The Evolution of Hedge Fund Management

please welcome your panelists for the evolution of hedge fund management moderated by Bloomberg TV's editor-at-large Eric Schadt scre good morning everybody and welcome to the evolution of hedge fund management here at the Milken Institute global conference 2018 I'm Eric shots Kirk great to see you here I think we're going to have a very interesting I hope provocative conversation today instead of introducing our panelists I would say first you can read about them in your program however the BIOS while informative or incomplete and I thought it would make sense to help establish some context and give you a better idea of who's on stage with me for our panelists to introduce themselves and tell you a bit about what they do why don't we begin with you done sure my name is dawn Fitzpatrick and I'm the CIO of Soros Fund management we run George Soros as family and foundation money we invest across asset classes and across geographies about 70% of our money is managed directly internally and about 30% we invest through third parties Ricky hi Ricky Sandler founder CEO and CIO of eminence capital we run a 7 billion dollar investment management firm about 5 billion of which is long/short equity traditional Bottoms Up stock pickers a dying breed but but surviving maybe thriving what I think I think it's coming that's part of the the evolution of the industry so but bottoms up stock pickers that run with a healthy balance sheet on both the long and short side globally invested and we've been in business for 20 years Andrew I'm Andrew Felton the co-founder CEO and CIO of Blue Mountain Capital we manage a little over 20 billion dollars the vehicles that we range from hedge funds to opportunities funds that invest in less liquid opportunities we manage about 10 billion dollars of cielos and we manage a number of single investor funds where for large investors we put together all of the pieces that we manage our investing capabilities range from quantitative equities to structured credit to volatility strategies to distressed discretionary equities all the way through to less liquid opportunities in private debt and private equity and finally demetri demetri bosnia founded by Asti asset management in 2001 which seems about 300 years ago and hedge fund we have about 10 billion and AUM 600 people spread around the globe we started in long/short equity and have expanded over time into macro fixed income commodities credit and quantitative strategies most of the strategies are market neutral or close to market neutral and we focus on uncorrelated consistent performance so as you can see and as you've heard there's an extraordinary range of expertise and depth of experience on this panel to give you a sense of what we hope to accomplish over the next hour we're going to explore the pressures and demands on hedge fund managers and try to give you a sense of how the industry is going to respond and what opportunities might emerge as those things evolve a question I'd like to begin with which I think will help us flush out all of the key issues is this one is the hedge fund model broken Don you've been an insider in the hedge fund industry now you are of sorts an outsider given that you're at Soros you're also a client of the hedge fund industry what do you think I I don't think it's broken but I think the you know two-and-twenty fits all model definitely is behind us I think investors have gotten way more sophisticated in terms of separating out kind of simple beta from an excess return that's differentiated and I think they're also very focused on alignment here so I think you will see not just you know fees don't necessarily have to just compress but things like slower crystallization of performance fees management fees that go lower as assets go higher I think I think things like that will matter more and more but in terms of you know the backdrop and Ricky touched on it you know the excess we're seeing in strategies like long short right here are really interesting as we see a lot of dispersion in stocks and I think as markets become more challenging our skills we've become kind of more in favor so if Don's right and the models not broken I want to hear from each of you on what if anything is wrong with it Andrew you know I'm gonna gloss over a metaphysical question which is what is a hedge fund because I think it has different meanings for different people and I'll just sort of take the question as asked if you if you think about investors preference for non commoditized returns I mean let's just not use the charged word alpha for a minute but non commoditized returns I think that there are a number of constructs of vehicles of alignment structures of fee structures that will enable investors to hire managers to seek for them non commoditized distinctive returns that aren't easy for everybody to achieve and so if the question is are people going to stop seeking those return streams I think absolutely not in fact I think people more and more will seek those return streams but I think Don's exactly right though the way you structure your relationship with the people who seek those returns for you inevitably is going to change Demetri Ricci what about you guys I'm gonna take the answer from a slightly different angle which is which is sort of is the return stream broken and is there is the construct between investors because ultimately is the model broken there's there's some discussion here about is the fee right and there's some discussion about why has the industry underperformed investor expectations you're right right and I think which is which is causing investors to ask whether it's broken and whether they should pay the fees and I think frankly the that the title of this panel sort of talks about it but the evolution the industry has created certain constructs that have actually created the the the lack of return in the industry and and by that I mean the industry you know first went through an institutionalization which was great for it and everybody got compliance and and you know best execution all this stuff and then the financial crisis hit and and that created a different construct between investor and client that changed the whole dynamic we we used to be able to get high returns with limited volatility and then when the financial crisis hit that limited volatility got questioned and investors began to push us to protect downside volatility rather than make their money and that created a construct where both portfolio construction within the long/short equity industry and frankly risk management and I'll call that the de-risking periods that we've had since then the job it appeared to be for the hedge fund manager was to not lose you money not not to make you money and that actually sow the seeds of very mediocre returns at high fees which which is part of the problem I also think part of the problem there was you had managers become acid gatherers more than focusing on the returns they delivered so part of that lower volatility was a fee