Master Your Hedge Fund Allocation ft. John Jackson

[00:00:00] John

You know, I think I’ve tried every shortcut. None of them have really worked. And when it comes to hedge fund investing, you have to do your work.

Otherwise, there’s going to be surprises along the way and they might be uncomfortable. That’s part of the reason why I like it. It’s just because it’s challenging.

Every day is kind of a challenge. And even though you might have heard the same pitch 10 times, you’ll hear the 11th one and you’re like, wow, this is really special and unique. And, you know, I kind of want to go along for the ride here.

[00:00:36] Intro

Imagine spending an hour with the world’s greatest traders. Imagine learning from their experiences, their successes and their failures. Imagine no more. Welcome to Top Traders Unplugged. The place where you can learn from the best hedge fund managers in the world. So you can take your manager due diligence or investment career to the next level.

Before we begin today’s conversation, remember to keep two things in mind. All the discussion we’ll have about investment performance is about the past and past performance does not guarantee or even infer anything about future performance. Also understand that there’s a significant risk of financial loss with all investment strategies. And you need to request and understand the specific risks from the investment manager about their products before you make investment decisions. Here’s your host, veteran hedge fund manager Niels Kaastrup-Larsen.

[00:01:33] Niels

For me, the best part of my podcasting journey has been the opportunity to speak to a huge range of extraordinary investors from all around the world. In this series, I have invited one of them, namely Alan Dunne, to host a series of in-depth conversations on the topic of what it takes to be a world-class allocator. In today’s world, portfolio construction is fast moving to the top of the agenda of many investors as they try to analyze and understand the riskiness of their portfolios.

And with ever-increasing uncertainty around the globe, being well diversified across many different strategies and themes in your portfolio can mean the difference between ruin and survival when the next crisis emerges. The aim of these conversations is to try and understand the experiences that have influenced these highly specialized allocators and the processes they follow to harness the best returns for their clients so that we can all become better informed investors. And with that, please welcome Alan Dunne.

[00:02:37] Alan

Thanks for that introduction, Niels. Today, I’m joined by John Jackson. John is a partner and global leader of hedge fund research at Mercer.

John oversees a team of analysts that work around the globe, focusing and sourcing initial and ongoing due diligence on the hedge fund and multi-asset universe. John has over 20 years, 23 years actually, in the financial services industry, 16 of which have been dedicated to hedge funds and has worked in a variety of roles. John, great to have you with us today.

How are you?

[00:03:07] John

Yeah, great to be here. Thanks for the opportunity. Looking forward to it.

[00:03:11] Alan

Not at all, great to have you. As I mentioned, you head up hedge fund research at Mercer, so it’s a very substantial and broad role. We always like to get a sense of people’s journey to their current role. How did you get involved in investing and how did you end up focusing on hedge funds?

[00:03:28] John

Yeah, it was a little bit of luck, a little bit of happenstance, I think. So, graduated university in 2000 with a degree in economics, really didn’t know what I was going to do from that point, but ended up at a ultra-high net worth advisory firm here, in St. Louis, which is where I’m based and from, but kind of quickly realized I didn’t want to go down the advisor route per se and was really kind of more interested in probably the research angle, which led me to the CFA, which also led me to pursue kind of institutional consulting.

And so, then I made the switch after about three years to a local institutional consultant here in St. Louis called Hammond Associates, which was then acquired by Mercer in 2011. I did a variety of roles there at Hammond, but I sort of pestered the head of hedge funds at the time, which was Dave McMillan, that if he was ever willing to give a young guy with little experience and little knowledge, a chance that I would be willing to learn and do the work.

Luckily, he finally gave in in 2008 and had me join the hedge fund team January 2008, which was kind of fortuitous in a lot of ways because I learned a lot about risk management and a lot about liquidity management in a short period of time, which I think maybe helped me get up the curve a little bit in terms of the hedge fund industry.

And the rest is kind of history. I kind of took over for the hedge fund research piece of it in 2017. I still work alongside Dave McMillan closely. We’re kind of one team today.

We’ve got a team of about 34, about two dozen of those are dedicated to the research and sourcing and then the rest are kind of focused more on building client solutions, if you will, on the hedge fund side.

[00:05:22] Alan

Good stuff. And so, in your role, you’re obviously doing research on managers. I guess you’re responsible for your platform or the managers that you’re recommending. And do you also build hedge fund portfolios? Is that fair to say?

[00:05:38] John

Yep, correct.

[00:05:40] Alan

Good stuff. Well, great. And we’ll get into that in a bit more, but maybe just start now from a big picture perspective.

I mean, we’ve gone through quite a change in the macro environment and 2022 is probably a watershed year with kind of traditional markets being challenged. A lot of people are saying, you know, now is the time for hedge funds. I wouldn’t expect you to disagree, but I mean, are you strongly of the view that we’re into a more changed environment for hedge fund investing? Or do you see there’s just a kind of a continuation or there’s always a case for hedge funds?

[00:06:11] John

Well, I’m biased. So, I do think they play a critical role within the portfolio and it’s a strategic allocation, not necessarily a dynamic or tactical one. I think now more than ever, we’re pretty convinced this is definitely a different environment, a pretty significant regime shift. I think the rise in rates, the associated cost of capital is a stark contrast to the prior decade.

And so really, I think in short what that means is basically the opposite of TINA. So central bank policy coming out of GFC really did leave no room for any alternative. So, your only option was really to own beta. You were mostly penalized for any severe diversification outside of that.

I think the opposite really is true now. And so, the rise in rates and the change in the cost of capital, we’ve already seen it’s leading to pretty significant macro and micro level volatility and dispersion.

