In his inaugural letter to investors, sent April 15,
Brad Balter argued for the use of alternative mutual funds to
gain access to investment strategies that have historically
been managed within a hedge fund structure. With Balter's
permission, that letter is reprinted here in full.
Dear Friends, Clients and Potential Investors,
Inaugural letters are a tricky thing, first impressions are
important. I could just write something generally bland about
us. Avoid ruffling feathers. Play it safe.
Or I could write it as I see it.
I want to make this first communication with the investor
universe one that is personal in nature and indicative of my
desire to operate openly and transparently. I recognize there
will be readers who vehemently disagree with the opinions and
views expressed in this letter. Others will wholeheartedly
agree and many more may simply scratch their head. Regardless,
I prefer to make my position and intentions entirely clear.
To put it simply, Alternative Mutual Funds ("AMFs") are a
game changing innovation that will likely alter the way we
construct portfolios . I firmly believe we are seeing the most
significant and disruptive development in the hedge fund
universe since the inception of the industry. In my view it is
a sea change of epic proportions and like it or not,
it’s not going away.
From the perspective of the dedicated hedge fund investor,
the immediate benefits of AMFs, relative to traditional hedge
funds, are incredibly obvious. I acknowledge that for much of
our audience, mutual fund vehicles have been an area of
expertise and focus within their client portfolios for years.
Much of what readers may take for granted in using mutual fund
structures is highly disruptive when applied to hedge fund
strategies. This intersection of hedge funds and mutual funds
is a heated area of debate for good reason.
Interestingly, the term "hedge fund" has come to represent a
legal structure rather than a reference to an investment
approach or particular strategy. We have often heard the
refrain "a hedge fund is a fee structure in search of a
strategy." Traditional hedge funds, as many of us know, utilize
a limited partnership format (private non-registered vehicles)
that allows for both a management fee and an incentive
allocation on profits earned by the partnership.
The Shifting Landscape of Hedge Funds
Hedge funds began as a cottage industry driven by
individuals who wanted to invest without institutional
constraints. Few managers existed, most of them were unknown,
and the universe for these strategies was virtually
non-existent. Today, hedge funds are a multi-trillion dollar
industry with an entire ecosystem of ancillary businesses and
service providers. Ironically, the industry has become
precisely what the original hedge fund managers were trying to
escape from. By our estimation, over 8,000 hedge funds exist
I am hard pressed to identify other industries that have
seen this degree of over-proliferation and competition without
any corresponding change to fees. For the most part, the hedge
fund industry has seen minimal fee compression, with many
managers believing a 2% management fee and a 20% incentive fee
is appropriate (I suspect many think otherwise but would never
say so). Perhaps more importantly, the vast majority of hedge
funds, both small and large, still take their performance fee
without any benchmark or mechanism to claw back incentive fees
taken in shorter time frames.
Long/short investing used to be a novel investment strategy
that commanded a premium, just as merger arbitrage and emerging
markets had in the past, based on the complexity of
implementation. We think that many hedge fund strategies, while
still highly valued, have evolved into common offerings. So why
have we seen little improvement if any in fees and where are
the more investor friendly structures?
It is not the hedge fund manager’s fault. They
are commercial market participants charging fees that the
market will bear. It is not the fault of those who originally
invested in these vehicles, most notably high net worth
individuals, who can no longer command the influence they once
held as institutions now provide the majority of net flows into
the industry. Years ago I spoke at an investment conference,
immediately following the head of one of the largest
institutional consulting firms in the world. This individual
had received a question from the audience as to why hedge fund
fees have not come down and his response was, "I
don’t know, but I wish they would." Case in point.
Those that have the power to help lead the industry to a better
place are either afraid or unwilling to do so.
As I began constructing this letter, I recalled an excerpt
from the book, "More Money than God", authored by
Sebastian Mallaby. Within the book is a discussion of A.W.
Jones who is credited with being the first hedge fund manager
whose investments were defined as being both long and short
various market securities (stocks in this case). He was
compensated by only an incentive fee, with the logic described
"Jones wanted to avoid drawing attention to the tax
loopholes devised for him by Richard Valentine, an attorney
at the firm of Seward & Kissel. Valentine was a creative
genius who could be cartoonishly absentminded in his personal
dealings: He once phoned a colleague’s home and
launched into a lengthy exposition of his latest tax idea,
oblivious to the fact that he was talking to his
colleague’s five year old. It was Valentine who
realized that if managers took a share of a hedge
fund’s investment profits rather than a flat
management fee, they could be taxed at the capital gains
rate: Given the personal tax rate of the time, that could
mean handing 25 percent to Uncle Sam rather than 91 percent.