maximization game Dmitry yeah I agree with a lot of that I mean we get a question a lot of you know why do you have six hundred people right and I think it speaks to the challenge and really generating consistent alpha and how capacity constrained it really is so we find that having a you know focused team and a fairly narrow specialty where they could be world-class hopeful amongst the best in the industry in their particular niche and have 500 million let's say of capacity in that particular strategy that's a much more you know replicatable consistent alpha generating strategy than you know a person or a team running you know lots of different strategies and with much larger assets and so if you sort of buy into that then you need you know lots and lots of people each trying to get you know a small slice of the Alpha and then when you can combine that with capabilities and you know and risk and quant and you know recruiting and management and take that off of the portfolio managers you know that's sort of one way to go about it but it's it's very you know very capacity constraint by definition like anything that has you know high alpha contents going to attract lots of you know smart folks to go after it so if you can find more narrow slices it's a you know more consistent way to go about it I think I understand what Dmitriy means when he says alpha but you described alpha as a what did you say a loaded word I think I said it was a charged word the charged word why I don't think there's a real good definition for alpha mostly because there's not a real good definition for beta is it too much of a rabbit hole for us to try and do that here I think so okay Don you and Ricky raised together a provocative point that there is more to the underperformance let's call it a disappointing performance seems a little less judgemental than poor by hedge fund managers collectively the industry collectively over the past decade certainly in the post-crisis period Ricky you highlighted the demands perhaps placed upon hedge fund managers by their investors changing set of demands changing set of expectations return of capital as opposed to return on capital perhaps Don you talked about growth for growth's sake if I could summarise it that way what else belongs on that list are there other things that we should put on the list that explain why hedge funds collectively have not done as well and hope to return on that so there's three trillion dollars in the hedge fund industry right and so if it's just without arguing too much about the definition of alpha let's just say that the investors expect you know say a 10% return in aggregate and most of that should be alpha on that right that is their 300 billion dollars of annual alpha to be pulled out of the markets right I would say no right I don't think it's anywhere near that and so you'd have everybody fighting over a fairly limited alpha pool and a large chunk of that pool goes to a small number of the largest firms with capabilities and lots of different strategies and everybody else is kind of fighting over the rest right and so if I think from the investors side I have to think about what you're trying to you know really invest it like what type of return stream and that one isn't necessarily better than another it's just being clear on what you're buying and they should have different you know different fee structures and different you know challenges to generating those returns you know you could buy a smarter long bias type of return stream you could trip by market neutral alpha type of return stream and they come in different amounts and they should have different prices I'm gonna disagree with Dmitry a little bit on the alpha opportunity I think I think the alpha opportunity in the market is as good as it was 15 or 20 years ago we've done work around that the percentage of stocks that outperform by 20% or underperformed by 20% or more and sort of what the spread is between the 80% tell them a 20% talent and the opportunities there what I like to say is is it's different and and that means that that the players in the market are different today than they were 15 years ago in pre-crisis and and those people are helps help setting prices and and our jobs as fund managers are both to get all the fundamentals right and figure out where the businesses are going over the next five years and what they're worth and also to figure out what the markets gonna pay for that stream and that narrative and that is different today that it was pre-crisis by a lot could you be a little more going out go ahead to Ricky's point I think one of one of the kind of things that's changed very materially is kind of the the growth of passive and I think part of hedge funds alpha historically was that we had this you know another active investor in the market that that hedge funds were clearly one step quicker then and an easy example is back you know ten years ago you would see big mutual funds trade very sloppily and that was actually a really good source of alpha for for equity hedge funds because you would buy that block and and at a good discount and within a matter of a day or two you had had a gain to show I think right now and this speaks to Ricky's point I think he's right there is good dispersion and winners you know go up a lot and losers go down but you have to be more patient and right now it feels like in investors are very patient with their private portfolios but when it comes to their public market portfolios its what have you done for me lately we should be at least mention that there's a cyclical element here as well as a sec possible secular elements you know for since the crisis we've had very easy money and easy money has created liquidity and that's bit up asset prices and it has been hard to generate really distinctive returns versus whatever you want to call the market in that kind of environment that may be changing it may not be changing but it that is more cyclical than secular the there are secular things going on as well and I think Ricky mentioned institutionalization which by and large has been very good for our industry and it's come from more sophisticated investors it's come from just the natural maturation of the market it's come to some extent from regulation but one of the things that it has brought to the market is an expectation of specialization that I think to some extent undermines the the purpose or the goals or the strength of the institutions that we all run the if what we're trying to do is generate non commoditized returns and when we strike upon some kind of alpha that we can extract from the market one thing I'm pretty sure about especially today is that tomorrow that will start to commoditize capital will flow to it labor will leave my institution and go to another institution intellectual property is not that easily protected and the the non commoditized returns will start to commoditize so what that means is if we want to stay ahead we need to change we need to adapt and maybe the the only persistent alpha if you will