We think that bodes well for active management, and we think hedge funds probably offer the broadest suite of opportunities and tools, if you will, as it relates to active management. And you’ve seen it in some of the performance kind of ‘22, ’23, year to date. And we’re seeing it on both sides of the portfolio, long and short.

And I think the most relevant points are global macro. Really struggled in kind of the ‘15 to ‘19 period. A lot of that is just due to the rate environment and the lack of volatility and dispersion.

And then the short side of portfolios, which really over, the last couple of years, we’ve seen significant change in the alpha that’s being produced there. But also, just kind of the contribution to portfolio returns in more challenging environments. We’re really seeing the shorts kind of pay off.

And then you’ve got the structural benefit, right? For those strategies that are more cash efficient with unencumbered cash, you’re getting that tailwind as well as kind of the short interest rebate. So, we think the hedge fund environment today is vastly improved from sort of post GFC to 2019.

[00:08:43] Alan

Yeah. And obviously a lot of people have been focusing on making a distinction between strategies that do benefit from rising rates and maybe ones that don’t to the same extent. And obviously, during the, I guess, the more challenging period for hedge funds, if you could generate maybe mid-digit returns, single-digit return but low vol, that was seen as good, and a bond replacement.

But that kind of approach won’t resonate as much with investors now. So, I mean, you touched on obviously global macro as one, but which would be the one, the obvious candidates that definitely benefit from higher rates and these strategies that are a little bit more challenged in the higher rate environment?

[00:009:26] John

Well, I think by and large, most hedge fund strategies are going to do better in a higher rate environment for some of the reasons I just mentioned. So, I think the structural benefits of higher rates and the tailwinds that that can have on strategies we think is here to stay. I don’t think we’re going back to zero rates or anywhere near it.

So, we think that structural benefit is going to be around for a while. And then the volatility and dispersion, that we expect our hedge fund managers to capitalize on, we think is going to stay here for a while. And then you’ve just got a lot of macro risks that are likely to give us maybe more dislocations than we had in the prior decade.

So, you know, I think if you think about one of the critical roles that hedge funds play in the market is to be a provider of liquidity or provide price discovery, we just think there’s going to be way more opportunities to do that going forward than there has been in the past. So, when I look across kind of the major food groups of hedge funds, by and large, I think the opportunity set is better across the board. Like in long short equities, we’ve talked about some of that, and even in long short credit, we might not get a huge default cycle here, but we’re seeing pockets of dislocations here and there, pockets of stress.

You’ve got maturity walls that are coming up where companies are needing to refinance. We’re seeing more and more of kind of the amend and extend type of deals getting done ahead of sort of traditional default environment or bankruptcies. Macro we touched on, we just think there’s going to be a lot more volatility and you’re going to need some of the dynamic and adaptability that comes through the macro managers to manage through those changes.

So, across the board, we think it’s just a better environment overall. And when you put it all together, which is kind of the way we look at the world, you need to build a diversified program across all of those underlying strategies. We just think hedge funds are going to deliver at a higher absolute level than they have in the past. And I think maybe more consistently than they have.

[00:11:50] Alan

You know, one of the challenges, I guess, in your role, or for anybody who’s trying to position hedge funds or clients, is a tendency maybe to look back at track records over the last 20 years, or the last 10, 15 in the lower rate environment, and make the point, well, you need to keep in mind that the shift in the rate environment. Do you think people are getting that or are still slow to kind of factor that into their asset allocation framework?

[00:12:14] John

No, I think by and large, the interest and conversations have definitely picked up across alternatives and hedge funds probably more specifically. Just because I don’t think it was fully recognized what that extremely low rate environment would mean for hedge fund investing in particular. And so, I think they were easy to ignore for a number of years because performance, on an absolute level, was actually a little bit muted.

We would argue they still sort of delivered what you would expect in that environment, right? We don’t want our managers chasing beta. We want the diversification benefits hedge funds bring to a portfolio.

Those diversification benefits were just on offer at a lower level, frankly, in kind of that post-GFC era. Now, I think it’s widely recognized. One, this is going to be a more difficult environment to produce outcomes, to achieve your objectives, whatever those might be. But two, you were penalized for diversification maybe in the past. And I think it’s pretty much widely accepted that there might be a benefit to diversification going forward.

Hedge funds, again, we think offer some of the strongest diversification benefits of anything out there, both in traditional and alternatives, and play quite a unique role in the portfolio from that angle.

[00:13:39] Alan

Very good. So, I mean, obviously you cover across the different strategy types. If you’re kind of sitting down with a client or an institution kind of building out a hedge fund allocation from scratch, how do you get them to think about it? Or how do you position the different types of strategies? I mean, some people think in terms of convergent, divergent, or do you have a framework or how do you kind of start off with clients?

[00:14:06] John

Yeah, yeah. I think, well, one, it probably goes to kind of the objectives. So, we kind of start with that, try to do a lot on kind of the education piece, kind of level setting in terms of what are we trying to achieve here with a hedge fund allocation?

What’s the role that they can play in your portfolio? I mean, part of the beauty, I think of hedge funds is just the flexibility. You can almost position them in any way that you want within a portfolio.

From our perspective, we think kind of the best role that they can serve is really as a risk reducer in the portfolio. So, I think importantly though, that risk reduction is delivered within alternative strategies or alternative diversification. So, it’s not necessarily an outright hedge to the portfolio. By introducing relatively independent and idiosyncratic risk and return drivers, not only can we deliver a kind of a complimentary return stream, but one that really diversifies the equity and interest rate risk that dominates client portfolios.