Jones duly charges his investors 20 percent of the upside,
claiming he had been inspired to do so by Mediterranean
history rather than tax law. He told people that his profit
share was modeled after Phoenician merchants, who kept a
fifth of the profits from successful voyages, distributing
the rest to their investors. Dignified by this impressive
cover story, Jones performance fee (termed a "performance
reallocation" in order to distinguish it from an ordinary
bonus that would attract normal income tax) was happily
embraced by successive generations of hedge funds.
History is quite instructive in this case that the genesis
of the performance fee never had anything to do with the
alignment of interests between the manager and the investor!
While it is not surprising that managers take what investors
have been willing to pay, the irony is that perhaps the most
economically lucrative industry in existence has actually
expanded fees over time. The additional luxury of stable
management fees has come without any compromise for investors
in the form of reduced incentives fees or hurdle rates.
I have faced a personal quandary as a result of these
critical issues. While I believe that the investment approach
hedge funds utilize is a necessary part of any investment
portfolio, I could no longer come to terms with the imbalance
between hedge fund manager compensation and the net return to
We have long been aware of the ’40 Act universe
but were skeptical that we could find good hedge fund managers
within these structures for the following reasons:
1. The assumption that any manager with true long/short
talent would refuse to accept daily liquidity and lower
2. The assumption that true hedge fund
portfolios would be unable to exist in a ’40 Act
3. The assumption that those who
couldn’t run a hedge fund defaulted to becoming
a mutual fund manager.
I believe that each of these assumptions was entirely
Assets Do Not Necessarily Correlate With
At Balter Capital we built our business focusing on
right-sized managers. We believe that unfettered asset growth
is the enemy of performance. Nothing scales indefinitely and
this reality is no more apparent than in the asset management
business. We believe that managers with an appropriate asset
base are more nimble and opportunistic than their larger peers
and are therefore could potentially generate better risk
adjusted returns over a market cycle.
One of the most frequently asked questions I receive when
discussing our strategy revolves around the dynamics of capital
raising in the hedge fund community. The core question is, "why
would a hedge fund manager charging a management fee and
incentive fee with locked up capital agree to your terms?"
It’s a good question with a great answer.
Over 3,000 hedge funds report to our firm. We have found
scores of hedge managers with strong 3 to 12 year track records
who manage relatively modest amounts of money.
Where’s the capital and why isn’t it
finding these managers?
The short form answer is that performance does not always
translate into assets under management (AUM) in the hedge fund
community. The long form answer can be summarized as
1. 80% of hedge fund assets flow to only 20%
of hedge fund managers.
2. The longer a hedge fund manager is
"small", the more likely it is they will stay small.
3. Historically non-institutional sources of
initial capital have a diminished appetite for traditional
The AIMA’s (the Alternative Investment
Management Association) 1st Quarter 2014 issue
included a short essay titled, "Brand is the New
Performance", by AIMA member Thomas Walek. He wrote the
The dichotomy between short-term performance and
long-term success is played out nearly every year in the
various hedge fund rankings. In 2013 a Bloomberg Markets
comparison of the 10 largest hedge funds in the
world versus the 10 top-performing large
hedge funds (funds with at least $1 billion
in assets) shows no overlap between the biggest and the best.
In fact, not a single one of the 10 largest hedge funds in
the world for 2013 shows up in the list of the 100
top-performing hedge funds for that same year.
The largest brand name managers will likely always be able
to set their own terms. The income received by these managers
on management fees alone is staggering. Whether the manager is
a brand name or a startup, the compensation structure is so
lucrative that the thought of reducing fees and providing more
investor friendly structures is anathema, in my opinion. Why
become investor friendly when investors are enabling the status
I am not making a broad statement that the hedge fund
industry is littered with individuals of compromised integrity,
all of whom are over-compensated. I am pointing out that hedge
fund managers are capitalists and if someone wants to invest in
their hedge fund structure, then, as a manager, they will
gladly accept that capital. It doesn’t mean the
arrangement is fair or equitable.
What’s the Solution?
If Balter Liquid Alternatives ("BLA") wanted to provide a
solution for the myriad issues we have with traditional hedge
fund structures – without sacrificing returns
– we needed to observe the competition and work on how
we could seek to improve upon current offerings. We noted that
some of our larger, well known competitors were convincing
large "brand name" hedge funds to provide a ’40
Act product for use in a multi-manager format. However, these
hedge funds would not agree to run the same portfolio they do
in their higher fee vehicles. This could mean anything from an
entirely different portfolio to one that only uses indices for
short selling. Think of the conflict of interest present in
running two portfolios, with one of those vehicles providing
significantly lower economics to the hedge fund manager. While
I saw structural benefits of the approach, I felt disadvantaged
as an investor.