in our industry is the the Alpha from adaptation it's building cultures and institutions and organizational structures and investor relationships and investment in technology that allows you to constantly stay at the frontier and if you don't constantly stay at the frontier you've become a commodity return provider which is Dimitri said I think is incredibly valuable but I ought to be priced differently and so part of institutionalization and one of the things that I you know that we at least really try to educate our clients about is that you want us continually pushing the boundaries which in some in some ways is contrary to the goals of institutionalization which tries to create efficiencies which are very understandable in the contracting relationships between between principals and agents yeah I agree with that and I think one of the other edges that is available is pushing your capabilities across different strategies like once you've built out a particular capability whether it's in you know quant or risk or you know long short stock making whatever it is it does translate a little bit to giving you an edge in the next tangential strategies so you know we've got you know pushed back over the years from clients as we expand it into different areas but and some work and some didn't but over time some of the best returning strategies and some of the best returning teams were ones that weren't around you know five years ago or ten year ago at our shop and if we would have passed on those we would have missed out on a really good uncorrelated return stream that I think it also speaks to you know the number of hedge funds that that you really need in the world to to kind of access the strategies because if you have if you buy into the point that business capabilities and management capabilities and infrastructure are really important it's it's very hard to have you know ten thousand funds that can kind of do that right and the folks that kind of perennial II have good consistent returns tend to not turn over that much right so I used to run a fund of funds with partners capital for for a long time from the 90s through about six seven years ago you know we had money with Ricky back in 98 right and here we are still operates 2017 it's it's there's a lot of persistency in the top managers in top you know kind of business folks that I think is contributing to the consolidation in the industry Dimitri I don't want to spend too much time on this point because it has been debated before but since you have introduced it twice I want to at least ask you if three trillion dollars of hedge fund industry capital is too much of 10,000 funds is too much if the quantum of alpha that can be generated in a given year is not 300 billion what is it what's the right size for the industry well I think it depends on what your definitions are so I think three trillion of you know alpha seeking assets of pure alpha and correlated seeking assets is way is way too much right I think there might be a couple hundred funds in the world as opposed to ten thousand that can consistently generate alpha you know if that scale right but that doesn't mean that there's not a legitimate you know business purpose and a potentially valuable return stream for clients but they just have to have a different definition so whether it's relative performance over particular index you know long bias a smarter way of gaining exposure to something that you can do in a hedge fund structure than in a in a non hedge fund structure that's fine but it can't all be you know a tip one type of hedge fund fee model and one type of alpha seeking return you know claiming that we're all going to generate uncorrelated returns of 300 billion dollars a year is that kind of what you were getting at with the definition against the metaphysical point it's much more of a continuum and the the the the reason I I suspect all of us at the core are in business is because we have fewer constraints than others other participants in the market and I'm not criticizing constraints first of all I think they're very necessary for efficiency and second of all they keep us in business but the to put an artificial stake into that continuum somewhere to make it easy to talk to people and to organize yourselves remember it's artificial and whether that's you know a stake between debt and equity or a stake between liquid and a liquid or a stake between hedge fund and something else or a stake between alpha and really really smart beta they're all stakes in the ground that are artificial and so I can't even answer your question about whether three trillion is too much or too little because I don't you can't bound it you know I do know that there's I think 85 trillion dollars of investable assets in the market now and predictions are that's going to well over a hundred trillion within a few years and the the markets are constantly changing the structures changing the participants are changing technology is increasing data is changing different sectors arising different sectors are falling the that there's always going to be if you're innovating and adapting something to do that is non commoditized and if you define it that way three trillion is a drop in the bucket you know Ricky mentioned or Don I don't remember who mentioned the transition to passive and what does that mean and it used to be so much fun to trade against mutual funds well it still is sort of fun to trade against mutual funds but it's fun to trade against passive - because passive is a it is another metaphysical puzzle right the you know III had a an investor asked the other day what's a better hedge the SP CDX which is a credit derivatives high-yield index or hyg which is a which is a high-yield bond index I said well they're all really different the you know SP is chock-full of technology companies low-risk companies that bulk the bulk of the market cap isn't very levered hyg is a very broad-based high-yield index that happens to have interest rate risk and call risk in it and CD acts is just a spread index with many fewer names about 5% of them about to default and so the if you think of these things as interchangeable all of them passive excellent because that means a lot of other people are thinking of them as interchangeable and we get to go in and understand what the constituents actually are and trade against the people who think they're trading passively but are actively making actually making active decisions about what passive means so I you know I just think the in the industry is constantly changing and if again if you define it as generating returns that aren't commoditized that aren't easy by doing things that others are constrained from doing then I think three trillion is just way too small an estimate and one thing one comment I would make Dimitri talked about kind of the bigger platforms being able to connect dots and and you know Andrew talked about kind of the being able to evolve when you actually look at hedge fund flows those big firms that can connect the dots are doing well