All About Hedge Funds

So what is a hedge fund? Hedge funds are so broad in nature that it's difficult to find a concise definition. So the best way to view them is what they are and what they are not. They are offered privately, in other words, not to the general public. Only qualified investors can invest. Due to the risky and sometimes complex nature of these investment vehicles, they have an incentive fee structure which means the fees are charged on a portion of the returns and most importantly including unrealized returns of the fund. They also typically have a management fee charging the assets under management. They're allowed to short securities, which means they can profit profit on securities that actually lose value. They're allowed to finance or in other words, borrow against the assets under management. So they can invest more than two times and sometimes significantly more than two times the capital contributed by their investors. They are risky. Now, there's some misconceptions about hedge funds also. They're not always hedged. There's no requirement that they be hedged. In fact, long only funds are many times referred to as hedge funds. They're not safe investments. They're not for wealthy individuals only. There are many different types of hedge fund investors that we're going to discuss in a little bit. They are not evil. They have a very important role to play in the stability of our financials markets. For instance, one role of hedge funds is to uncover frauds in the marketplace. Now, the most popular and well known type of investing for hedge fund is shorting a security. And here's how that works. The PM of a hedge fund is a view based on research that the price of a security is going to go down and wants to profit. On that view, the PM borrows that security for 2% fee from a lender and then sells the security at the current market price for 100 bucks. The PM has the proceeds of the sale in hand. Assuming that the PM was right, at some point she'll want to lock in the profits. At that point the security will be bought back at the lower price of 40 and the security will be returned to the lender. The profit is the initial proceeds of 100 plus the amount of cost to buy back the security of 40 and also less the borrow fee of $2 for net profit of $58. Of course, it could also go the other way and the security could go up in price, theoretically to infinity. Then the fund would lose money. Since the increase in any given security price is unlimited, yet the decrease can only go to zero. The profit on the trade is limited, but the loss is unlimited. As such, short selling can be a very risky business if you don' your eyes wide open. And even if you do. Now, there are many different types of hedge funds and here are just a few more of the popular ones. There's long short equity hedge funds. These are what people typically think about when they refer to hedge funds. These funds generally buy long the stocks of public companies and hopefully the price goes up and sell short stocks at public companies hoping the price goes down. The short side is generally thought of as the hedge in the hedge fund. If the market goes up, you're going to make money on the long side and if the market goes down, you're going to make money on the short side. The idea is just do a little bit better on both. That's what the term alpha refers to. Julian Robertson used to say that it's a perfect business. You just have to be right a little bit more than 50% of the time on both sides with some leverage. That's financing and borrowing, you can do really well. Macro funds. Macro funds don't invest in stocks. They invest on a more global basis as industries, currencies, interest rates, commodities. Think about your macroeconomics courses. They can invest either long or short, but just not in stocks. Event driven funds seek out specific events such as mergers and acquisitions reorgs and look to take advantage of opportunities that present themselves when and if these events occur. Multi strats pursue different strategies in lieu of focusing on a particular investment strategy. These might be in house or allocated to sub managers outside of the firm. Long only funds are just what they sound like. It's a great business because if you have a hedge fund already, there's not much more work to do. You just buy more of your longs and b. Markets generally go up. Of course there's no hedge, so you can get killed in bear markets. Short only funds are a lot more difficult for just the opposite reason. And that's why there aren't many of them. Markets over time tend to go up. People or institutions still invest in them to hedge out the other investments though funded funds are basically funds that invest in other funds. The positive is that you can have somebody doing all the due diligence for you to safely going to hedge funds. But the downside is of course a double layer of fees. Now in general, hedge funds are less regulated than mutual funds. Hedge funds are thought to be more complicated to understand than mutual funds and also have the potential to be riskier due to the amount of leverage and short selling that's allowed. Hedge funds also have higher fees and their redemption terms are generally longer. They're, however, still required to invest with the SEC if they have assets under management in excess of $150 million. Accredited investors, by the way, are defined as people making more than 200,000 per year or 300,000 for a couple for the last two and having a net worth in excess of $1 million. Also, entities worth over 5 million in assets are considered accredited. Now, most hedge fund entity structures have what's known as a master feeder structure with two parallel entities that their partners can invest in, one onshore and one offshore. The onshore is utilized by U.S. taxpaying individuals or entities, while the offshore vehicle is used by foreign investors and tax exempt partners. This structure allows the foreign and tax exempt entities to keep their preferential tax status. Now I'm going to talk about some of the more hedge fund terms, starting with fees. There are typically two types of fees that are charged to investors. The first fee is on assets. This is referred to as a management fee and is typically in the 2% range and it's charged on a quarterly basis, for example 50 basis points per quarter. The second fee is the incentive allocation, which is sometimes referred to as the carry. This is typically 20% and refers to the portion of the gains that the fund will retain as its incentive for doing well. For example, if an LP invests 1 million and the fund is up 10% for the year, the overall gain will be 100,000 doll. The fund will keep 20% or 20,000 and the LP will get the other 80,000. The incentive fee calculations are typically done at the end of the year. There's usually a term in the agreement referred to as a high water mark. This means that if the fund is down at the end of the year, the manager won't take any fees next year or even in subsequent years until they make back what they lost and only will take fees on the amount above the high water mark. By the way, this is the reason why many hedge funds close down. If they get too far below the high water mark, the probability of earning incentive fees in the future gets too low to run the business. In other words, there literally is no incentive to the doors open. Key employees may leave because they feel they won't get paid for a very long while, if ever, including the manager. Redemption Terms Redemption terms inform you of the options of liquidity that you have. Unlike mutual funds that provide daily liquidity, hedge funds are typically quarterly or annual. Ours were actually five years. There will usually be a different fee structure depending on the liquidity term that you choose. The longer the funds are locked up generally the lower the fees. A somewhat controversial term that relates to liquidity are what are referred to as gates. A gate term will disallow redemption for certain reasons. Usually if too many LPs try to redeem at once, the gate provision will only allow pro rata percentage of your account to be redeemed. It's a good idea to look for this in the docs if you're investing and a good idea to add it to your docs if you're managing a