Saturday, 25 March 2017
Last updated 1 day ago
Feb 25 2013 | 2:32pm ET
Before founding his current venture—Ridgefield, Conn.-based boutique investment manager Simple Alternatives—Jim Dilworth worked on the floor of the Chicago Mercantile Exchange; helped Reuters build out its Globex platform; worked at GAM vet Clark Winter's fund hedge funds; headed his own, Charles Schwab-backed alternative investment firm; and worked at institutional fund of funds Common Sense Investment Management. Over that time, he tells FINalternatives Senior Reporter Mary Campbell, he came to respect “smaller long/short equity-focused guys with significant short-selling experience.” And when started his own mutual fund of hedge funds—the $68 million S1 fund, which returned 6.2% in 2012—those were the managers he sought.
What was the genesis of the S1 Fund?
I literally started Simple Alternatives from scratch off of a business plan that I sketched out on a napkin. I had an opportunity to partner with a large firm early on but instead, with the support of my wife and family, decided to do it independently where we could focus on building a quality firm without outside pressure to “grow at all costs.”
We also determined early on that we wouldn’t pay for fund assets or do a seed deal or anything like that; it's all grown organically, really just through word of mouth and through the industry contacts. Of the clients that we have right now, I'd say 75% of them are fee-only high-net-worth advisors, and the rest are defined contribution plans, an insurance company, a foundation, and recently we've got several institutional consultants to allocate to us. But I think the big money's going to end up coming from many of the same people that I've worked with over the years, institutional consultants. They're going to be using more of these types of liquid vehicles.
The key issue in this channel is the majority of their clients are using mutual funds as the vehicle of choice to facilitate custody, and they have been limited to using limited partnership structures for typically only a small portion of their accredited investors, since it's just very hard for them to custody those assets. So I really started scratching my head post-Madoff, thinking, "Why are we locking people up for 12 months in a liquid long/short equity strategy? There must be a better way to offer this same alternative investment value proposition in a more liquid, more user-friendly vehicle."
My game plan wasn't to offer a dumbed-down fund of hedge funds product to the masses; it was really to offer the same institutional clientele, and this fee-only consulting channel, a different and better way to access the same high-quality alternative investment strategy—transparent, daily liquidity, lower minimums and all the user-friendly benefits of a point-and-click mutual fund allocation.
How is the S1 Fund structured?
One of the benefits of our mutual fund structure versus a traditional fund of funds structure is we can run a more concentrated portfolio. We use managed accounts where we have full transparency into the underlying securities of each of the managers and that just makes for a superior way to manage portfolio risk. You don't have that level of transparency in a traditional fund of funds LP structure, and, of course, custody requirements for mutual funds remove the potential fraud risk that you may have when investing using an LP.
We also believe a more concentrated portfolio can outperform a portfolio of, say, 30-plus managers, and that's been the case for us. We're currently running five managers and we would envision the fund at no more than eight to 10. We spend quite a bit of time up front getting to know the managers, both quantitatively and qualitatively. We go into these relationships hoping they will be long-term, although we're not shy if it's not a good fit or there's chronic under-performance or other issues of concern; we will remove a manager. We have removed two managers since we launched the fund.
What criteria do you use in your manager selection process?
There are some inherent barriers to entry in terms of the initial manager vetting process when using a mutual fund structure. All of the underlying sub-advisors need to be SEC-registered, that's a requirement under the 40 Act. Also, we are unable to pay an incentive fee under the 40 Act; instead we pay a flat management fee. Those are the structural things that we consider as part of our process; if a manager can't meet these criteria, it's not worth having a follow-on discussion.
Our manager selection really begins and ends with integrity. We spend a lot of time getting to know the manager, what makes him or her tick, what motivates them, do they pose any kind of headline risk to the fund and to our investors, etc. Additionally, we tend to focus on smaller managers because research has supported that smaller managers tend to outperform larger managers, so we're committed to boutique managers who have made the choice to run a smaller pool of capital. This way we know that the manager is giving us his or her full attention. We also like managers who have a significant amount of their own money invested alongside our capital. This is all standard stuff that most fund of funds would look for, but that's an important point for us.