and and I believe wholeheartedly what what Dimitri and Andrew said that's valuable but that field is narrowing so and the flows in aggregate are not going to those bigger firms it's what you've seen lately as flows go to the 250 to 500 billion dollar hedge funds that are more nichy and I think that's that goes back to being able to deliver a differentiated return especially when you're at the top of a market cycle and you want kind of not just line item diversification but actual return diversification we have the seeds of a debate here on the one hand we've heard about the need to evolve the need to diversify on the other we've heard just now that specialization may actually deliver better uncorrelated returns or if we like alpha I think I think I think for periods of time specialization works and I think you need specialization within a larger firm and you need that step-back perspective because as Andrew said I'm Dmitry said I think I think the reason that at least the three of us have been in business for over 15 years because we've we have adapted we've realized the world's changed and we have to keep building and evolving our firms and and so there's in in my view there's part specialization that you need you need analysts that that know industries and information and what's important in a stock and in a business and can and can gather data and analyze it and then and then you need somebody that can also step back and have sort of a more generalist perspective at least that's the model that that we pursue and and to us that is one that could constantly evolve how much freedom do you have to evolve to change to adapt if you will Ricky you made the point earlier that one of the problems with hedge funds as an industry is that they're responsive and to a degree there should be responsive they answer to their clients that if the clients want to put hedge funds in a box and the consultants furthermore want to put hedge funds in a box to make it easy to market those hedge funds to their ultimate clients the LPS how much room is there to maneuver well I think I think it comes down to your communication with your investors I think the one thing that we have to do is do what we say to our investors and and and what is that I think I think if investors come in and are horrified that you could have lost you know 18 percent in 2008 you'd have to push back on that and say I don't know what you you thought this fund was going to do and and we have to be true to the the return stream that we think we can deliver the risk in the reward and and what flexibilities we're gonna use to kind of do that and and how we're going to evolve and so it comes down to a constant communication I think we talked a little bit about the Institute channelization one of those things is transparency and transcript transparency doesn't just mean at the position level it means that sort of the leading thought level of here's where we're going these are the things we're doing and I think ultimately the investors have to have to trust our judgment but we have to communicate it well and make sure that they understand what we're doing yeah I agree it's it's about communication it's about setting the right expectations it's about picking the right clients clients who want to be long-term business partners not just short-term investors the pickup on the seeds of your debate I I disagree I I'm not I'm not exactly sure that Don meant it this way but I disagree with I think her point about the small nichy funds and agree more with what Dimitri was saying about a wave of consolidation it's really expensive to to have a sustainable organization trying to achieve the things that we're trying to achieve and it's only getting more expensive the the importance of technology is only accelerating in our industry like all industries the importance of data and data science the importance of being able to innovate in a more competitive market you have to innovate faster you have to innovate across a wider space you have to be able to dial down your activities in one area dial it up quickly in another area only the dial it back up in that first area at a moment's notice well that means you need to have a diversified team of people and a diversified team of a difference my set of capabilities and infrastructure and you can't carry that with a small fund it's just it's it's not economic for the owners of the fund so I agree with Dimitri I think you know I'm not surprised that he has 600 people I think it's a great strength of theirs I'm not I will not be too surprised to see continued consolidation and I think that the the the firms that succeed are going to be the ones that figure out how to scale without losing that ability to innovate because we all know that there is a tension between scaling and complacency or scaling and losing that innovative edge and so one of the things that we focus a lot on is how do we scale to be able to meet the economic demands of the industry that we're in while at the same time retaining that ability to constantly evolve and innovate yeah I sort of think of it like the private equity evolution over the years where you know when it first started up and it was a successful strategy that you know hundreds and hundreds and hundreds of private equity firms and then it's really consolidated and you have a small number of firms that own a very large part of the market share and then you do have lots of smaller niche firms but the vast majority of institutional dollars go to a small number of firms that have capabilities that they leverage across lots of different you know sub strategies into space I think we're all on the same page the specialization is really helpful to generating returns the question is like how do you come up with a construct that gives people the wherewithal to really focus on their investing and have the resources to specialize and the consistency of the capital base because the other problem was with small fund besides that you know the business distraction of investing and running the business is the unstable nature of it right if you only have one you know strategy and you're specialized in your niche e right that's great when that strategy is in favor and there's lots to do but you know the following year there isn't as much to do and it's out of favor and returns might not be as good and so what do you do and if you need the infrastructure and the management and the technology etc you need the ability to invest in that so to invest in it you need more assets right and so then you you're pushing back against your whole capacity constrained specialization and now you're you know hiring people in different strategies or expanding into other areas and the performance inevitably goes down because that's not the core skillset of that of that manager if you don't do it then it's a very unstable organization four so like we have lots of specialists and every year we have a top ten performer dinner and the attendees of that dinner are very different every year right there's there might be