fund. Its purpose is to prevent a run of the bank type scenario and that can have a devastating impact on your fund without it. Now, the expenses of the fund are typically broken out into two types. Expenses that are borne by the fund, meaning the LP pays for them indirectly, and expenses that are borne by the management company that are paid for by the management fee that's already been levied. Fees that are typically borne by the fund are fees like audit expenses and legal expenses that relate to the fund. Fees that are typically paid for by the management company out of the management fee are things like rent and salaries. Now these are market terms, not required terms. So it's important to deliberate on both of them from both an LP and PM consideration when you're looking at setting up your fund. So here are the dominant documents and filings for any given hedge fund. First, we'll start with the documents. The Offering memorandum, which is typically called the om, spells out the terms of the fund and also disclose the pertinent risks of the fund. The subscription documents, also called sub docs, are what the investor fills out to gain entry to the partnership. The key term here that the LPs must attest that they are accredited. The Limited Partnership Agreement the LPA is basically just the agreement between the LPs and the Fund. It spells out all the LP's rights and obligations. The Compliance Manual is required for hedge funds and it contains all compliance policies and procedures. This is a crucial document to adhere to as the SEC will examine the fund and this is the blueprint. The due Diligence, or ddq, is basically a Q and A for investors that describes all the policies and procedures for the fund that an investor would care about. The isda, or the International Swaps and Derivatives Agreement, become a little more popular in news these days, defines the terms between the fund and the investment bank when dealing with OTC derivative products. Now, there are also many filings that a hedge fund may or may not need to make, depending on various factors but the following are the most common Form ADV is a required annually filed form for hedge funds that manage over 25 million in AUM. It notes general key information about the fund and its key members and service providers. Form 13F is a publicly available SEC form that is filed quarterly by firms managing in excess of 100 million. It lists all equity positions held in the last day of the quarter you have access to it. It has some serious flaws though. Namely it doesn't need to be filed until 45 days after quarter end. It also doesn't have short positions on many derivatives. So it's limited in value and in fact can be very misleading. Warm PF is a form that's non public. It's filed with the SEC either quarterly for large funds or annually for smaller funds. It's an extremely broad and complex document and detailed filing. It's primarily designed to disclose potential systemic risk that the fund poses for the entire financial system. So it's a really important document. So now we're going to discuss the standard functions and roles of a relatively mature hedge fund. Startups have these functions as well, but depending on the size of the fund, they may not have hired senior people for all of these roles. In fact, outsourcing, as you're going to see, is now the go to for most startups in many of these roles. Not the first one though. Portfolio management is handled by the portfolio manager and that's a day one role. PM is also usually the founder. We're going to talk more specifically about the requirements of this role a little later in the presentation. The management of the entire process is handled by the Chief Operating Officer and this is a day one role as well. Therefore, the COO is usually a founder of the fund. It's an important role and it's important that the PM remain focused on the portfolio, not have to worry about running all the aspects of the business. COO will work closely with the PM and the senior executives, including the cfo, to ensure that the business operates efficiently and effectively. A top COO will focus on all processes of the business, including optimizing the processes for research and portfolio management. The research function is handled by the analyst team reports into the pm. We're going to discuss that function a little bit more in depth a little bit later in a few slides later. Legal function is supervised by the firm's Chief counsel. The GC works with other senior members of the management team, is responsible for all contractual matters, mitigating legal liabilities, overseeing investigations. Important functions. The GC is to work closely with and sometimes even supervise the chief compliance officer. Now, the compliance function is overseen by the firm's chief compliance officer. The CCO is responsible for ensuring a culture of compliance at all levels of the firm. It's especially important that senior management expresses how important compliance is. This is referred to as the tone at the top. CCO's Bible is the compliance manual that we previously discussed. Ensuring that the firm is properly trained in all areas of compliance is a crucial function of the CCO since insider trading is such a potential risk area. High Potential Risk area the pm, the analyst team of the firm's traders should all be viewed as part of the compliance team since they are on the front lines. If they're not well trained to spot insider trading red flags, the firm is at risk. Once you've stepped over the line, it's too late. Insider trading isn't a black and white area, so training is really important. The CCO is responsible for the firm's regulatory filings and along with the gc, for managing any SEC exams or investigations which will happen. The trading function is supervised by the firm's head trader. Portfolio managers. Sometimes managers decide what to trade and then the trader decides how to trade. With some guidance from the pm, they can execute the orders in one of two ways, either electronically themselves or through counterparties of the firm, like the big investment banks that also serve as prime brokers for the fund. The trader has a very important role because there's significant costs involved with trading. Two types of costs are execution costs and the other are commission costs. Breakage costs are the difference between where the PM decides to put the trade and ultimately where it gets executed. Commission costs are a highly coveted source of revenue for the counterparties, and the trader will want both execution and research in return for the firm's commission dollars. The accounting and tax function is responsibility of the firm's chief financial officer. The responsibilities include supervising the firm's annual audit by working with the firm's outside auditors and administrator, overseeing the books of the firm, overseeing the records of the firm, a management company, the treasury management, ensuring that all tax filings are proper. There's a lot of responsibilities for the CFO. Now. The operations function of the firm is responsibility for the Director of operations. The operations function is generally considered to encompass all processes necessary to settle trades after they have been executed by the trading team. In that regard, the operations team works closely with the trading team and the the process is handed off to the accounting team to record the trades, a crucial role the Director of Operations plays at a Hedge fund is securing the borrow necessary for shorting stocks from the firm's counterparties and also for managing the costs associated with the borrow function. The technology function is headed up by the Chief Technology Officer, or sometimes known as the Chief Information Officer. As the firm grows, there will also be a Chief Information Security Officer, ciso, who's primarily responsible for protecting the firm's data against cybersecurity attacks and theft. That's really important role these days. Especially a director of software is another role that will be brought in as a firm matures. Responsibilities of the technology firm are to ensure the daily processes and to mature the necessary hardware and software that will allow the various other functions of the firm to seamlessly acquire