How to Select Hedge Funds for a Portfolio
Elena Chirkova
Nov 5, 2024First of all, we pay attention to the profitability of hedge funds. If it is very low, such a fund is unlikely to be included in our portfolio, although there may be exceptions, which I will discuss below.
The next important aspect is the fund's lifespan. It should be long enough, but not excessively so. A long operating period is important because the fund usually has a declared strategy, and investors cannot thoroughly verify it. Firstly, if an investor fully understood how this strategy works, they could implement it themselves. In other words, we are looking for funds with strategies that cannot be replicated or thoroughly verified.
For example, if an activist fund sends us a report with a case where they write: "We found a company, informed its management that some processes were inefficient, proposed changes, management rejected them. Then we decided to get a seat on the board of directors, started gathering votes for the proposed changes, and so on." Sometimes they describe a dozen cases over many pages. This can probably only be verified by another activist fund that has deeply analyzed the same companies, but no one else.
Secondly, no one will ever fully disclose their strategy to avoid the risk of it being copied by competitors. We know of such a case: a long time ago, another of our funds (not GEIST) was interested in crypto funds. In a conversation with one of them, we mentioned that we knew their strategy because we discussed a similar strategy with another crypto fund. When we named the fund, the interlocutors reported that this fund had stolen the strategy from them. It turned out that the fund conducted due diligence, promising a $100 million investment, and asked for the model to be provided. Subsequently, they created their own fund using this model and invested the same $100 million in it.
Thirdly, even if you fully know the strategy, it is unknown whether the fund will follow it. This cannot be verified. You would have to track the fund's decisions in real-time, for example, once a week. It is hard to imagine that an activist fund, for example, would disclose everything about the company they found.
As a result, since the fund's actions cannot be thoroughly verified, we can only rely on very long data series to determine if the fund has the ability to outperform the market. If a fund has outperformed the market for three consecutive years, it may be a coincidence.
Therefore, we want the time series to be long enough — five years, preferably ten — but not too long. We have seen funds created in the 1990s that often show high returns since inception but average in recent years. A typical example is Warren Buffett's company Berkshire Hathaway. The older the fund, the lower the returns it generates.
Moreover, strategies can become outdated. Since the 1990s, the world and the market have changed. Therefore, it is good if the fund is about 20 years old, but provided that the results have not improved, and the manager is still young enough and plans to stay at the helm. If the fund was created in the 1980s and the manager is around 80 years old, there is a high probability that they will soon retire. So, the second factor we pay attention to is the fund's lifespan.
The next factor is the fund's volatility. High returns can be generated through high volatility. But the opposite is also true: there are good funds that show returns of up to 10% with negative beta. These are so-called hedging funds: when the market goes up, they go down, and vice versa. You can create a portfolio of such funds and funds with high volatility, and it will be better than the S&P 500. A fund with negative beta will reduce the overall volatility of the portfolio.
The fourth factor: the strategy should be understandable so that we can believe in it. We do not believe in every strategy. For example, we have quite a few funds working in the biotechnology sector. This is a very profitable area, and the corresponding index often outperforms the S&P 500. When managers add their alpha to this, the funds significantly outperform the S&P 500 index. We believe in this.
We also believe that the most successful activist funds outperform the S&P 500 by making improvement proposals in companies with inefficient management. This allows for additional returns. We are also interested in funds created by former investment bankers, for example, from Goldman Sachs, who offer companies capital market deals. Such funds, for example, may hold old convertible bonds, which they sell at a premium to the market, and buy new ones at a discount. Their profit comes from both the returns on the deals and the fees for consulting services. We know a fund that earns about 5% annual returns from such services. We believe in such funds too. They are rare but do exist.
We also believe that funds operating in the small and mid-cap company markets can bring significant profits because such companies are less covered by analysts. This leads to a less efficient market and more price distortions.
Interestingly, what we do not believe in. We regularly encounter funds whose managers claim they "feel" where the market will go tomorrow, and so on. Or, for example, there was a fund investing in companies like Google. It claimed to analyze the social networks of employees to understand what is happening inside companies. Perhaps this allows them to see some internal processes, but it is impossible to outperform the market this way.
Thus, strategies based on intuition or technical analysis do not inspire confidence in us. It has been proven that technical analysis is not effective, and no fund operating based on it has made it into our portfolio. Our portfolio consists of 27 funds, all of which use a value investing approach.
Why this matters
Choosing a hedge fund is a complex task that private investors find difficult to accomplish on their own.