like one two or three that that perennially come around but the vast majority of a year are different from the prior year and it's very hard to predict who's going to be there you know the following year right could I just pause for a moment in the hope that the person back here who's sorting cutlery can hear me could we stop sorting cutlery okay that was value-add right there I don't know if you guys could hear it but it just got louder so I think they did hear you but they're protesting my kids do the same thing I was going to save scale for later but I think it's worth pulling each of our panelists on this question of scale you're right it is getting more expensive to run a hedge fund not just because of regulatory and compliance demands but also as you mentioned the need to invest in technology let's not forget about the cost of talent can we venture a guess or at least maybe something more than a guess some analysis as to what can you boil it down to a number what do you need to be to have the necessary skill to compete this is I hadn't thought about it in that way and I wouldn't put it in terms of assets under management because that doesn't necessarily describe the in the capacity that you have to reinvest in your business says something about how much revenue can generate yeah so I think you need you you need the ability if I'm answering the question now against the benchmark of you want to be around and thriving ten years from now I think you need the ability to cover a hundred million dollar expense base hmm Demetri I think it really depends on the type of that you have I mean for us like that would be you know we need multiples of that for you know if you're an itchy firm with with a single strategy and you have an investor base that's really bought into it not from the standpoint that this is the cool strategy for the next couple of years but like this is really a sustainable thing for 10 years then we want to be in through the ups and downs then you could you could do it smaller but I do think that that whenever we talk to folks that are starting funds they perennially undervalue the difficulty and the infrastructure that's required like the days of you know I'm gonna have a Bloomberg in a couple of analysts and a you know a CEO oh and we're good to go like you just can't compete with well finance people that have you know all the corporate access resources the sell-side resources you know syndicate technology risk compliance like the list goes on and on so whatever the number is for that business I would I would tend to err on the high side I think I think it depends on on the type of business you want to run and Dimitri runs a very you know wide number of strategies and needs a lot more scale than than we do but we still need scale because we still have to make the the quantum data science investments we still have to make the investments in analyst and we have a short only team that just focuses on shorts in addition to to what the rest of the team does Long's and shorts so you know for us we run seven billion and that feels like scale to be able to make all the investments and evolve I think that the the bigger challenge is the more you go for scale the harder it is to keep that scale because because assets are fleeting and the industry is very fragile and so I've been famous for saying that running a 7 billion dollar hedge funds an awesome awesome business except if you started at 20 billion because then you're out of business and you you built this scale for 20 and and now you're at 7 and and and so the bigger you are you have to have an asset gathering machine that can that can hold that in place and so there's there's a balance here between having enough scale to invest in whatever it is that you do and you do it well and continue to evolve but making sure that you can hold that at acid-based strong and stable because the fragility of the industry creates this virtuous circle the other way when when assets there there are ways to address that though the other than descaling so for example one of the the most frequent conversations we have with our largest clients is let's trade nominal fees so we will lower our nominal fees in exchange for size and duration and so now we have the confidence that the capital will be there for multiple years five to seven years in some cases and this is not solely to invest in less liquid opportunities this is because we and our client want to co invest in our capabilities and so now we have the confidence to spend fifty million dollars a year on technology and data and if I thought that the assets were fleeting and disappearing potentially in a year there is no way I would make that kind of investment in technology and data so you know we talked about how the industry's terms might might restructure I think one big trend and we're certainly pushing on on this with respect to our clients may be a better time horizon alignment and a co investment in the business an exchange of duration and flexibility to innovate in exchange for the the capacity to use our capabilities at attractive feel oh don't you just create that new issue in five years or seven years from now I know that's a long time but you know locking them up and them causing them to have to make another decision for five or seven years I think structuring your business that every one of my every one of the clients matured on the same five-year date would be a bad idea so you know we definitely try to stagger that in a way that we don't have that pin risk what's your what are your thoughts on scale Don you know I think it really comes down to strategy so there there clearly are some platforms that work way better at scale but but I would also go back to the argument that there are capacity constrained strategies that don't want to sit on a multi-strategy platform that are really valuable to access and the key there is that the manager is intellectually honest about what that capacity is and and and they define it upfront and they define the opportunity set and also I think Dimitri touched on this some of those opportunities are not going to be persistent so you have to have that dialogue when you go into that investment and recognize that well we still have some time I think it's worthwhile asking each of you what you're doing we've talked in general terms in some specific terms about the things that are happening in the industry and the things that you're doing in your own funds but I a little more detail would be helpful how are you trying to evolve where are you finding a challenging what kind of pushback are you getting from your investors andrew since you've probably been a little more vocal about this why don't you continue that's a penalty for being but for speaking up or hey sometimes it's better to go first well in terms of where we've made the biggest investments as a business over the past four to five years we've invested quite a bit in our quantitative and systematic equity capabilities and so that's been a you know it's it's it's interesting people worry about