and disseminate crucial information necessary to run the business. They're basically the firm's nervous system now. The marketing function is also referred to as business development. In the early stages of a fund's life, this also functions as investor relations, but that function eventually splits off into its own role. The Director of Business Development is responsible for raising capital for the fund and he discussed that in more detail as that's a key role for launching any fund. The IR role has become increasingly important as the industry has matured and the investor profile is more institutional in nature. Now, the risk management function is typically not held by a single person, in other words a risk manager, until a fund is more mature. Until then, the role is split amongst other senior executives and tied together by the coo. Some of the key risks that a hedge fund has are portfolio risk, cybersecurity risk, legal liability risk, counterparty risk, reputation risk schema. There's a lot of risks that need to be overseen by a hedge fund. The key to any risk management management process is to identify first the magnitude of impact of the risk and then the probability of its occurrence. In this way you can identify the firm's top risks. This will inform you as to where to spend and allocate the appropriate level of resources to mitigate those risks. The human resources function is managed by the Director of Human Resources. This is usually not a day one role, but it probably should be since human resources are the lifeblood of the firm. This role is responsible for all aspects of human resources the firm in coordination with other senior executives. Gap analysis, acquisition, retention, compensation, employment practices, training reviews, goal setting and termination. These are all responsibilities of the human resources function. Those are the roles and functions of a hedge fund. Now in launching a hedge fund, there are four key service providers that you'll need to retain. There are many to choose from in each category. So you can be selective and you should be. It's important to know what criteria you're looking for when you're selecting them. Prime Broker is a key partner in the launch of your hedge fund. They have deep resources for free and they also do a lot to earn your future business as you're going to be providing them with lucrative revenue streams for years to come. Many millions of dollars. One of the revenue streams will be financing costs. They will lend money to the fund to invest more than the capital that the fund has on hand is also known as leverage or margin. PB will use the fund securities as holdings for collateral for loans. They'll debit your account with the interest on these loans. They'll also lend securities for the purpose of short selling them. They can charge you a borrow fee for that. They're going to also execute trades for you and charge you commissions on the execution. In return for these fees, the funds provide a series of free services or relatively free services such as capital introduction, settlement of securities, investment research, and various other advisory services. Another service provider that you're required to retain is the funds administrator. The administrator is an independent third party that keeps the funds books and calculates the net asset value and communicates this to the LPs on a monthly basis. They also can be served to be the sole owner of the book's accounting records. But most funds, especially the more mature funds, have at least some sort of parallel books and records. It's important to note that the administrator is not legally liable for the accuracy of the fund records, and that's why it's important to have a system to recalculate those records or a minimum to look over them. Fund will also need to retain an accounting firm to conduct the annual audit and also prepare the fund's tax information. For limited partners, that's a K1. Finally, another required service provider is the fund's law firm. The law firm will prepare the fund's formation documents such as the offering memorandum that we talked about, limited partnership agreement, the subscription documents, and the compliance manual. There are always going to be legal issues that the firm's attorneys will need to advise on as fund growth. It's important that funds attorneys are well vetted prior to retaining them. They're also quite expensive. Outsourcing key functions is becoming a more viable and oftentimes desirable option for hedge funds and especially startups that can't afford a deep bench to start. If the fund hires an experienced CEO that has already managed these functions, outsourcing becomes an even more attractive option. Even as the fund grows, it can bring some of these functions in house or partially in house. Now we're going to focus on the number one issue facing startup funds, raising capital. First of all, you need to know the rules. First. Principle they teach you in law school is that ignorance of the law is no excuse. You can't tell the judge, I'm sorry I didn't know about it. Your Honor, the rules, especially around advertising, can be complicated and differ based on the jurisdiction. There's also some performance disclosures that you need to be very careful about. Such a stating net performance, not gross. You also have to be careful about cherry picking your performance or using hypothetical you need to be careful with track record portability right from a previous employer. And also testimonials are also highly restrictive There are some significant hurdles that you need to overcome to successfully raise capital. The industry has become a lot more institutionalized. This is because there are more institutional investors entering the hedge fund scene. And also as a result of Madoff and the banking crisis, investors are insisting upon a sufficient level of staffing, especially in compliance and accounting. It's crucial to have a really strong COO and or a CFO in place to raise capital. Other roles can be outsourced but will be important to whom the vendors must be qualified and experienced. Institutional investors especially don't want to invest in funds that have even a hint of potential regulatory or accounting issues, regardless of the PM's track record. The LPs also don't want the PM to be spending time on that side of the business. They want the firm to be fully staffed with sufficient resour that the pm, the analyst, can spend their time on the portfolio making them money. Another hurdle to raising capital is the level of aum. This is a bit of a chicken or egg scenario. While there are some exceptions, in general, institutional investors don't like their investors to more than 10 to 20% of a firm's AUM. They also don't like to invest in amounts smaller than 25 million, which means that for most institutional investors the fund needs to have between 250 and 500 million. Next, you need a strategy or a plan for marketing, for branding, for advertising. They overlap, but there are differences. The key is to have a plan for each one of them. Timing is really important in all of this. Be sure to put all of your information together before you meet with respective investors. First impressions are crucial and people will talk. That's what they do. It's a small community, believe it or not. So what are the key aspects of your marketing presentation. First, there are four documents to prepare the Tear sheet, which is really just a quick summary term sheet. The deck is crucial and really should be prepared by a professional. Remember, there's a lot of competition out there and this is an area that many managers tend to skimp on. The elevator pitch really important so you can get your story out and get investors excited about it quickly on an elevator ride to the 10th floor. Then there's the DDQ, which is merely just a formal Q and A that can answer a lot of the technical questions about your fund. You don't want to waste your precious minutes during a meeting with an investor reviewing technical issues that can easily be read in a document, right? Send those before you want to spend your valuable time influencing and bonding. Right? Remember that sales is mostly about striking rapport. Also, be sure that all members of the team and outside