So, formally what that means is we’re kind of targeting a cash plus 4% return with about a third or less of the volatility of equities. And then in diversification language, the beta of our hedge fund portfolios is typically around 0.2 or less when compared to equities, and relative to interest rates it’s typically flat or negative. So that’s sort of the objective at the high level.

Now within that, from a portfolio construction standpoint, it’s critical that you kind of start with manager selection first. So, I think a lot of times if you start with, I’ve got these buckets that I need to fill, and then I go out and I find managers that fill those buckets, it can lead you down maybe a different path than starting with, where’s the talent at? And then how can I best utilize that talent to achieve the objectives that we’re aiming for?

So, I think you kind of have to be open-minded to say, you know, where can I find really good talented managers that have a skillset and a niche that I think that they can execute on consistently, you know, with some persistence and add value to the portfolio. So, we try to avoid filling buckets. We identify talent, kind of build a team, put them on the field, and let them execute.

That said, we do have kind of broad categories or buckets for the hedge fund allocation. One is just multi-strategy. And, you know, the role here for multi-strategy is really kind of to serve as a base or core for the portfolio. Really to kind of provide a consistent all-weather return stream to the hedge fund allocation.

We complement that with what we call security selection. And those are really kind of the return drivers, if you will. So, there’s a little bit of return enhancement through security selection specialists. We break that down into two subcategories, basically long-short equity and long-short credit.

Then the last piece of the puzzle is what we call diversifying strategies. And these are diversifying to the hedge fund portfolio, but also the most diversifying to the broader portfolio. And that’s discretionary macro, that’s systematic macro.

Then we kind of group together long vol and some tail strategies for some added convexity or asymmetry to the portfolio. And at a high level, that’s kind of the starting point for the portfolio construction framework.

So, we do kind of advocate for a portfolio approach, build a diversified basket among those food groups. And hopefully that will build a resilient hedge fund portfolio and deliver objectives.

[00:18:13] Alan

Yeah, so I was going to ask you, is there an optimization process for the sense like when you’re using the word resilient, probably not. Is it less optimizing or more building based on kind of fundamental building blocks? Is that fair to say?

[00:18:27] John

Yeah, I’d say it’s probably more art than science for us. We think, generally, optimizations can give you maybe a false sense of security. They’re a good sanity check.

So, we do use some tools in that sense, but it’s more about the fundamental building blocks and really kind of knowing what you own and understanding each individual manager, their style, their process, and how they’ll fit into a portfolio. Position sizing, loosely speaking, is just inversely to risk. So, the higher risk profile of a manager or strategy, the more likely the lower weight within the portfolio. But we can get, I think we can achieve our objectives without the optimization process by-and-large.

[00:19:13] Alan

I was reading a paper recently, it was a collaboration between GSE, the Government of Singapore Investment Corp, and JP Morgan. And they were looking at different portfolio, hedge fund portfolio mixes and making the point that, you know, when you take a kind of a total portfolio approach and integrate into a 60/40 portfolio and then kind of do your process, you might end up with a different strategy mix then when you just look at it from a standalone basis, which I guess in some ways makes sense.

I mean, is that something you find, or I mean, does that kind of influence the kind of strategy mix in terms of tilting more towards the diversifiers or does it kind of depend on the managers if they deliver very consistent returns anyway, they might negate that argument or what’s your perspective?

[00:19:59] John

I think for us, it’s just more, if you think about the diversification and risk reduction angle, it’s more what is the risk that dominates the rest of the portfolio? And by and large, it’s equity risk and interest rate risk. So, the primary objective is diversify that away or complement in some way.

But yeah, I think if you don’t have those clearly defined objectives up front and kind of clear understanding with everyone – all the stakeholders, it can just lead you down a different path. And oftentimes it’s over-concentration or maybe excessive risk taking within the portfolio. And the portfolio can just kind of lose its way over time, or the allocation can kind of lose its way over time is what we’ve seen.

[00:20:50] Alan

They touched on the multi-strats, which have become kind of an increasingly dominant force, I guess, within hedge funds investing and I guess different perspectives. You know, one, assets have grown so big. You know, does that mean they get all the talent and that they’ll dominate for years to come? Or does it mean that their size is kind of a tail risk?

And, obviously, returns seem to be, have been very consistent. But, you know, it’s only been a number of years since they’ve been managing such large levels of assets. So, it hasn’t been tested through like a 2008 type scenario, maybe.

So how do you think about all of that? Do you think it’s more positives than potential negatives? Obviously, they’re a core part of your portfolio, so clearly you like it. But how do you think about the risks as well?

[00:21:33] John

I think mainly what you’re speaking to is probably the pods or the multi-PM structures, which we tend to have less of, frankly, in our portfolios. I would say, from a due diligence perspective, they’re just a little bit more challenging to kind of get your arms around in terms of like knowing what you own.

You know, there’s, in some cases, hundreds of risk takers. And they can be very complex portfolios, again, to try to get your arms around. But I think the model is maybe one that we didn’t appreciate early on. I think for those structures, it is more about the infrastructure and the machine, if you will, than it is maybe the individual risk takers and how that machine is optimized.

And so, I think the early movers in that space kind of continue to lead the charge. And I think, you know, continue to take market share, frankly, from some of the weaker hands. I think we’ll see a little bit more of that consolidation.

The war for talent is ever increasing. So those shops continue to pick up talent. But the turnover there is just, you know, it’s so high that it just seems now that the top firms are really just trading talent around and kind of using those return streams as long as they can. And then when they hit a drawdown, they just find another home.

