we look toward the future, we’d like to express our deep gratitude to all those who contributed to our success. Tremendous thanks to Joel Katzman, whose vision – not only for JPMAAM, but also for the industry as a whole – was extraordinary. To Harold Ehrlich, whose pearls of wisdom and historical perspective were greatly appreciated. To our friends at Harris Associates and Ivy Asset Management, whose insights and connections were a beacon of light within an otherwise opaque industry. Tremendous thanks to our employees – both past and present – for contributing to our world-class culture and for the great work throughout the years. To our hedge fund partners for the noteworthy contribution toward our success and many valuable lessons learned along the way. And, most importantly, to our clients. We wake up every morning deeply grateful for the trust you’ve placed in us and never lose sight of the privilege of managing your money. Thank you.