advisors have a consistent message about the fund. Nothing worse than an investor hearing conflicting messages about your fund. This is one that a lot of founders don't think about, but can really give you an edge. Be a thought leader. This is legal. You can do this. In other words, get the word out there that you're an expert in your space. You should find ways to provide insights in the topics that you'll be investing in. This will build trust and credibility with your potential investors and differentiate you. You'll need a content strategy. What will your content be? Product specific? Industry specific? And what form will it be? Text? Audio? Video? How will you disseminate or distribute it? There are many dissemination vehicles to choose from. Why? Books, articles, websites, Social media, Podcasts, Interviews, Speaking engagements Next on our list is the firm's website. This serves as a digital hub between the business and the outside world. The idea is to draw people in to tell your story. This is where you're going to connect with various potential leads. So it's important to have the right messaging now. It's also cruel to identify potential sources of capital not talking about investors themselves, but the connections to investors. The most lucrative and important sources by far are the cap entry teams of the prime brokers. These teams are quite valuable because it's their role to match the prime brokers brokerage clients with potential investors and they are incentivized to do so. The larger the hedge fund is, the more money they have under management, the more fees the prime broker will eventually realize. Merging manager conferences sponsored by various vendors including cap intro teams of the prime brokers. Another great source of meeting vendors Fairly recent occurrence has been the introduction of outside Consultants performing due diligence on behalf of investors looking to invest in funds. Theoretically, these firms have more expertise than the investors themselves. They will report back to the investor their findings and leaving. Give the investor a grade. You guys thought you were done with upgrades. Not all types of investors are the same and therefore it's important to have a set of criteria for the fund's ideal investor or avatar if you will. You can direct your marketing efforts at these avatars and ignore the rest. Is a much more efficient and wise use of your resources, especially time which is the most limited. Think about what the criteria are for the ideal investor. Who is your avatar? Some possibilities are an investor that has the ability to fund margin market managers under certain aum. Remember you're going to start small. A large enough pool to add to their investors investment. Right? You want them to be able to add and grow with you over time. Reputation for not taking up too much of the manager's time. Right? Keep your time for managing the portfolio. Not be too risk averse stickiness of their capital. In other words, you want them to have a long term investment horizon. Can they add value perhaps to the research process? Can they add value by introducing other potential investors? So here's a list of 10 classes of investors, right? These are types of investors. As I mentioned. It's important to recognize that not all investors have the same profile. The classes themselves have different profiles and then the individual investors within the classes have different profiles. Be sure to know what you're looking for so you can target your marketing to your ideal lp, your avatar. Also, don't be afraid to turn the tables on your potential investor and ask them for references on them as an lp. Due diligence can and should work both ways. I didn't figure that out till we were well into our partnerships. Like wait, we can. We can actually do due diligence on our investors right before we take them in. They will literally be a partner of yours. So you want to be sure that you want them as a partner. Really important. In order to successfully grow your fund, it's important you have at least one anchor partner. Someone has to step up first. There are generally two types. Banker partner relationships, seed partners and founders class interests. Seed investors will invest a certain amount initially and in return will get an equity interest in the fund. They may also provide some type of advisory services to help the fund grow. A founder's class of investor will invest early in the fund's life and in return will receive preferred terms such as reduced fees or liquidity options. Generally, a Good idea to get one of those at least. All right, now we're going to move on to the investment process. For our purposes. The information I'm going to share, while basically the same for most funds, is really the approach to the classic long short equity hedge fund files, which is what most tiger cubs are, and that's my background. They tend to have a longer term investment horizon. The overall mission for a hedge fund is first to generate alpha, which is generally thought of as the return that the fund earns over a benchmark index. The actual calculation is a little bit more complex, but for our purposes this definition is sufficient. However, just beating the market isn't good enough for a great hedge fund. What if the market's down 10%? You're only down 6%, you have a 4% alpha, but you still lost money. Is that a good year? Some would say yes, even though you lost money. However, you can't eat negative returns. While you want to beat the market, you also want to be sure that generating positive returns regardless of the market's return, and that's what's referred to as absolute return. For instance, we didn't just look at shorts as a hedge. We viewed them as an insurance policy that paid us the premiums. We were right more than we were wrong on both the long side and the short side. Over time we'd make money. The other part of the mission is of course, risk management, which we'll talk about a little bit later. So here is an overview of the entire investment process of a hedge fund. Specifically the research process, which is mainly the responsibility of the firm's research analyst. And then the portfolio management process, which is the responsibility of corporate or the portfolio manager. The first part of the process is human resources, which is necessary to get the right team in place depending on the maturity of the firm. This is a shared responsibility, but overall it's in the hands of the pm. We're not going to talk too much about human resources because while it's actually the most important part of the process, this is really a key function of any firm. I do a separate webinar on just the human resource process since it's so crucial. So feel free to reach out to us on a webinar on this or just some consulting on us if you'd like to go deeper. Now, I view the HR part of the process in essence the same as portfolio management. The idea is to have the right people on your team, just like you want to have the right investments in your portfolio. First part of the process is sourcing and hiring the best talent. This is a 10 step process that I love to consult on because it's so important and most firms don't get it right. We're just going to go high level here, but feel free to reach out. As I mentioned, it's the most important process for any firm to get right. First thing you need to do is a gap analysis of the team. What's missing? Then you create a very clear job description for who to hire to close the gaps. Determine the best sources to find the talent. Could be other funds, investment banks, interns. Perhaps it's within your own firm. Promote. Then you need to search for the talent. Who's going to do this? Outside recruiters, internal recruiters. Once we have some candidates in the pipeline, the next step is the filtering process. This is basically a screening process. The process entails initial screening, interviews, assessment tests, projects. Basically what you're doing is putting a value on the candidate. And we literally do. We look at hundreds of candidates and score them. Those with the highest scores move on to the next stage of the process, which is an interview and then the hiring manager and possibly others. The interviews entail a more detailed scoring process