So, I think it’s really an amazing structure, what they’ve done and built. The consistency there is good. I think the concern, for us, is really around the, you know, getting your arms around it from a due diligence perspective. The amount of leverage deployed in some of these is quite high. The crowding in the space and the growth is significant.

So, I think there are a number of challenges there, but I think they do offer a pretty broad diversification bucket, if you will, in the multi-strategy space. And they’ve done pretty well, you know, recently. I think those returns are going to be a little bit challenged in this higher rate environment.

So, you mentioned on what strategies might do well or less well. Relative value is still an area that we think will do well, but maybe less so in the higher rate environment. And the rise of the pods and the growth and some of the crowding there, I think is going to eat away at those returns for those structures specifically who maybe don’t take as much directional risk.

But they’re all sort of, a lot of them have a lot of overlapping underlying strategies and a lot of the same type of traits. But the risk management frameworks there are, you know, really tight. So, they can’t control the drawdown quite well.

I think the other thing to note, just for investors, is just the split of the economics, which gives us a little bit of pause when you think about the LP or the investor that supplies 100% of the capital, but maybe gets 45% or less of the gross return in exchange. We think maybe those economics, at some point, might come under pressure, particularly if returns for the group, you know, come down from what they had been, which we do expect in some sense.

[00:25:15] Alan

Yeah. And I mean, speaking more broadly, you know, you talked about issues around, not issues, but potential issues with leveraging crowding, et cetera. I mean, sometimes within the hedge fund space, you get episodes of degrossing or, you know, correlations going to one and, you know, in the extreme ( 2008 is more of an extreme example), but obviously these things can happen where lots of hedge fund strategies, which were maybe kind of somewhat correlated to equities, but not very correlated equities, suddenly all start to struggle at the same time. I mean, what’s the mitigant to that?

It’s obviously your due diligence, I guess, and envisaging different scenarios. But for safer strategies that haven’t been around since 2008, you know, how do you get comfort that they’re not going to be caught in a wave of kind of degrossing or deleveraging?

[00:26:08] John

Yeah, you really have to understand kind of what you own there and how they’ll manage risk in different periods. Now, if they have a track record, that tells you something, but if it’s a newer emerging manager, you really have to roll up your sleeves and really get to know their process and how they think and how they think about risk management and how they’ll react under pressure and all of that good stuff. And for us, it’s really about what sort of asymmetry do they bring to the mix?

And so, we’re really looking to, you know, protect on the downside first and foremost and participate on the upside as much as we can. But we want that asymmetry balance there for our managers. And so, yeah, it’s not uncommon that in a de-risking environment, the initial phase for most is going to be to de-risk some, reassess.

But again, as long as they kind of can preserve capital on the downside, we think that’s a good thing. It’s just, we want to see the flexibility and the dynamism to then redeploy capital into those opportunities or those dislocations to where we can kind of provide those uncorrelated returns.

Then I think for us, that last piece of the puzzle that I mentioned in diversifying strategies, where we’ve got a long vol and some tail strategies, we think that will further help protect our downside and provide some convexity, at least in those initial stages, but also be a source of liquidity where we can maybe take some of those tail profits off the table, redeploy back into our managers that we expect to be redeploying in that environment.

So, I think, again, I think that kind of goes to building a diversified mix, right? I think a lot of investors maybe make the mistake of, I’ll just pick two or three hedge funds and maybe one or two of them will be a multi-strat and I’ve got my bases covered, but then you get down the road and you get into environment and then you’ll have some surprises along the way. So, that’s why we think it’s critical to kind of build that diversified mix and whatever your objective is, if it really is to protect that downside, you might need even something extra like some tail hedges or something to deliver there.

[00:28:32] Alan

Yeah. So, I mean, delving into the diversifying strategies a bit more, obviously you mentioned discretionary macro, systematic macro, which I think includes things like trend following, managed futures, and then kind of tail risk. I guess all distinct in approaches, but all seeking to deliver, you know, at least people look to them often to deliver those returns in the more challenging periods. Is it a case of owning a little bit of all of them or how do you kind of differentiate between the merits of each of them?

[00:29:03] John

You’ll probably hear this over and over from me, but it is really about the diversified mix. So, discretionary macro, we think, is really there to kind of pivot on these regime shifts maybe faster than systematic macro can. So, what we look for from our discretionary macro managers is to really identify those pivot points or those turning points in markets to sort of reassess that risk quickly and then redeploy capital where it needs to go.

Systematic macro, as you know, or trend following specifically, does well in certain periods but might struggle on very sharp, short-dated sell-offs. So, if the change is quick and violent, they might be slower to react just because those systems tend to be more medium to long-term on balance.

And then those discretionary and systematic, we think, complement each other in that way. And then the tail and long vol piece really give us that added convexity for those kind of sharp, violent moves down. That just further enhances that basket for us really.

It has to be smaller in size because, obviously, there’s a cost to that. We think we’ve formulated it enough where the costs are somewhat controlled and offset by some of the other sleeves.

[00:30:30] Alan

Yeah. So it is, I mean, obviously it is kind of a topic that comes up with clients and investors. Are they willing to accept that bleed from long vol? But it’s obviously, if it’s blended in as part of a portfolio, you think it’s palatable.

[00:30:46] John

Yeah.

[00:30:47] Alan

And I mean, looking across all of the strategies, I mean, you mentioned, I think cash plus 4% for the portfolio as a whole. I mean, is there any science to kind of return expectations at the manager level? Or is it largely driven by historic performance or kind of historic sharp and then factoring in the higher rates? Or how do you think about what are reasonable expectations kind of looking ahead that can feed into kind of capital market assumptions for people doing strategic asset allocation?

