Monday, 27 February 2017
Last updated 50 min ago
Feb 7 2011 | 10:05am ET
Let’s say you’re a hedge fund manager and Benchmark Plus, the New Jersey-based fund of funds with $1.8 billion in assets under management, has decided to invest with you.
First, the good news: Benchmark Plus, true to its name, has devised a benchmarking system that allows it to recognize (and reward) your skills as a manager, no matter your strategy.
The bad news? As a Benchmark Plus manager, you will be expected to work for those rewards. “We don’t give you credit for the benchmark,” says Mike Mikytuck, director of investor relations, “We give you credit for the plus.”
Mikytuck says his firm, which was founded in 1996, is able to determine whether managers are exhibiting real skill thanks to its benchmarking system.
“When you look at the long-only world, it’s relatively straight forward to benchmark a long-only manager—if I’ve got somebody doing long-only stocks, I’ll compare him to the S&P, if I’ve got somebody doing small caps, I’ll compare them to the Russell 2000.”
To apply benchmarks to hedge funds, says Benchmark Plus Principal Scott Franzblau, they first have to create them:
“We construct a benchmark that represents the risk embedded in each manager’s portfolio to assess whether the manager is producing alpha. To construct alpha return streams, what we choose to do is offset those risks using the derivative markets to neutralize the beta.”
Take the example of a manager with a 50% net exposure to the S&P 500. When Benchmark Plus invests $1 million with this manager, says Franzblau, “We will offset that 50% long exposure by shorting $500,000 of the S&P 500 futures against the manager.”
A month passes, the S&P adds 2%, the manager calls and tells Benchmark he’s up 75 basis points. If he’s expecting a pat on the back, he’s in for a surprise. Says Franzblau:
“Benchmark Plus says, ‘Well, time out here, you had a 50% exposure to an index that was up 2%, we shorted that so we’re minus 1 and you only produced 75 basis points, so to Benchmark Plus you actually had a negative alpha of 25 basis points.’”
On the flip side, if the S&P loses 2% during the month in question and the manager calls up and says he’s down 75 basis points, Benchmark Plus, says Franzblau, will say, “Wow, that’s great,” because the manager, given the risk in his portfolio, should have been down 1% and instead he’s “produced a positive alpha of 25 basis points.”
In a portfolio with 25 managers, Benchmark plus will construct a benchmark for each one.
“We’re constructing a benchmark for each manager that represents that manager’s risk, offsetting that risk, and capturing and analyzing the resulting alpha.”
How do Benchmark Plus’s managers respond to this method of evaluating their performance?
“Very positively,” says Mikytuck. “They see...that we’re giving them credit for their skill regardless of what market fluctuations are doing. And we may be the only firm that says ‘great job’ in a down market...They also understand that we know their portfolios as well as they know their portfolios and there’s even some synergies where managers have seen what we’re doing and begun to incorporate those processes themselves, realizing the power of stripping out that systematic exposure.”
But before Benchmark Plus can evaluate managers, it has to find them. Franzblau says sometimes they choose an area in which they want to invest and seek out a manager and sometimes managers come to them. More often than not, these managers are working on the peripheries of the capital markets, mining some decidedly niche markets.
“We are focused on managers producing alpha,” said Franzblau. “How do we do that? We’re looking for managers that have a sound [method] of finding inefficiencies in the marketplace, have a proven mechanism to extract alpha, and have barriers to entry that keep others from infringing on that opportunity.”
So, for example, if Benchmark Plus enters the distressed debt market, it does so through a very particular channel:
“Inside of distressed lies this little kind of sub-element called trade claims,” says Franzblau, “And trade claims are really receivables held by the vendors of bankrupt corporations.”
When a corporation goes into receivership—as, for example, Kmart did in 2002—a lot of suppliers are left with unpaid bills.
“When Kmart goes Chapter 11...all of these creditors to Kmart...are now forced into the bankruptcy process. So...the holders of these trade claims—the electricians, landscapers, the dressmaker who sold $2 million worth of dresses to Kmart—these individuals don’t know anything about bankruptcy or reorganization, going through the court, the litigious process of securing the trade.”
A distressed manager, understanding that the bankruptcy process can take years to play out and that people like the dressmaker might prefer to “extract what value they can” now, will bid for the claims. Says Franzblau, “They go into the public market place, buy trade [claims] at, say, 16 cents and they can short publicly traded subordinated debt that’s pari passu in the workout at 28 [cents]. And they can make the spread between 28 and 16 if held through the duration of the ensuing reorganization.”
Sounds complicated? That’s because it is.
“Trade claims is a specialized area for a few reasons,” says Franzblau, “because it’s privately held, you have to have the information on who holds it, have a systematic means to legally transfer the trade from one owner to the other, and you have to have a pretty well-built organization that goes out and tries to procure this paper and that is very laborious—you’re sending out hundreds and hundreds of letters to the owners of these receivables, you’re following up with phone calls, you’re trying to transfer trade from privately held to whatever fund you’re managing, so the barriers to entry are great and it’s this nichey little area within distress that produces a lot of alpha.”
The same is true of micro-caps, another area where barriers to entry are considerable because the companies involved—with enterprise value of $400 million or less—are below Wall Street’s radar. An analyst choosing to follow them must, essentially, build his own database and “he’s not going to be on the newswire sharing that information,” says Franzblau. Equal access to information is generally seen as a prerequisite for an efficient market, and the lack thereof in the micro-cap market could represent a market inefficiency waiting to be exploited.
And if you’re a manager in the process of exploiting it, Benchmark Plus may be calling.
Franzblau says BenchMark Plus’ results over the past two years in a zero-interest rate environment have been strong enough that they are clearly “based on skill not market exposure.”
“Benchmarking has worked for 30 or 40 years in the long-only space and for the last 15 years we’re, I think, the only group that has applied it to the hedge fund universe because it’s a little more difficult and requires a lot more work but that’s not an excuse for not doing it.”
“We’re not smarter than anyone else that’s investing in this universe,” he says, “We just have a different process.”