process for the candidate. Don't forget the sales process in the interview. Many people do. You need to sell both the firm and the role to the candidate. You can't assume that you don't have competition. I mean we go like, wait, they took another job? But we had such a great interview. What happened? You didn't sell the firm. Make the offer right. You want to be sure that you've got the right market value for the candidate as you don't want to lose out at this late stage due to a below market offer. Once the offer is accepted, then we're going to do some due diligence, references, background checks that all checks out and the candidate accepts. We're going to begin the onboarding process now. There's an art to all this. I literally spend the first hour of my day every day at my firm or route to working on this process because it's that important. I've developed a very sophisticated scoring process for this. When the process of actually developing software for IT project entails not only building the software, but also we're writing a book on it and doing webinars and seminars on it. I love this area. Nothing more important than human resources. So once you've hired the team, the hard part begins right now. You need to manage the team. First is you want to set goals for each member of your team so they Know what their individual goals are as well as the mission and goals for the firm overall. Second, you want to be sure that the employees have the proper training in all the firm's important processes, as well as keeping their technical and soft skills like communication sharp. Feedback is a tricky and crucial area to get right. Communication is the key here. Remember, you can't manage what you don't measure, and that's especially important for employees. There must be a detailed review process with a score. You should also score yourself, or better yet, have them score you anonymously. You'll want to be sure that your team is compensated fairly, both for incentive purposes as well as retention. Finally, the hardest part of the role of any leader or manager is one of termination decisions and actually the termination itself. Just like an investment portfolio, if the employee isn't adding enough value to the portfolio or to the fund, they must go. It's a crucial mistake that managers make. Keeping people on who are not assets of the firm. They keep them on for too long. There are many reasons for this and it's too important not to master. Of course, any termination must be handled with the utmost of compassion and fairness. You need to help that person move on to the next stage of their career. It's never a good idea to burn bridges. Alright. It's important to have a research process that returns the highest levels of value with the least amount of resources. This doesn't mean to skimp on resources. It means that the analysts and the firm should get the highest return from them. The process in general starts with identifying high quality ideas, then performing high value added research on these ideas. Then acquire a level of conviction on the names and be able to communicate the high conviction names to the PM for inclusion into the portfolio. Once in the portfolio, the analyst needs to monitor the names in the portfolio for any changes in the story and also stay on top of the names in the pipeline while generating. So it's a lot to do for an analyst. We're going to go into each of these areas in some more depth right now. So the first part of the research process is of course, idea generation. Identifying quality sources of new ideas takes both experience and ingenuity. PMs and analysts from different funds tend to share long ideas with each other because there really isn't competition there. There's not competition for these long ideas. There's plenty out there. They can share research, they can share their models. Now, the short side though, is somewhat different. Funds tend not to share their best ideas because there is competition on the short side. The main reason there is that you need to borrow shares in order. Short and oftentimes borrow can be a really scarce resource. However, it's important both on the long side and short side for regulatory reasons not to know when the person you're sharing information with will be trading the idea. Do not talk about trading. Timing. Reading blogs and just being generally in the know about your industry can generate ideas. Also, many of the best investors insist that their best ideas come from within. Setting aside time for meditating and thinking time are crucial for this. Some of the best managers do that. Buffett, Gates Dalio Loves to meditate. Griffin Huge meditator It's really important to track the sources of your best ideas and score the sources based on the quality of ideas. Why? Because you want to go back to the well for more. Use technology for this. Also be sure that you compensate those who provided you with ideas so they have incentive to bring you more ideas. This can be through commission dollars, just paying outright, even sharing your own ideas. Encourage creativity to come up with ideas. Retreats, hackathons and contests are all excellent ways to come up with ideas. Retreats are great because they rid you of distractions and therefore can help you to focus and enter the coveted flow state. Contests Promote the competitive of spirit, invoke accountability and provide incentives. By the way, we teach all of this at my new firm route. We even have meditation training Promote a Culture of Trust and Innovation Google spent years studying the key performance traits of top teams and the number one trait they came up with was trust. Why? Trust provides psychological safety for employees to take risks around their team members. There's no humiliating people if they make a mistake. When generating new ideas, it's crucial to have an initial score of quality of the idea. There's an initial score score of it. Why need to decide if this is an idea that is worth spending time evaluating? Worst time to spend time pursuing. Remember, time is your most valuable resource so you want to spend it wisely. We also have training on time optimization. My number one course Time optimization. Having a checklist system for scoring to knock out those ideas that won't make it into the portfolio anyways is just good time management. For instance, sometimes an analyst will work for weeks on a short idea only to learn that they weren't able to borrow it because it was unavailable. How they had they checked this first, they would have moved on quickly to the next idea. Checklists save time and save lives. Ask any surgeon. One of my favorite books is the Checklist Manifesto. Now once an analyst has an idea that is Worthy of expending resources on. Follow a process to understand. Eventually score all aspects of the company that will serve as criteria for the analyst. Conviction level. Second scoring level. There should be formalized checklists. At a minimum, develop a model of the company. During this stage, it's important not to form any concept conclusions. Keep an open mind. Focus only on the facts. Just the facts. The categories and subcategories will be weighted and scored eventually. Some examples of criteria to research would be to understand management, their reputation. These are some of the lists that we've come up with. The reputation, their experience and their incentives. Do they know how to allocate capital? Crucial Understand the industry. Who are the players and is it on the rise or falling and out of favor? Understanding the product and its use. Why is it unique? Best to experience it. Taste the ice cream. Get an understanding of the key competitors and any new entrants that may be in the queue. Understand the company if it's got a long term competitive advantage. Is there a moat around the business? Do you understand the chain of buyers and suppliers? Now some of the sources for this research in order of difficulty to research and that usually means in order of highest value would be competitors and suppliers. Excellent sources of value. This usually takes hard work though to access and analyze. Lots of points for doing that. Rolling up your sleeves. Industry conference is also another excellent source of value added research. Expert networks can be of