[00:31:16] John

At the individual manager level?

[00:31:19] Alan

Yeah. And then what that looks like from the portfolio level. Yeah.

[00:31:23] John

Yeah. I think, again, I think for us it’s probably a little more art than science. So, it’s really in the hedge fund space, as you know, there’s a lot of dispersion across risk and return profiles, even within the same type of strategy or category. So really it comes down to understanding the manager and their approach. What sort of inefficiencies are they looking to capitalize on in the market?

If you have a track record, yeah, I think the history can tell you a lot. You can look at things like percent positive months, average win/loss, volatility drawdown. These are kind of some of the metrics that we pay most close attention to. What’s kind of the skew, what’s kind of that left tail risk in sort of a worst-case scenario?

Then you can look at the strategy relative to the environment. So by-and-large, we think hedge funds are in a better space today. So maybe an uptick there in terms of our cash plus hurdle at the total level.

You can look at how cyclical is the strategy or not, how cyclical do you expect it given sort of the mandate and the manager’s ability to manage through that? And then kind of take a look at peers or relative indices that might have a similar risk profile. And then I think from there, you can kind of start to put down some ranges by individual managers, what you expect.

We usually have sort of a base case range for each manager, and then kind of what we would expect in terms of drawdown over the next five years, given sort of today’s starting point and what we expect the macro-outlook of the next five years. So, we’ll have that by manager, and then it kind of rolls up to the aggregate portfolio.

[00:33:12] Alan

Okay. And in terms of the overall hedge fund portfolio, I mean, in terms of number of managers, what does it typically look like?

[00:33:19] John

Typically, probably 12 to 18. And really, ideally, it would be smaller than that, but to get to the diversified mix that we’re wanting. So, one of our key mandates is multi-dimensional diversification.

So, we want diversification across strategies, across risk profiles, across geography. So really kind of across the board, we want to build as much diversification into the portfolio, again, to kind of make it as resilient on its own that we can. And to get there, typically, it lands around 12 to 18.

[00:34:00] Alan

Okay. And most people think in terms of hedge funds, as you say, kind of risk mitigation, risk reduction. As for some strategies like CTAs and maybe commodity-focused hedge funds, they can do well in periods of rising inflation. We saw that again in 2021, not for all trend followers, but certainly some data and obviously some commodity-focused hedge funds.

So, what do you think about their role in the portfolio? Is that just part of the macro bucket? And do you think of hedge funds having an inflation kind of dampening or an inflation hedging role at all?

[00:34:37] John

Yeah. I mean, not that we’re specifically kind of targeting inflation hedges, but we think you sort of naturally get it and probably the most across trend following in the CTA space. So those managers that, you know, trade a wide variety of markets and include commodities, we think are probably going to do pretty well in this environment.

We’ve seen it already. You’ve seen cocoa this year. And so, we’ve got managers that are active there that have capitalized on that.

So, we think it’s inherent in what we do, but it kind of goes back to our process as well. You sort of put these puzzle pieces in place for when the time is right, they’ll capitalize on those opportunities. Trend following, we use to pick up sustained trends in markets. And in an inflationary environment, we would expect commodities to deliver on that. So, it’s kind of inherent within that diversifying bucket.

[00:35:43] Alan

So maybe moving into kind of manager selection and, you know, obviously there’s a large universe of managers out there. It must seem like a challenge to know where to start. You know, is it, do you have kind of cutoffs in terms of AUM or kind of length of track record or things like that to kind of whittle down the field, even in the first instance, or what’s the kind of process from going from the whole universe to a more targeted group?

[00:36:12] John

Yeah, we try to be as unbiased and open, at least in terms of sourcing, as we can. So, we’ve got a global team. We’ve got two dozen across the globe that are really out there day to day, trying to find the next best opportunity while also staying on top of, you know, our current buy list.

So, we don’t have any kind of requirements or restrictions per se. We will really look at anything and everything. So, the top of the funnel is really as wide as we can possibly get it.

But then from there, it’s about a filtering process to get into, you know, kind of our recommended list, if you will. That filtering process, you obviously want a consistent, repeatable framework around that, and you kind of want it, you know, hard to get through that filter.

But the way it works typically is, you know, we’ll have intro meetings. We have committees that are dedicated to certain strategies. They’re called lead research committees. So, we’ll have ones for macro. We’ll have one for equity, credit, managed futures, event driven. Those committees are mostly responsible for kind of managing the pipeline of opportunities that would run through those channels. But across the team, most of us are generalists and we’ll kind of, we’ll look at anything, and then it kind of gets routed through those channels, if you will.

And then from there, it’s kind of more of a discussion and debate, kind of getting more people on board. Hey, we’ve got an interesting opportunity here. Do you think this is something we should move forward with for deeper due diligence?

And if that kind of floats to the top, it’s relatively organic. So, we’re rarely kind of targeting specific things. We’re really just looking for, who do we think is the top talent out there at any point in time? Who does it make sense for us to partner with on behalf of our clients?

So, we really do kind of let the sourcing be as organic as it possibly can. Otherwise, again, I think you just, you find yourself down a road maybe that you didn’t intend to go down.

But then from there, it can result in full due diligence. And if it achieves our high rating, then it’s effectively on our buy list for inclusion in client portfolios.

And then for discretionary mandates, there is another committee that approves kind of those particular opportunities for specific client portfolios. But for our advisory clients, once it’s on the buy list, it’s there for the taking.