machines taking over for humans and and our experience and I suspect this it's at least as a general rule the experience for other quantitative equity managers per dollar of capital invested we have more people in our quantitative businesses than we do in our discretionary businesses they're doing different things you know they're they're researching signals they're researching how to get better execution they're researching how to do better databases how to make our computing go faster they're doing different things but there's more of them per dollar invested than in other areas of our firm so we've made a very big investment in that a substantial percentage of our capital is now invested in how many people are we talking about by the way we in terms of people per dollar of capital in our in some of our discretionary businesses it's fewer than ten people per billion dollars of capital in our systemic businesses it's more than thirty people and some depending upon how you think about it maybe more than forty people per billion dollars of capital so it's just a it's it's a it's a different again they're doing very different things and just knowing a little bit about the size of some of the large firms doing it I suspect again I'm sure there are some exceptions but I would suspect it's a general rule in systemic or quantitative equity investing where we're going now in systemic investing our origins were in the credit markets we know we evolved to be multi-strategy pretty early on in our history but we do have deep expertise in credit and we're starting to invest more and more in systemic credit strategies I don't think at least in the next few years we'll be able to do it the way we do systemic equities because the markets not as complete or continuous but it's an area where where we think we can where we can generate quite a bit of non commoditized returns I could go through each of our strategies but at the other end of the spectrum in in private capital we're at present investing quite a lot in resources to invest in healthcare because we think there's such a transition going on in healthcare you know we had ten years of massive transition in the financial industry we're making a bit of a bet that will have massive transition in the healthcare industry for the next ten years Demitri it's probably the most interesting thing we have going on is along the same lines of the intersection between quantitative investing and fundamental investing so I think when you look at different firms and obviously everybody's trying to figure out how to go about go about it on the quantitative side you know on billions they have people put together a box and see how that works out to figure out the higher and everybody's got a different strategy I think you have to start with what's the capability of the firm how does that firm get an edge and compete with the folks that have been doing it for long time so we started it from the standpoint of we have a strong fundamental long short business with hundreds of people and you know thousands and thousands of ideas all the time that's very valuable data right so we started collecting that data analyzing that data and then giving it back to the portfolio management teams to help improve their performance and doing the Moneyball thing of finding tendencies then we started about five years ago like running quantitative portfolios off of those same ideas using the fundamental ideas as your as your input as the ingredients in the soup but making the soup in a quantitative way so much more factory neutral much more evenly weighted much more passively traded and that's been successful over time in the last couple years we've taken it from the learnings from that business and started the purely systematic longshore trading and purely systematic macro trading and now we're even starting a new group where we have fundamental analysts that do all the fundamental work but then just enter the ideas as opposed to discretionary trades they enter the ideas into a quantitative trading engine and so it separates out the kind of the alpha assembly line of research and trading and portfolio management which a lot of times the folks that are great at research are not particularly great at portfolio management it's distracting and the research suffers so we're trying to disaggregate those in one of the groups so there's there's lots of things you can do with it but but I think the important thing is you know how do you bring to bear kind of the capabilities of that firm to really compete and then build you know off of that Ricky yeah so you know I I'd say well we probably two areas that highlight one is going to be very similar to Andrew and Dimitri you know eighteen months to two years ago we had 16 people on our research team today we have about 23 and all of that growth has come in two areas one is quantum data science where you know we've used it much like Dimitri described in his first two elements where he's diagnosing his own tendencies and and using it at the individual stock rigor level not yet to actually make investments but sort of the concept that man plush machine is better than man alone and it's better than machine alone so making our fundamental team better by using the data and and the capabilities of quant and data science in a much bigger way the second area has been on the short side I think shorting and shorting individual stocks has become a bit of a lost art I think that the bull market has had a lot of people leave leave the business I think this is an area where you absolutely need scale because you cannot take large concentrated short positions it doesn't work when they go against you they become bigger problems they wreak havoc on your P&L and you have no ability to be flexible so we run with about 90 short positions twice as many as we run alongside they're smaller and to have that scale you need not only all of our analysts to to work on the short side but we also need a dedicated short only team that looks at things from a different lens from an accounting lens or a fraud lens instead of just a sector lens which is which is also important so I think I think those are two areas that we've been investing in over the last two years that that allow us to continue to evolve Don can you talk to us on both levels what you're doing at Quantum and and what you're doing in the way of allocating to other like you mentioned the amount of capital that's going to smaller strategies I presume that's something that you've been doing as well can you get into some more detail sure so you know one of one of the things that we've been really focused on is defining our competitive and competitive advantages and taking advantage of that you know for us our size and the semi permanence of capital and the the mission of the foundation we served our clear competitive advantages and then we've been deciding what we can do very well internally and where we can connect the dots across those asset classes and across geographies to effect a better outcome but then there