value. Be sure that you understand all of the compliance surrounding a usage of paid expert networks. There's a lot of them. Do you have access to management here? Again, be sure you understand all the compliance issues surrounding interactions with the company's management. Street research from sell side firms is a common source but not as useful since everybody's reading it. It's not as necessary. Right? Because most of the information come from the companies themselves. We're incentivized to slant the bull case. Financial information from public filings is another key source of information to understand. This is just tip of the iceberg. There's a lot of information to accumulate and organize. It's crucial to have a research management aggregator that serves central repository to organize all research in one place to make it easy to access and share information to be able to use it in the most efficient and effective manner. This is a build versus buy decision. Now the next step of the process is to arrive at a conviction level for the idea. This is a weighting and scoring process based on the research criteria at the analyst level. The analyst has been aggregating and assessing this during the bar stage. Of the process, value added research stage of the process. Now it's time to score the company based on the research. There are different factors, of course, based on whether position is a potential long or short idea. On the long side, first you look at the business model. Is the tam, the total addressable market, sufficient for growth? Are there significant barriers to entry? What is unique about this product or service? And look at the management. Do they set a high quality goals? Have they been able to execute on those goals? Are they good capital allocators? Are they ethical? Is the idea original? What is the level of variant perception? Or in other words, does the analyst have a differentiated view from the view of the company on street? This is really the only way a position is going to make money. If there's a different view from what others think to be the case, right? Those numbers are theoretically baked already into the stock price. Another test of originality is whether the stock is a popularly invested name already invested by other firms. It's often referred to as a crowded name. If so, this drives the originality score lower. If it's crowded, is it uncorrelated with other names in the portfolio? Then it gets a higher score. Uncorrelated is good. You already have that exposure and for risk management purposes, we'll see. So, as you'd expect, the short side is pretty much a carbon copy opposite of the long side criteria in terms of scoring, there are two important differences, however, and those are timing and the borrow. Timing is a key criteria for the short side for a number of reasons. It can be expensive in terms of borrow costs and risky to hold shorts, so the sooner they implode, the better. The idea is to look for triggers that will take place in the near term future. Some questions to ask in order to accurately score this criteria are can the company be delisted in the future? Is there debt coming due? Are there other hardships that the company might be facing in the future? Is there a way for the company to extend its timing, thereby postponing its inevitable demise? In other words, the best short is a short that is running out of time. In order to short security, the security must first be borrowed from the firm's prime broker. There needs to be sufficient supply to do so, as we discussed, and the cost of the borrow should be not so onerous as deed into the estimated return. These should be factored as part of the conviction score of security. Now, once the analyst has a clear sense of conviction on the position, it's up to the analyst to clearly communicate that level of conviction. To the portfolio manager, the firm should establish a consistent process for efficient and effective presentation of ideas to the pm. In terms of efficiency, there should also be a consistent presentation process amongst all analysts using the form of a template so the PM can compare ideas to each other and not have to figure things out each time that an idea is presented. Need to make it easy for the PM to get a conviction level and compare it to the other ideas vying for entry into the portfolio. The key is being able to break down the complex into the simple meaning of PM needs to see it and get it right away. Remember that timing can be of the essence in getting a position into the portfolio. Any delay can cost the firm money or even the entire opportunity. In order to be effective in this part of an analyst role, an analyst must have the skills to influence read Dale Carnegie's book on this or attend a course. By the way, this is Warren Buffett's number one suggestion to anyone read the Dale Carnegie book for Investing for anything. It's their number one piece of advice. I've read it Gone to the course. The analyst must also be able to debate with others on the team to get the level of conviction and idea to the portfolio management manager. Bull versus Bear Case Both influence and debating are important skills for an analyst to possess. Now, once a position has been added to the portfolio as an existing position, it's important that the analyst really is not done with that. Analyst role is to monitor the current positions in the portfolio and then also the pipeline positions. You got to stay on top of both of those as well. In addition to finding new positions really important monitor the positions in the portfolio. Understand that you're also looking for new positions in the portfolio. Really important that you do both of these tasks. Now. There are various ways to measure the performance of an analyst over time. In essence, this is the conviction level that the PM will have for the analyst. Here are a few broken down by tangible and intangible measurements. This is what a portfolio manager is also going to look at in terms of the performance of an analyst. Batting average Count the analysts winning positions over total positions. This metric allows the PM to evaluate how often an analyst has right versus Wrong Slugging ratio the analyst P and O their winning percentage over their losing percentage. This metric allows the PM to evaluate how much more an analyst makes when they're right as opposed to when they're wrong how much they lose when they're wrong Number of new ideas in the portfolio Count of how many new ideas the analyst has added over a certain period of time. This metric allows the PM to evaluate the breadth of idea creation over a period of time. Some of the analysts P and L over a period of time. That one's obvious. The average alpha. The average stock price return of an alpha is compared to the average industry's relevant index. The metric allows the PM to evaluate an analyst identifying outperformers in their respective industries. Gross Exposure Rank this is long market value and short market value associated with a particular analyst. This metric demonstrates the analyst contribution the composition of a portfolio at a specific specific point in time. Net Exposure the calculation here is long exposure Less short market value associated with a particular analyst. This metric demonstrates the analyst's ability to contribute to both sides of the portfolio. Finding quality shorts is far more difficult than finding positions on the long side. So this will tell if an analyst is focused on both sides. A high gross exposure and a low net exposure is ideal. Now there's also some intangible measurements like teamwork, communication and grit. Really important that an analyst has those as well. Now at the end of the day, portfolio management is about allocating the firm's resources to minimize minimize risk while optimizing return. There are really two portfolios that a PM manages. The investment portfolio and the team portfolio. That's human resource that we talked about. We already discussed some of the PR processes necessary, but I'm going to go a little deeper things that are more specific to the portfolio manager's process. The research process is what the analysts execute, but the PM that designs the firm's process and holds the analyst accountable to adhere to it. The portfolio