Book Notes – So You Want to Start a Hedge Fund

I know it sounds like a cheesy book name, but like Joel Greenbaltt‘s classic “You Can Be a Stock Market Genius“, this is another great book with cheesy name. The author Ted Seides is one of David Swensen‘s proteges, having worked on both asset owner and money manager sides. Therefore, this book offers unique perspectives (from both capital allocator and money manager angles) on how to build a great money managing business. Lastly, although the book name may be alluding to step by step how-to guidance on starting a hedge, it doesn’t have anything like that. Rather it is fully loaded with real cases, about how start up funds succeeded or failed,  which are invaluable lessons for anyone considering starting their own money managing businesses.

soyouwanttostartahedgefund

I think I probably read this book too early as it could serve these readers with more experiences and are closer to the point of setting up their own funds. Nonetheless, following are the lessons I found most valuable to me. They either significantly changed my existing views or offered brand new insights to me.

  • Diversify your client base to build a great business: I always liked Seth Karlman’s approach of building clients base, which is only working for the ones that appreciate your investment approach and have a true long term investment horizon. Interestingly, the book gave an example of the other side of the story. In 2004, Philip Timon started his own concentrated value hedge fund Endowment Capital Group (he went so far that he put his intended prospect in his firm’s name), specifically working for endowments who is known for long term orientation. The business started well with $200 million raised from nine endowments and foundations, and grew through appreciation to nearly $500 million in AUM by 2006. However, after subpar performance in the following two years (presumably concentrated value strategy got hit hard by the Financial Crisis in 2008) , all these “long-term-oriented” clients, except for one, decided to quit at the bottom in 2008, leaving him about $50 million in AUM. Even though the firm produced stellar return the next two year (well over 100%), it could not regain the scale needed to make major institutions comfortable. According to the book, Timon decided to close the shop in early 2014.

I think the reason for this different outcome is that Klarman was so successful already when he started accepting institutional money in the 90s (by when he already had more than a decade of great track record for managing individual high net worth investors’ money). It’s like when you are a super star in sports, wherever you go, the team will design tactics for you and build the team around you, or even let you pick the coach. But before you are a star, you only get to be picked.

The Lesson for me, I guess is that you could still be selective to some extent for clients when starting up, however you also need to maintain a diversified client base just so to decrease the possibility of failure in case all clients act the same in certain market condition.

  • Put best foot forward, jump in with both feet: This is another shock to my existing view. As a value investor, I would think a value manager could take time to deploy the capital as he/she sees the opportunities suit, especially when the manager started the fund in a time when valuation may appear expensive, thus less attractive opportunities are available. Well, that’s Utopian. Peter Carlin‘s Estekene Capital is a great example showing you the world simply doesn’t work that way. The fund was officially launched in March 2010, by when Carlin already felt wary about the roaring equity market. So he took the approach of investing slowly and being price sensitive to only deploy capital on these best of the best ideas. However, the market didn’t work his way and the fund’s return (albeit good) was dwarfed by the roaring market. Specifically, the first month after launch witnessed a 6% advance of S&P 500 (a single month alone!), and Estekene only had 10% invested and ultimately got only 0.6% up. Simply put, from the moment the fund is launched, the benchmarking never stopped (even though many type of absolute return hedge funds don’t really have benchmarks, but S&P 500 is always opportunity cost for clients as they could simply go passive indexing strategy and pay marginal of what they pay hedge fund). Not surprisingly, with moderate returns, Estekene had a very hard time growing its AUM and ultimately close its doors in 2014.

Two takeaway from this example: 1) once the fund the fully up and running, you should start building your positions relatively quickly; 2) to mitigate any risk associated with last point, you may want to time the start of your fund at a bottom of a economic cycle (e.g. after the burst of a bubble, 2009, 2003, etc.).

  • Flexibility is all about setting clients’ expectation: There is a fine line between being flexible and having style drift, and that’s all depend on how managers set clients’ expectation. Featured by Michael Lewis’ The Big Short, Michael Burry‘s Scion Capital was well known by the main street already. I still remember the ugly dispute on Burry’s conviction of U.S. mortgage markets between him and one of his seed investors from the movie. Could that be avoided should Burry communicate better with his investors? Possibly. Additionally, the book provided good example of Whitebox Advisors, a multi-strategy hedge fund founded by Andrew Redleaf, who evolved its strategies gradually to reach a optimal level of flexibility. Bottom line, a manager should avoid unexpected surprise to its clients as much as possible.

 

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