The strategy of hedge fund selection

The strategy of hedge fund selection

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So far this decade, hedge funds have been perhaps the most complicated asset class to navigate. Sideways markets should be – in theory – happy hunting grounds while low interest rates and volatile equity markets have made uncorrelated strategies relatively attractive. But hedge funds have disappointed during this period.

Sussex Partners is completely focused on hedge funds, for its various groups of clients. Founded in 2004 it started from the point of view of identifying ideas it would invest in itself, identifying managers able to fulfil its strategies.

“First we come up with an idea – say why commodities or Japan is interesting – and then find the best managers in that space,” says Patrick Ghali, managing partner and co-founder of Sussex Partners. “Typically we have one or two big ideas per year like that to work on.”

The other main side of the business is helping clients to put together fund-of-funds. “We would not manage the portfolio – we help them define their risk profile and then how it should be implemented. We then go out and find the best managers to implement that strategy.” It creates shortlists of perhaps 20 funds, sets up a beauty parade and helps whittle down the list to find the best manager for the mandate. It then carries out the monitoring on an ongoing basis.

It also caters for a few multifamily offices, creating a menu of recommendations of hedge funds and fund-of-hedge-funds, as well as strategies to consider.

Selecting managers is at least as much a qualitative as a quantitative process, according to Ghali. “We try to understand the strategy and then see whether what the manager tells us is reflected in the numbers. If he tells you a great story and the numbers are terrible, there is a disconnect somewhere.”

Typically, for its clients, avoiding losses is at least as important as chasing stellar returns. “Wealth preservation is extremely important for all of our clients, more so than making money. They are conservative institutions, or the underlying clients are ultra-high net worth. The most basic tenet of finance is the positive compounding of returns – if you can avoid drawdowns, you have won half the battle. They are not looking for trades; they are looking for core allocations for their portfolios.”

As a rule of thumb Sussex Partners avoids residual legal risk – say, avoiding PIPEs as they are vulnerable to the regulator changing the rules – and illiquid assets that do not have a market price, due to the lessons of 2008. “And there are soft factors,” says Ghali. “We do not like arrogant managers – because if they make a mistake they will not concede it. And we all make mistakes. In our experience, it is the arrogant guys who cover it up or take crazy risks.”

Ghali also likes high-conviction managers: “We like managers who have a view that they can articulate. We understand that if you have high conviction, sometimes you get it wrong. That’s fine, you learn from it and you move on.” Sussex Partners uses databases only as a “reality check”, comparing a manager they like with a peer group. “That is not how we go about finding managers. Sometimes it is about managers that are not only on databases – it can be more about word of mouth or networking.”

That hedge funds have not been able to achieve the returns of the pre-crisis golden era is to some degree due to capital crowding out opportunities. “One of the reasons we particularly like China and Japan is that hedge fund assets make up less than 1% of the market whereas in the US it is 4-5% and in Europe around 6.5%. In the US people complain everyone is in the same trade. We prefer liquid but less efficient markets.”

For example, South East Asia is of less interest because trades can move the market and dent returns whereas Japan offers real depth: “There are 3,000 listed companies, 30% analyst coverage, you can short cheaply, managers are well experienced in sideways markets – that is interesting. Results this year show this is a hedge fund market.”

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