We really prefer managers who have a definable edge and who are focused niche players. We are also sticklers for finding managers who are good short sellers. We really try to understand how the manager thinks about managing their short book. For us it's very important to have a manager who has significant short-selling experience rather than a long-only manager who is just trying to expand their business into a long/short strategy. The typical manager we would gravitate to is someone who likely wouldn't run more than 150 gross and tend to float their net exposure between 20% and 50%. We don't like short-biased managers and we don't really like long-biased managers, we like variable biased. Another thing we look for is experienced managers that might have spun out of a larger organization but are getting started. We're actively looking for that kind of manager. We can not only help a new manager with early capital but we also try and be helpful to all of our managers with respect to introducing them to our industry contacts to help them grow. We really come at each relationship with the desire for it to be win/win.
Running a concentrated portfolio with niche managers, do you have any concerns about representing too big a percentage of a manager's business?
One of the benefits of using managed accounts is if we ended up becoming 100% of a manager's business, meaning if we were their only client and they were totally focused on running our strategy, and they could pay the bills, we wouldn't have any problem with that because there's no business risk to us.
What type of strategies do you invest in?
We're a fundamental, bottom-up, simple, long/short equity-focused firm. We don't like to see wide-scale use of ETFs, and we don't like to see managers that are heavy options users other than to box in their positions.
The firm’s name probably gives away our ethos but we really try to focus on managers who run pretty simple, straight-forward portfolios. They're easy to understand and monitor and they don't subject the fund to unnecessary risk. We're not fans of systematic strategies and managed futures strategies where we think we may subject investors to unnecessary tail risk, liquidity risk, counter-party risk, etc.
What leverage limits do you face as a 40 Act fund?
The limitation on leverage is 250 gross, so that's 150 long, 100 short; and within the long/short equity universe, 90% of long/short equity managers would not bump up against those leverage restrictions.
How do you begin the search for a new manager? Do you choose a sector or strategy you'd like to be involved in?
The approach that we take is kind of old school—it's fundamentally simple, bottom-up manager selection. We don't cull the macro and then try to pick the next hot sector. We start with the premise of risk-adjusted returns, and then we analyze the manager's return stream for attribution. If they are a sector specialist then we look at how that plays into the overall S1 Fund portfolio. Do we want to add another technology, media, and telecom-focused manager right now? Probably not, because we may end up with name-overlap or too much sector-specific risk. So we really try to focus on how a manager fits into the portfolio given what the other managers are doing. We've done a good job so far, with almost no overlap in position or sector. We are patient and spend a lot of time and effort finding the right managers and ensuring their strategies are complementary. It’s hard work building a turn-key solution, but that’s what makes it efficient for advisors, consultants and investors looking to allocate to alternatives strategies.
Who are your sector specialists?
We've got one manager, Starwood Real Estate Securities; they're obviously focused on real estate. And we have another manager that we hired recently, last year, named Maerisland Capital and the manager is Mark Beder. Mark would call himself a generalist, but he really has an edge in the TMT sector, he's got a lot of experience there and he's done a really good job with technology, media and telecom and we've got some really good exposure out of him there. Some of our other managers don't want to pigeonhole themselves into a sector but we try to understand what they are really good at. Where's their information edge and what's their background? In a case like Mark Beder, he's just an exceptional manager with I believe a strong edge on the TMT side.
What's your outlook for 2013?
This is a little bit of gut instinct, speaking with our managers and a little bit of talking to some of the consultants and industry pundits. We believe that 2013 could be the turning point for fundamental driven long/short equity strategies. If you look at Q4 of 2012, and even so far in 2013, long/short equity has really made a strong comeback in terms of relative performance.
I would also say in terms of the markets overall, smarter people than I have talked about the bond bubble that's forming and that equity markets are likely going to continue to chug along unless there's some exogenous shock to the market. There is always that looming tail risk out there, the black swan event that everyone's worried about, but that’s why alternatives strategies exist in the first place. Against this backdrop, we believe it could be another double-digit year for equities and, on a risk-adjusted and absolute return basis, long/short equity managers should be able to really shine.