[00:38:56] Alan

Interesting. And maybe just to speak about some strategies specifically to bring it out a bit more. So, say something like discretionary macro, you’ve got some managers maybe managing kind of 45 billion, big shops, kind of established names, obviously very good track records, but managing a large amount of assets, which could be a constraint in certain circumstances versus more niche players or people, maybe managing a hundred million or a couple of hundred million.

I mean, how do you think about, obviously you can look at track record, which is an indicative of talent and ability. But obviously you’re not going to rely solely on track records, I’m guessing. How do you think about, say something like that, discretionary macro, what makes an opportunity compelling or not, would you say?

[00:39:48] John

Across the board, so we do have some biases, but we’re kind of willing to violate all of them, as well, in the pursuit of pursuing something exceptional. But one of those, I guess, preferences, if you will, is just a broader mandate. So, really across the board, whether it’s discretionary macro or whatever it might be, the broader the mandate, generally the better for us in that we’re looking for managers that can be adaptable and flexible, that can really tilt to wherever the opportunities might be. Not that we won’t pursue specialist or niche or narrow mandates, but I would say it’s a higher bar.

We have higher expectations for specialists. We expect them to manage through maybe some of the cyclicality of their strategy better than their peers. But by-and-large, we just think broader mandates can bring more flexibility and dynamism to the portfolio and can really move faster than we can act from an allocation perspective, right?

Our end client has a process that they have to go through to approve allocations. And these days, markets move increasingly fast, with efficiency, and you need those managers that mandates can capitalize on some of those opportunities that might come up in a matter of weeks instead of months or years. So broader, flexible really is kind of what we’re looking for there across the board, whether it’s discretionary macro or not.

And then if you’re a specialist, there’s room for you in the mix. It’s just maybe a little bit higher bar and we have higher expectations. And frankly, it’s really mostly reserved for larger hedge fund portfolios. So, the smaller ones, we do want to express conviction.

So I said 12 to 18 managers, but we want conviction expressed in our top manager picks within the portfolio to drive the results. So, there’s a competition for capital there. And frankly, if you’re niche or narrow, you tend to be reserved for the bigger portfolios where we can maybe squeeze you in around the edges.

So, I don’t know if that answered your question, but broader is better. But then assessing risk or assessing skill or risk really comes down to their risk management process, probably more than anything. How do we think they’re going to manage through the difficult periods?

Because really that’s where hedge funds outshine, right? It’s in the more challenging periods. One, they don’t draw down as much, so, it’s less to get back to even.

But two, how do they manage through those periods? How proactive are they in sort of taking down risk, but then taking risk back up to capitalize on the opportunities? And so, it really comes down to learning their process as deeply and intimately as we possibly can.

The idea is we want to know as much as we can about them and their process before we put a dollar of capital to work to form a set of expectations. And then when something falls out of those expectations, then it might be reason for us to act.

[00:43:27] Alan

Yeah. And for strategies like quant strategies, I mean, obviously, there are lots of trend following managers out there. There are differences in terms of speeds, market sectors, allocations, as you touched on, some more commodity focused, et cetera. What’s your thought process in terms of selecting on that side? Is it again, obviously different types of approaches, I’m assuming, but anything that particularly resonates in terms of what you look for?

[00:43:58] John

I would say, on the systematic side, you need something to hang your hat on there, right? So, we do spend a lot of time understanding their process and sort of the alpha that’s targeted there. What’s the inefficiency that they’re trying to capitalize on? We don’t need the code or the algorithm, but we kind of need a basic understanding of what’s targeted.

But then I would say, in systematic space, you do maybe kind of need to see it come through in the results. So, you do need a track record maybe to kind of tie it all together; to say, okay, here’s what we know, or here’s what we think we know, here’s the market environment and how did they deliver on that?

So, I think, in systematic space, not that we wouldn’t do it, but it’s harder for us to maybe be earlier day one with a manager that we’ve not known or never heard of, without a track record. So, I think you do need some evidence there that everything you think you know, everything they’ve told you about the program and the models, is it doing what you would expect in certain environments?

[00:45:10] Alan

Yeah. And I mean, in terms of the ongoing assessment of quant managers, is it any different? Obviously, I just say, once you have a program where you can look at it, you can look at a track record, but obviously you’re investing in the manager, the manager will review the program, do research, decide whether to introduce and/or retire models. Is it more the manager or more the model, would you say? Or obviously both, but is it a bit more tilted one way or the other?

[00:45:36] John

Yeah, I think it’s trying to understand how robust their models and systems are from the outset. Obviously, a more robust system is going to deliver over the long term, we think. But it does come down a little bit to the people as well.

We want to understand what’s their R&D process. How much are they looking to kind of improve the system? This isn’t a space where you can kind of rest on your past work.

You do have to evolve, and you have to progress and it’s a competitive space. And we’ve seen a lot of changes in the last few years in that space where managers have obviously expanded number of markets. They’ve looked at alternative data, they’re looking at alternative systems to kind of diversify the trend component, or maybe offset some of the shortcomings of trend. Some with some success, some with less success.

So, we’ve seen a lot of change in that space, but it’s how robust is their system from the outset? And then what are the ways that they’re looking to improve it?

And frankly, that’s a tricky area. If you’ve got a really robust system, there’s ways to screw that up pretty quickly by tinkering with it too much. So, you want to see evolution, but I don’t know, it’s a hard space.

[00:47:07] Alan

Yeah, yeah, and obviously once you get into the quantum space, the great hope, now, is machine learning, AI. You hear very mixed perspectives, at least from my perspective, speaking to managers. Some people are quite skeptical.

Others saying, no, this is something, obviously some people have dedicated machine learning programs and really believe in it, et cetera. Where do you lie on this? Have you found it being something that is being transformational or is too early to say it’s going to have a huge impact? I mean, what’s your perspective on AI and machine learning in the quant space to date?