are clearly places where we think others can do better job for us so examples of that onshore China I think we'd kid ourselves that we that we could do that better than then then you know a Chinese national who's doing it who's doing it on the ground in Shanghai or Beijing Biotechnology it's it's an area where we care a lot about but there are some niche players there that are not their capacity constrained and they're outstanding and that's that's also an area where you know it's important to us you know back to kind of the data side it really is kind of a data as data arms race out there to be competitive you have to have good data so we have been investing a fair amount in just our data architecture and data library I think that's really important you know one thing that I think people kind of confuses is is data and AI I think right now we're the majority of the hedge fund industry is it's on accumulating that data and figuring out how to use it but more in quantitative ways versus the AI applications I think have have yet to really materialize in a big way when you talk about the data arms race it makes me go back to the point that we were debating earlier about scale is there I guess it depends on what strategy are in but and of course the amount of data available is not infinite but is where do you draw the line and particularly in a firm like Soros where you're operating in so many arenas how much data is enough data it's interesting one of the other things that I think was as notable is some of the data because you have a lot of people trying to sell you data as a hedge fund right now and one of the things is that data tends to have a half-life in other words it's valuable when when you know five hedge funds have it but when 50 hedge funds have it the value drops although you probably want to want to know what it's what it's what it's telling people but it really depends on on the strategy but I'd say generally you know more is better when you're when you're when you're making decisions do you one last question for you specifically do you because all three of your fellow panelists talked about an approach taking a similar I would say not the same but a similar approach to call it quantum mental thinking Soros doing the same thing yeah and I think Ricky touched on it I think also looking at behavior analytics and recent thing you know everyone has a recency bias the one thing that I think you have to be careful with is it's very unlikely what's worked you know we've had a huge bull market and credit and equities from last nine years it's very unlikely what worked for us the last nine years is going to work for you going and going forward in the same way is I mentioned earlier that I'd like to get a sense of where you're finding it challenging to evolve where you're getting pushback perhaps from your investors and where you feel you need to educate them along the way who wants to take a stab at that I'll take a stab at that because you know we we've grown up as fundamental Bottoms Up stock pickers we're you know kind of doing the traditional research and analysis on companies has been what was successful for us and for for peers like us and I actually think the push into quantum data science scare some investors for for fundamental investors and and they worry that we're changing what we do they worry that we're no longer fundamental and we're you know sort of going to be beholden to a computer and and and we try to educate them that that we're not doing that these that the data is making us better at our jobs that it's not just about a computer telling us to invest but it's harnessing the power of what a computer can analyze to help the human make better decisions in the same framework you always did but but I think that that's something that gets lost with investors when they hear Kwan and there are some investors who I think want to want to sort of put their head in the sand and say you know that I don't want the the new world I want what's worked because I know it worked and and we're trying to say we're doing the same thing but we're doing it better with the advent of quantum anybody else encountering that conservative attitude from yeah I mean we've we've definitely encountered it over the years I think whenever you're doing something that's a little bit innovative it's always going to sound somewhat you know crazy right like the more innovative it is like the crazier it sounds so I think the important thing from from an investor perspective is you really want the firm's you invest with to innovate and to adapt I mean we did a employee meeting a few years ago where we handed out backstory they said adapt or die right like if you're trying to make money in exactly the same way in long short today as you did you know 10 years ago like you're definitely out of business and I think that's across you know across strategies so from an investor's standpoint I think it's important to actually encourage the firm's investment to push the boundaries and try new things and experiment but you have to do it in a way that's it's a controlled experiment right like when you do something new you're probably gonna be the worst at it when you start right you've know the least about it you're gonna be better at it a year two down the road but you're two down the road maybe the opportunity won't be as good right so you have to find like the right amount of resources and the right risk allocation to start something and as long as you can control those bets and make lots of those bets and be supportive of the managers if they don't work out if they you know kept the risk to what they said they were gonna do because over time if you invest with good people like more of those bets will work out than not and it creates a larger moat you know around you know the strategies and gives them a bigger competitive advantage if I'm not mistaken the word fees has only come up once or twice in the course organization to bring it up again can we talk a bit about this there's obviously a lot of attention paid to fees there's a great deal of misunderstanding about fee structures today I think we're gonna talk about the evolution the hedge fund manage we have to talk about the evolution of fees and what they might what they're look what they look like now relative to what they were once upon a time - and 20 and what they're likely to look like in the future as this conversation between manager and investor continues where do we start there I'll take I'll take one crack at it which is you know I think you know for for the right high alpha generating strategies I don't think fees are net Sara Lee - hi but I think on average they've clearly been too high and maybe it goes to Dimitri's point of too many hedge funds and we haven't had as good of returns as an industry but I think I think that the conversations going to change to a more of an alpha base fee structure even if as Andrew said it may be hard to define what alpha is we're gonna have to work hard to do that you know absolute return fee structures make