manager has sole discretion over the timing and sizing of the positions of the portfolio based on the research and conviction level provided by the firm's analysts. The PM doesn't trade but does direct to trading desk to execute execute orders within certain parameters or guidelines. So the PM designs and reviews the management reporting to allow for efficient and effective measurement. We're going to go through all of these areas in some detail right now. As previously discussed, the PM is responsible for the design and makeup for the investment team over the life of the fund. This means continually looking for and closing gaps in the skill sets of the team. Performance measures of the analyst team is a key responsibility of the portfolio manager. This is a process that the PM not only should be a part of designing but also executing because the results are crucial to many areas of the success of the firm. The review process assists the manager with understanding an analyst strengths and areas of development. It also informs a PM how to compensate and appropriately incentivize an analyst. If analyst is superior in skill, there's always the risk that they'll leave to start their own fund. In this instance, a potential retention strategy is for the PM to reward such analysts with their own portfolio to keep them from leaving the firm and starting their own fund. Process is key to alpha generation. There's direct correlation between the quality of the process and the resulting decisions and outcomes. The PM must ensure that for repeatable functions, the team has a process and that process is counted on to be done and improved on all along the way. Communication amongst team members managers with the PM is paramount to the success of the firm. Included here is identifying what modes of communication are appropriate and for what purpose. Encouraging the team to be clear and concise in its communication regardless of the form it takes. Collaboration tools like Slack should be part of any discussion on communication. The culture of the team is crucial to the investment manager's success. The PM is the culture bearer of the firm and must make it clear what the values and principles are for the team. For instance, building a culture of trust is a crucial element for any team as it spurs creativity. As we discussed, the PM must also infuse accountability into the team's cultural fabric. Team members should be accountable to themselves, their teammates, their manager, their direct reports and most importantly, to the limited partners of the firm. Intellectual curiosity is another great cultural trait to have that's often the lifeblood of the firm. Without this, the firm won't grow. Humility is also a crucial trait. Successful firm is always challenging their own ideas and the ideas of their colleagues. A good analyst should spend the resources to build conviction but won't be wedded to any position if proven wrong. We have a saying at our firm. Strong opinions weekly held meaning build a conviction but don't let your ego hold on to it if proven wrong by the facts. It's the PM's role to make the final decision on both timing and sizing of positions in that portfolio based on the research information, importantly the level of conviction provided by the analysts. The analyst will provide fundamental analysis which evaluates the intrinsic value of security. This can help side the sizing of positions. They will also provide technical analysis which provide information on the entry and exit points from a security based on trends in the stock's price, the volume or other factors. Exit points for security depend on the firm's philosophy. Many times there are predetermined exits where target price is determined in advance. These can even be automatically set to execute, for instance as a stop loss order. Sometimes firms will have A check in price to reevaluate the hypothesis to see if the conviction level on the stock's future performance has changed. If not, PM will continue to hold. The hypothesis has changed. The PM will either exit or add to the position. In the latter case, that means that the hypothesis is even better than it initially was. Now, with respect to timing on the long side of the portfolio, and a portfolio with a long term investment horizon, the timing of entry is generally as soon as an analyst has a level of conviction in the security. If the firm has a long term investment horizon, timing of the long security isn't as important, say as a short term investment horizon such as a day trading firm might have. The exit will occur once the hypothesis has played out or the hypothesis has changed. On the short side of the portfolio, timing can be a little more tricky. There's generally more volatility on the short side, so timing does make a bigger difference. There are also different types of shorting scenarios, each with their own strategy and also having different stages of exit entry. For instance, in a fraud scenario on the short side, if you uncover a fraud through legitimate value added research, the ideal price to get in is before others figure it out and drive the price down. Another ideal entry point for a struggling company is a trigger point, such as when the metrics of the company start to fail, such as a debt offering coming due or debt that can't be paid, or another better product that's being introduced, or a competitor coming into the market. The ideal exit price for a short is zero. That's the ultimate feather in the cap for a short seller. Sizing of positions largely depends on the level of conviction of the pm, right? That comes from the research analyst. While key conviction isn't the whole answer though, if it was the sole determining factor, the position with the largest conviction would be the only position in the portfolio. Risk factors such as diversification, correlation with other positions and other factors play a role inside the timing of positions for a portfolio manager. Now, as mentioned in our discussion on timing, the importance of trade execution depends on the duration of the investment style. For an investor with a long term investment horizon, the impact of trading isn't as important because over time, theoretically there will be large moves in the stock. Short term trading firms, on the other hand, depend on taking advantage of small, smaller moves in the price because they earn their returns on volume over time. The goal of the PM the trader is best execution. Traders going to look for guidance from the PM as to how to execute the order. If there's a trigger that's expected, then the PM may have some time sensitivity, as we discussed, to get the order on quickly. This is rarely the case for a longer term fund and the order will usually go slowly. The PM would tell the trader, for instance, to be a percentage of the volume so the order itself doesn't move the stock price up or down. On the short side, as we discussed, there may be a trigger that the fund thinks will drive the price down, like debt coming due. The risk might be some time sensitivity there. The hedge fund has a fiduciary obligation to get best execution for the fund, which means that the fund has an obligation to make a good faith effort to get the best price, either an entry or exit of a position. The most common way to test best execution is to compare the actual execution of the trade with a benchmark such as vwap, which is the value weighted average price of a given security over the course of the day. Slippage is when the order is done at less than a favorable price compared to the benchmark. Can occur if the trade is done too quickly or during the day where there's a lot of volatility. Volatility or maybe some news came out. The fund usually has a trading oversight committee to review the trading performance of the desk. Trading costs such as commissions are also reviewed as part of the trading oversight committee's role. Another cost that is more difficult to measure is the change in price from when an analyst has arrived at a conviction level for security to the price at execution. Theoretically, the longer this period, the higher the cost is. Doesn't really have a name, but I think you get the idea. The PM might provide guidance to the traders in the form of execution conditions and