[00:47:46] John

Well, I think in the quant space, it’s really more about, it’s more of an evolution. Machine learning or big data has been around for two decades for the leaders in the space. So, I think it’s more of a, it’s a significant change, but it’s more of a step change for them. The managers that we speak to most, I would say it’s still kind of early days on like, you know, having a completely autonomous system.

So today, mostly what we have out there is algorithms or decision-making that’s been programmed. So, it’s humans that have a thesis or an inefficiency and they’ve programmed that in some way to capitalize on it in the markets. For the managers that are kind of looking to take that out and just have the machine sort of decide what’s a good strategy and how should I implement, very early days on that. We’re seeing some managers pursue it, but either with internal capital or small allocations within their existing programs.

Those that are already on it, in the early phases, seem very optimistic in terms of kind of the output. It seems to be uncorrelated and diversified in terms of what they’re already doing. So, I think there’s promise there. I think to be determined on how big, or where it goes from here, but it’s more of a, I think, it’s more of a step change for them rather than a complete evolution.

[00:49:24] Alan

Yeah. And from your perspective, I mean, how important is transparency? And I’m thinking from, obviously, as the industry has evolved, I think there’s been a general trend towards more transparency for institutions in terms of managers being willing to share positioning at some level and risk exposures, et cetera.

But also, I mean, from the AI kind of machine learning perspective, if a manager has a machine learning driven system, is it important for you to understand why it’s in a certain position, or if the manager can’t explain that it’s just machine learning. Is that kind of a no-no from an allocation perspective?

[00:50:02] John

It’s, I think, yeah, absolutely. It’s important for us to know what are the guardrails? So, what are the expectations we should expect and maybe in terms of exposures and risk and what have you?

And if there are no guardrails around it, then I think we probably would have some reservations. But, you know, in the quant space transparency is somewhat limited, but still, we want to kind of know the risk exposures and ‘at fully all in on risk’, what would it look like? And again, like during maybe a volatility spike or whatever triggers a deleveraging or a de-risking, what does that look like? So, yeah, we definitely would have to at least understand sort of the bounds or the range of what the system might be doing.

[00:50:53] Alan

Yeah. Okay. And obviously, we’ve talked a lot about manager selection and portfolio construction, etc.

Obviously, managers go through drawdowns, or people leave, etc. So, the process around de-selecting or kind of changing your manager roster, is it performance? Is it people leaving that are the typical drivers of a manager being removed or replaced?

[00:51:16] John

Yeah. It comes down to the people. You’re trying to identify who do we think is going to be the best stewards of client capital and deliver on return expectations?

So, I think there is maybe too much turn in our space, frankly. If you’re going to take the time to sort of do the due diligence and the hard work and really understand these managers, you kind of need to build in a little wiggle room to let them execute on what their strategy is because their strategy is not always going to be in favor and there’s always going to be challenging periods. And I think you need to go in with a mindset of take a five to 10-year approach with your manager selection.

Like, we hire every manager with the intention that someday we’ll part ways, but we hope that the relationship is maybe five years or longer at a minimum. So, I think we need to take a longer-term view with some of these. But yeah, I mean, in terms of moving on, it usually, we have a set of expectations and anything that falls outside of those expectations really will prompt a discussion.

If we can’t kind of get comfortable with the explanations around any of it, we’ll move on. So, there’s that, maybe, from a portfolio and performance perspective of like, okay, this, you know, something pops out at us, and it seems like this is out of the norm relative to what we understand. You can’t just automatically pull the trigger on that.

You have to look at each individual circumstance on its own and try to understand what’s going on. And then outside of that, it’s kind of the standard stuff. Like, if we see turnover too elevated or if turnover is related to basically the key decision maker that our thesis kind of hinged on, usually that will prompt us moving on.

A lot of times, it can be risk management failures. So, unfortunately, you will see it in performance from time to time. It’s just inevitable. So, it could be a risk management failure.

It could just be, you know, the business grows, there’s distractions, product proliferation, capacity management. These are kind of all areas that you underwrite a manager, you have a thesis, and then the business evolves and changes. And it’s kind of determining, is that evolution and maturation of the business and the team and the approach? Or is it sort of, you know, kind of going in too many directions at once and losing focus? So, you have to assess that individually. Okay.

[00:54:07] Alan

OK. At the other end of the spectrum, I mean, in terms new relationships and emerging managers, some allocators maybe like to have maybe an emerging allocator book, you know, to kind of have a smaller allocation to see how managers evolve in live trading as opposed to just leaving them there and analyze them – the kind of performance remotely. Do you think that is that something you do? Or do you see a case for that? Or do you just wait for emerging managers to mature somewhat before you start to get interested?

[00:54:41] John

No, we spend a lot of, and significant amount of time and resources, on emerging and new managers. From the research perspective, that’s our primary role is to identify these opportunities and talent maybe before the market does. And secure that capacity because capacity is finite in our space for the benefit of our client portfolios.

So, we talked about systematic macro where maybe you need to see some evidence there. So, that might be a ‘walk before we run’ type of approach with new or emerging managers. But outside of that, we try to be as early as we possibly can, and we might size them smaller in portfolios from the beginning to see how it goes. But we can get comfortable to deploy capital early on. It just takes a little bit more time.

You got to spend more time with the manager and the team to really understand like what’s their process, what’s their approach, what sort of expectations should we have here to get comfortable with?

