How to identify top talent without an official track record

Wed Apr 9, 2014

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Making decisions with limited information.

  Dipak Jogia of Oppenheimer Asset Management
  Brian Altenburg of Oppenheimer Asset Management
  Dipak Jogia and Brian Altenburg

By Brian Altenburg and Dipak Jogia

The topic of investing in emerging managers receives considerable attention from investors. While allocators increasingly talk about the need to find the next generation of investment talent, the largest firms have continued to attract the majority of capital flows since 2008. This can in part be attributed to a "flight to safety" phenomenon based on long-term track records, brand, and business and operational stability of established firms. In our view, this trend is likely to persist given that it is hard for allocators to invest with newer managers without an audited track record.

Making a judgment on an investment team with either a short or no verifiable track record is a major analytical challenge for the vast majority of allocators. Furthermore, there is increased operational and business risk in allocating to emerging managers, and also career risk considerations on the part of the allocator. To successfully invest with emerging managers requires significant experience in sourcing from an opaque universe, combined with the ability to take a forward-looking view and make decisions with limited information.

Investing with emerging managers can be part of a much larger and fundamental objective of increasing the probability of investment success combined with the alignment of interests with the investment manager. We believe that investment teams earlier in their life cycle and smaller in terms of assets under management tend to outperform their older, larger counterparts, as well as provide greater transparency and access. In addition, hedge funds have life cycles and the alignment of interest with investors may decrease as investment managers scale assets and products, diverting some of their focus away from investment returns.

Ultimately investors are making a call on human capital regardless of the tenure of the track record. There are a number of criteria that allocators should focus on in their investment process when evaluating emerging hedge fund managers.

Pedigree and Experience: Beyond the Brand Name

Despite the fact that there are approximately 10,000 hedge funds globally, the number of investment managers that can generate alpha remains scarce. The majority of active managers do not add value, a useful fact that can serve to reduce a considerable amount of white noise in the sourcing and due-diligence process and focus efforts on the most compelling opportunities. In our view, investment managers should be executing investment approaches which are difficult to replicate successfully by allocators and require an investment team with a distinct skill set.

In our view there is no substitute for experience and being trained by top-tier investment talent. It is critical to understand portfolio managers’ experience at their previous firms and how this experience frames their investment philosophy and strategy.

Allocators need to determine whether a portfolio manager’s prior firm employed a specialized, alpha-driven investment strategy with the ability to generate consistent investment returns over market cycles. The due-diligence process should focus on the attributes that resulted in the success of the portfolio manager’s prior firm. Was success driven by the firm’s culture or was the portfolio manager simply in the right place at the right time? Is the portfolio manager talented regardless of the environment?

Allocators should aim to invest with emerging managers with both significant and relevant experience as a portfolio manager or senior analyst with tenure and influence over portfolio decisions. In the manager selection process, there is no substitute for spending time with an investment team to understand their experience combined with using an established network of industry contacts to both verify and clarify the portfolio manager’s experience and responsibilities at their previous firms.

Process Orientation

Allocators should verify that emerging investment managers are highly disciplined and have a strong process orientation. A process driven approach in our view is likely to result in a repeatable and scalable investment strategy. Furthermore, while allocators aim to find a discernable "edge," investment success is also driven by effectively executing on basic investment functions. While having the attributes of creativity and imagination and the ability to think in non-linear terms is important, these attributes ultimately have to be combined with a clearly defined investment process.

Risk Management

We believe that investment managers that have been successful over a meaningful period of time all share the hallmarks of being disciplined risk managers and have an appreciation for "staying in the game." An emerging manager should have a clearly defined risk management philosophy and framework consistent with the investment strategy. While it is hard to forecast returns with a high degree of confidence, investment managers can have a strategy to control both the nature and the level of risk within their portfolios and have a pre-defined plan on how to manage position and portfolio level exposures in the event of a drawdown. In the post-2008 world, investment success for emerging managers is a combination of strong security selection and disciplined risk management.

Alignment of Interests

A key ingredient of success for emerging managers is the creation of a direct alignment of interest by investing the majority of their net worth alongside limited partners. Investors in large, established firms often lose contact with the key investment decision-makers over time and have limited transparency into portfolio positioning. In contrast, emerging and capacity-controlled managers may be more willing to engage in direct communication with investors about portfolio positioning and their business, and are potentially more likely to provide a meaningful level of portfolio transparency. Additionally, emerging investment managers may be more likely to negotiate on the reduction of management and incentive fees, which provides increased alpha to investment returns.

In summary, by investing in emerging managers allocators are implementing a forward-looking investment approach. It is ultimately a lonely endeavor since the approach typically lacks the safety and comfort of investing in managers with a multi-year track record, but may provide an opportunity to potentially outperform a portfolio of established managers.

Brian Altenburg and Dipak Jogia are co-heads and managing directors of the Alternative Investments Group at Oppenheimer Asset Management, an affiliate of Oppenheimer & Co.

ISSN: 2151-1845 / CDC10004H

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