restrictions. A stop loss order as an example of that that specifies that a stock is sold when it reach a specified price, below the current price or a limit buy order instructs the trader to only buy at or below a certain price. Those are some examples of some firm restrictions. So risk management so while some funds have risk management, many do not really. That's the responsibility of the PM, right? PM's the sole risk manager for the fund on the portfolio side. Most important risk that a hedge fund faces the degree of leverage that it employs. Leverage is in essence a line of credit that can be drawn down upon and collateralized by the securities of the portfolio. The objective is for the fund to magnify its gains by putting on more exposure. But it can also magnify its losses by doing that right. In other words, more risk, more return. If the bets go south against the hedge fund. Prime brokers can sell the collateral which can magnify the losses. When this happens, basically game over funds out of business. We'll talk a little bit about that later. The intention of derivatives exposure is asymmetric risk, which means that the maximum loss is much less than the maximum gain. There are many risk management tools, but over the years I've found that the one that works the best usually is requiring the hedge fund portfolio manager to keep a percentage of his or her net worth in the fund alongside the LPs. The better true alignment of interest. Again, even that doesn't always work right. CR take off. Here are some exposures to risk that a PM must manage. Right Liquidity risk Liquidity risk not having the cash when you need it. This is the famous economist Peter Bernstein's quote. It basically means that you can't sell at what you feel is a fair market value because there's not enough demand. Macroeconomic risk Think interest rate risk for example. Sector industry risk may be overexposed in a sector and industry concentration risk. The portfolio may have too much exposure in any given area. It needs to diversify correlation risk. Different investments may react the same way to other investments. There are some common portfolio risk managements that can be viewed at the fund level. Determine the level of risk that a fund has. Gross exposure is the total exposure of the portfolio to the market. So for example, if the fund is 120 million of long exposure, 80 million of short exposure, the gross exposure of the fund is 200 million. The net exposure. The long exposure less the short exposure. In our example 120 -80 fund has a net exposure of 40 million. By the way, these two levers, gross and net exposure, are the most important tools that the portfolio portfolio manager has in its toolbox to manage risk, both leverage and risk to the market. Beta is a measure of a fund's returns relative to the industry of an index. The index being compared is assigned a beta of 1. Fund with a beta of 1.5 therefore will tend to have a return of 1.5% for every 1% of movement in the market of the index. VAR or the value at risk is the highest amount that can be lost in the portfolio over a period of time with a specific confidence level. Doesn't always work. Sharpe ratio is a popular hedge fund risk measurement tool. It measures the risk of a performance of a fund compared to a risk free investment after adjusting for its risk. It basically represents the additional amount of return per unit of additional risk. Quality PM decisions are only as Good as the information he or she has to make the decisions. Therefore, the reporting that a PM gets, measuring performance, not only the portfolio and the analyst, is crucial to measure the processes that led to the results as well as the results. Really important reports must have the highest amount of quality information with the least amount of words and numbers. Right? In other words, the PM is really busy. He or she needs to get it right away. High quality, concise reporting. I call this principle the billionaire's mindset. How to break the complex down into the simple. Now to routine addition to teaching all the technical information in the presentation. We go a lot deeper into the cognitive and development side of building leadership skills. All important for managing a portfolio. We help people, executives and businesses to raise their standards to become the best versions of themselves. Along those lines are a few relevant themes that we talk about. We talk about mindset. Understand the mind. Understand cognitive biases. Understand the great mindsets too. Grit, curiosity, crisity. Understand process. Find out what works, keep doing it. Find out what doesn't work. Stop doing that. Learn how to manage your resources. Your intrinsic resources especially. Right? That's what a leader does. A leader can manage their time, their energy, their discipline, their focus. Learn how to manage your extrinsic resources. Capital dollars, human capital, technology, service providers. The key to all of this is waiting and prioritization. We also teach decision making processes, nothing more important. Communication skills, learning skills, listening skills. That's covey. Right? Influence skills. That's Carnegie brevity skills. Turn the complex into the simple. The billionaire's mindse. Goals that focus you in on your mission. Crucial to have plans to achieve the goals. The key is to prioritize the actions within your plans. Accountability strategies. Right? Keep you on track with your plan. That's why I love coaching so much. Why it's the focus of my new business. Measurement. You can't focus on what you don't measure. Right? Finally, you need outside forces to help you get there. Your professors, mentors. Yes again, coaches. This is our success formula. It's basically the framework for what we teach. Basically, start with your mission. You move to a gap analysis. Where am I? Where do I want to be? Set goals to close the gaps. Design plans to achieve the goals. Prioritize both the goals and the action items within your plans. Schedule in your actions. Execute on your actions. Have an accountability strategy, like a coach. Measure your result along the way. Make sure you're making progress. Revise your approach. If the measurement's not where you want it to be. Right. Call a timeout, score's going against you revise your approach. Where in the process is it not working? And then you achieve your mission, right? And celebrate what happened to GameStop? In January of this year, social news website Reddit triggered a buying spree aimed to short squeeze hedge funds that had large positions in GameStop. Price went from 17 to almost $500 per share is crazy. It wasn't worth $500 per share. The short squeeze occurs when a shortest stock suddenly jumps in value, forcing the short sellers to buy back their positions to stem potential losses. It's a risk management thing. They've got to do it. Otherwise the firm could end. Right Purchases are, you know, cause this death spiral because the purchases themselves cause even further price increases. Right now some funds had to be bailed out with capital infusions to stay afloat. Volatility caused extreme profits for buyers and losses losses for sellers. Day traders, however, also cashed in big time just from the volatility. Many day traders made millions on this popular trading platform. Robinhood halted purchases of GameStop. Very controversial. They faced major regulatory scrutiny for it and there's actually class action lawsuits on for doing so. There's also a lot of regulatory scrutiny as a result of volatility and potential manipulation. Now a contributing factor to the increased buy, including anger at hedge funds. Right. The general anger out there at hedge funds from some retail investors who basically wanted to punish the short sellers. And this is a way to do it. And it worked. The price has to come back down, has already has now come way back down to much more reasonable levels. It's true value. And it's too soon to tell if this pattern of behavior is repeatable, although it did happen shortly thereafter with AMC Networks, but on a much smaller scale. It's really too soon to know whether there's going to be a regulatory response or how the industry is going to react to this in general. But it's a really great classic example of a short squeeze. It.