And I would say we probably have the most success with spin outs. So, we want to spend a lot of time with the teams that we have and maybe go one or two levels below maybe the senior decision makers to figure out where is the talent hiding. And when it spins out, we want to be in a position to know, should we act on it.

[00:56:16] Alan

Yeah, makes sense. I mean, from a new launch perspective, what do you think is a reasonable size, these days, for you to look at something? Obviously, you see now people spinning out of multi-strats with 3 billion or even more. If somebody is starting a new macro fund or long short equity with 50 or 100, is that still feasible? Do you see much of that still?

[00:56:40] John

Yeah, I think it’s getting harder and harder. I think especially right now, the launch environment is a little bit challenging and it’s all over the spectrum in terms of initial sizes. I do think you probably need north of 50 these days, just from a business perspective and longevity.

The first couple of years are challenging from an asset raising perspective. So, you probably need 100 million or more these days to launch effectively. And even then, there’s still a significant amount of business risk.

So, yeah, we might go slower in that aspect. We want to see the business get some legs under it. And you really have to pay attention to co-investor risk. So, oftentimes, it’s the co-investors and the concentration of that mix that you really need to be aware of in terms of the business risk and whether they have long term viability. Many times, it’s a very muted or short drawdown, but the co-investors don’t have a tolerance for it and the business is at risk as a result.

[00:57:52] Alan

Just wanted to get your sense on one other topic before we wrap up, and that’s around decision making. And you mentioned some of your process involves lead research committees. I mean, selecting managers, do you think the committee approach obviously has benefits in terms of getting the expertise of lots of different people?

Can it be challenging in terms to reach a consensus? Or what are the pros and cons? Do you think of that type of approach?

[00:58:20] John

We really like kind of the diversity of thought and inputs there. We’ve got a pretty diversified mix of people on those committees: geographies, age, or experience. And I think, on balance, that just adds to a more robust process. And so, everyone has a voice. It’s pretty free and open. Anyone can kind of bring anything forward that they think is compelling.

So again, we kind of want that autonomy across the team to go out and bring us forward interesting ideas that you have found and seen. But from there, really, the committee’s process is, does this fit with our needs? Is it additive to what we already have? Or does it complement? Or is it an upgrade? And then it’s kind of ensuring process.

So, we’ve got a framework for initial due diligence, and it’s kind of holding everyone on the team accountable to say: you’ve followed all the steps, you’ve dotted the I’s, you’ve crossed the T’s. We’ve been consistent here in how we’ve approached every single opportunity.

It’s made it through that process, and then everyone has signed off, or at least we have a majority sign off on it. So, I think that is healthy.

Maybe the one drawback, which is probably obvious, is it can slow things down. But again, I think we’re looking at these manager allocations for a five to ten year periods. I don’t necessarily think the best decisions are always rushed. I think a type two error here is your friend. So, we’re happy to take our time, we maybe even pass on really good opportunities, which really we do, frankly, every day. But I would say that the committee structure, on balance, has more benefits than it does drawbacks.

[01:00:22] Alan

Yeah, how often do you find that a manager gets through the layers of committee and then you go into due diligence, and it actually unearths something and you say, oh, that’s not going to be a good fit? Is that 50% of the time, or 20% of the time, or 70% would you say?

[01:00:37] John

No, it’s probably quite less than that because there is a lot of discussion and debate that happens naturally with multiple inputs, so, multiple people across the team will have already met with this strategy and probably already have a view on it. So, a lot of the filtering is more organic than it is prescriptive in terms of structure. A lot of the ideas sort of get kicked to the side early on. I would say that once we dig our heals in and do the work it’s maybe 15%, 20% where you get in there and something kind of says we need to take a pause here. A lot of times it’s reference checking.

Again, I mentioned that this is a people business, or you’re in the business of identifying talent and investing in people, so we do put a lot of emphasis on reference checking, independent reference checking to see, are these good people. It’s a ‘trust but verify’ approach and you take everything that you think you know and then you want to see, sort of, evidence of that at the initial stages but then ongoing.

It really never stops. It’s an iterative process. Just because something was rated yesterday, or last year, you have to stay on top of it. It evolves and we have to evolve with it and stay on top.

[01:02:11] Alan

Good stuff. Before we wrap up, we always like to get our guest’s perspective on any advice you would give people who want to get more proficient in hedge fund investing or hedge fund allocation, anything that was very influential for you and your career in terms of things you’ve done or things you’ve read, or any advice at all?

[01:02:30] John

I would say, don’t look for shortcuts. That probably applies broadly in life, but definitely in the hedge fund space. I think I’ve tried every shortcut. None of them have really worked. When it comes to hedge fund investing, you have to do your work. Otherwise, there are going to be surprises along the way and they might be uncomfortable.

I don’t think there is any substitute for hard work. Taking the time to learn this space, it’s nuanced, there’s a lot to learn. That’s part of the reason why I like it, just because it’s challenging. Every day is kind of a challenge. Even thought you might have heard the same pitch ten times, you’ll hear the eleventh one and you’re like, wow, this is really special, unique, and I kind of go along for the ride, here.

So, I think there’s always something to learn and a lot of challenge in our space. But again, there are no shortcuts and no substitute for hard work. You have to be willing to do it.

[01:03:31] Alan

Good stuff. It sounds like good advice. So, John, thanks very much for doing this today. It has been a fantastic conversation.

So, make sure you follow John’s work because it is so important in an uncertain and ever-changing financial landscape to consider how you allocate capital and select fund managers.

So, we hope you’ve gained some valuable insight today. So, from all of us here at Top Traders Unplugged, thanks for tuning in. We’ll be back again with more exciting episodes so stay tuned.

[01:03:57] Ending

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