The only solution that made sense to me was to have hedge
fund managers run "pari-passu" portfolios within any vehicle we
created (pari passu is a Latin phrase that means "with an equal
step" or "on equal footing"). In other words, we wanted to hire
hedge managers whose ’40 Act portfolio would be a
mirror image of their hedge fund portfolio. For those that are
invested or considering investing in a vehicle where the
manager is being chosen for their hedge fund performance
record, it only makes sense to have this requirement.
Changing Our Lens
Adjusting to our evolving views, we began to incorporate into
our analysis whether the usage of the traditional private
partnership structure for a given strategy was appropriate. The
question we ask ourselves upon any initial contact with a hedge
fund manager is whether the strategy is one that can be done in
a ’40 Act format or is a less liquid private
structure required? Based on an answer to this question, we
began to categorize hedge funds into 3 distinct buckets: liquid
alternative hedge fund strategies (the most liquid),
conventional hedge fund strategies (less liquid), and niche
hedge fund strategies (the least liquid).
Utilizing this process to conduct a full review of our
universe, we realized just how many existing hedge fund
strategies can be run within ’40 Act constraints.
Whether the manager is willing to do so is another question
entirely. Equally as important, we recognized that there are
strategies that belong in less liquid traditional structures
that were not conducive to a ’40 Act wrapper.
While investors can still quibble as to whether the fees are
appropriate, there are hedge funds that can’t be
removed from consideration altogether, just because they are
unwilling to offer daily liquidity. With that said, I do have
to consider my other options for any given strategy presented
Manufacturing the Right Products
As a firm, we are directly interacting with the hedge fund
universe on a regular basis. The investment team at Balter
Capital Management annually reviews materials on at least 750
hedge funds, conducts at least 200 manager due diligence calls
annually, and at least 50 on-site manager meetings. We have a
long history of sourcing hedge fund managers. Prior to forming
our first vehicle, we identified what we believe to be the 3
main impediments for a properly constructed AMF portfolio:
1. The potential for adverse manager selection
2. Misaligned manager
3. Over-diversification within existing
How do we attempt to overcome these identifiable impediments
as a manufacturer?
1. Adverse selection is a function of sourcing
and capital. Therefore, we needed to be
able to offer high quality managers sizable assets on Day
2. To ensure proper alignment of manager and investor
interests, the solution was requiring a pari-passu or an
"equal footing" approach. We wanted sub-advisors to provide
us with the same portfolio they use in their hedge fund
structure. This ensures the purity of the portfolio and
removes the potential for conflicts of interest.
3. Over-diversification was the easiest to solve. Simply
restrict the number of managers and be willing to limit the
scale of the product in return for a higher quality product.
We approached managers that we had come to know over the
years and discussed what we wanted to do. At the same time, we
approached our largest family office client with a proposal. We
knew how to build these vehicles correctly, but the key element
would be a large and stable capital base. Without these
elements, it would have been difficult to corral the manager
set we desired.
While we have been critical of hedge fund
manager’s fee structure, we do believe that
managers should continue to manage their limited partnership
vehicle while also sub-advising for a ’40 Act
Fund. We believe that a combination of these investment
approaches may be the formula for a successful hedge fund firm
I am more than happy to discuss the relevant aspects of the
capital that we utilized to launch our first fund and our
partnership with a leading Family Office. We expect all of our
vehicles – present and future – to have the
same characteristics that are required to build what we believe
to be the highest quality liquid alternative product family
I’m not here with a message that investing in
hedge funds is wrong. I have always firmly believed that
long/short investing is the most effective way to deploy
capital. That said, up until recently investors had no
alternative to paying high fees and enduring long lock-ups
offered by traditional hedge funds. This is no longer the case
and I believe that the flexibility that innovation offers
investors is nothing short of revolutionary.
I expect there to be significant pushback from those who
want the status quo to remain intact. Many hedge fund managers
will likely provide excuses for their inability to offer a
liquid version of their strategy based on the "sophistication"
and composition of their portfolios. Some of these managers may
be justified, but most are not. There will always be benefits
and draw-backs with each structure, but as a fiduciary we will
stand behind the approach that provides the maximum potential
benefit for each client. Alternative Mutual Funds may prove to
be part of that equation for every portfolio moving
I look forward to discussing, debating and deliberating
further as we move into a new era of hedge fund investing.
Brad Balter is the managing partner at Balter Capital
Management, a boutique hedge fund research and investment firm,
and CEO of its subsidiary, Balter Liquid Alternatives, which
manages Alternative Mutual Fund vehicles.