Hedge Fund Investment: Back to Basics – Manager Risk

May 17 2011 | 11:47am ET

By Karan Puri -- The Presidents working group on financial markets committee recently coined the term ‘Meta Risk’ that describe non-quantifiable exposures within hedge fund investing. According to the brief, these risks essentially relate to ‘manager risk’ or the risk of sub-optimal investment management due to moral hazard, over-reliance on financial modelling and so on. While it is true that these types of risks do not carry explicit numerical representations, it may be possible to assess their impact indirectly by analysing the somewhat softer characteristics of hedge fund investment.

The aim of this article is to discuss two such characteristics.

My money is yours but what about yours?

Most hedge fund investors today require the manager to invest a “significant part” of his/her equity into the fund. The purpose of this investment is to align the interests of the manager with those of the investors. However, there is very limited research that clearly defines what is significant. Is it:

  • Absolute dollar value investment?
  • Predetermined or contractual relative fund share?
  • Rolling Investment?

Under either case, the manager can be seen as a shareholder of the fund which is a win for investors, but does the manager behave like one? Or rather, should he act like one?

For a fund with significant managerial ownership, the manager may become overly driven by capital preservation while too little equity may drive the manager towards more aggressive investment strategies. Both extremes are sub-optimal from the point of view of the investors who would prefer the manager to remain consistent and maintain an objective decision making process. Since the extremes don’t work, an optimal equity level must exist that provides the right incentives to the manager whilst aligning his interests with those of investors.

So what is optimal?

The question of optimal managerial investment is a difficult one to answer and it is even more difficult to generalise as the hedge fund industry is highly segmented with regards to strategies, legal structures and investment techniques. As a result, its derivation must surely come at the fund level.  In other words, ownership must be a function of the underlying strategy choice, the potential risks, level of liquidity and other fund characteristics such as lock-ups, which investors are commonly subjected to.

Investors must closely consider the impact managerial investment has on the manager’s decision making incentives prior to investment. However, this analysis must not stop with the decision to invest. It is vital for investors to make sure their manager does not deviate from the stated objectives as the implications of such changes could have detrimental effects on the investor’s portfolio. 

A Numbers game without numbers?

Potential investment decisions are usually made based on among other characteristics the hedge fund manager’s track record. This historical performance can be quantified and hence measured and assessed through a variety of tools. However, by focusing solely on the objective performance evaluation part of the game, investors pay little or no attention to the underlying subjective characteristics that drive the performance in the first place!

The interplay between managerial ability and effort has vital implications for the successful running of the fund. It is these manager characteristics that in all probability cause the high level of heterogeneity found within the industry as well as the widely documented survivorship bias. Indeed the standard “2/20” style incentive contract was setup in order to attract the best talent to the industry. Since managers differ in both their ability and effort incentives, investors in the search and identification of potential hedge funds must also consider these manager attributes when finalising screening. Furthermore, particular attention should be paid to the imbalance between these two concepts that could reflect operational weakness or inefficiency.

How?

One working definition of managerial effort can be the determined attempt to gather information through available sources as well as the sourcing of potential resources during strategy execution. Managerial ability can then be defined as the manager’s overall skill in the interpretation and use of the collected data and information in portfolio formulation. The likelihood of successful performance as a result is a combination of effort and ability and is positively related to both.

So what does this mean?

The purpose of the above arguments is to urge investors to somewhat shift their attention away from the numbers and consider the ways in which the manager effectively uses his resources to gather information, generates and capitalises on trade ideas and essentially runs the business. By doing so investors would gain a deeper understanding of what drives the manager and his/her philosophy of investing and aides them in making informed decisions. Furthermore, such knowledge may also lead to the early detection of fraud should the manager be involved in unethical practices such as trading on insider information.

Conclusion

Whether a hedge fund investment is part of a grander asset allocation scheme or a standalone investment, the background and reputation of the manager are key contributors to this decision. As a result, investors must segregate the management from the fund and develop a thorough understanding of each aspect prior to making an investment decision.

Karan Puri is a PhD student in Finance at the University of Bath, Department of Accounting and Finance, U.K. He is currently in his second year as a doctoral student. His areas of expertise and research lie within the field of hedge funds. He undertakes both empirical and theoretical work on the performance of these funds. Contact Details: Email – kp212@bath.ac.uk; phone: (+44) 7823770026


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