sense if your market neutral absolute return strategy a alpha based fee strategy works if you're you have a different construct that may have some beta and I think there are there are investors out there and all burns been out there with a with a piece you know talking about paying only on alpha and so that that the beta is essentially free because they feel like they can buy beta for three basis points and I think on that people are willing to it really comes down to the net returns and and that those returns are differentiated as Andrew said and I so I think that investors should be flexible when it comes to fees if they're if they're getting a really persistent differentiated return they should be willing to pay 30 percent you know there's they should pay a lot for that but I think the problem has been in aggregate the value delivered has been disappointing yeah I agree with everything that Ricky and Don said I think there may be a trend in more transparency about the economics the profitability or lack thereof the capital investment of investment managers I think the market is reasonably efficient and the efficient equilibrium here will be investors who are seeking non commoditized returns will have an interest in cultivating nourishing helping to grow investment managers who can achieve that for them and they will be smart enough to recognize that if they don't allow them to profit and make those investments they'll disappear on the other hand they will be smart enough to know they don't want to pay for you that they're not getting so how do you how do you square that circle how do you resolve that the attention just more transparency about the economics of the investment management business this is what we're investing this is how much it costs us to invest this is in general what our compensation structure is this is the time frame to be able to deliver those returns you agree on what the expectations are what is success and what is failure and I think that's just part of the maturation of our industry and I think the you know it's both managers and investors will evolve might you know I think managers will become more creative more flexible more transparent and how they structure these arrangements with investors investors will at least the the smart and sophisticated ones will take a longer-term view of the business what are your thoughts in the future I would say and it is changing I think in the right direction I think these structures are becoming much more aligned so if you think of what was probably the the most unfair you know portion of it if you if you think of somebody with a you know 10 billion dollar fund and eight people being you know using a very extreme example you know that's probably not the world's most aligned fee structure right and that's you know obviously changing so I think alignment is very important I think also just like having it line up to support the type of business that that you're running that fits with the mandate and gives you both investor and and the manager a sustainable advantageous structure for achieving what you want to achieve right a lot of times you you could wind up negotiating a fee lower as an investor thinking that it's really helpful to you but if that restricts the manager from making the investments and people and systems that they need to make to put up the returns at the end of the day might be worse off right so I think it's really important to to align those types of things together can we talk about what that what is I I think it's wrong to try and boil down all of this to one thing because two-and-twenty is gone and what were places it isn't going to be 1 in 10 and 0 and 30 whatever the case may be but do we have a sense as to what I think you're thinking too simplistically just based on numbers I think it I'm thinking - I think it'll be more like the here's a five-year horizon the you know we're gonna crystallize fees at the end of 5 years but we'll pay a management fee along the way that will you know be able to the ultimate performance means we'll be able to offset against the management fee maybe we'll have a herd all very dynamic but it'll be it'll be ways to incentivize patient capital to help fund the constant innovation and evolution while sharing the spoils fairly one last question before all burns put out a piece with a model they call one or 30 which is in effect Texas features which what yeah and and which is in effect you get the 1% up front against 30% of the alpha now I don't think 30% is the right alpha share for high alpha generators but the construct makes sense to Andrews point about you get fees and then you get performance fees against it and and you get and we have to get aligned on what we can deliver and and how we're gonna measure alpha but it's just supply and demand right like so I remember when I was running a fund of funds I really wanted to get into Renaissance medallion fund at foreign 50 or whatever it was and they won't let me in right I'm still interested by the way it's supply and demand if you if you're controlling capacity and you have capacity in a strategy that that's high also in limited capacity right like that that has a different fee structure than something that has a ton of capacity and a lower alpha content I think the markets over time are pretty efficient that figuring that out we have 30 seconds left I'm tempted to ask I'm not sure we can get useful answers to this question in the space in the amount of time the way I left but I'm going to try anyway because one of the things that must ascertain is whether hedge fund returns are going to improve if so so quickly our hedge fund when it returns going to improvement if so why yes because there's plenty of dispersion in the market we've seen capital outflow from from other fronts of competition is down and those that are left are adapting and surviving in the new world Don so I think in the excess return space are alpha they're gonna get better but absolute terms probably lower just because we're we're at late stage Andrew I think over a three to five year period they'll get better I think we're coming out of a very tough cycle for this kind of investing and I think we're going into a much better cycle for this type of investing and I think there has been capital retreat from this type of investing which that's sets us up pretty well for the next three to five Dmitri last word to you I hope ours are and more broadly yeah I think so I got a relative basis I think they're going to improve because the the long bio strategies which is where most of the rest of the world is invested I think I've had a fantastic run over the last ten years and it's unlikely to repeat in the next ten years so on a relative basis I think for sure Dmitri Andrew Don Ricky thank you very much evolution of hedge fund management please join me in thanking our panel [Applause]

Channel: Milken Institute

Views: 27,963

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Id: Zk4v41mNpMU

Length: 60min 20sec (3620 seconds)

Published: Mon Jul 09 2018