Book review: Ted Seides – “So you want to start a Hedge Fund”
Ted Seides, the author of this book came to some fame because of his 2007 bet with W. Buffett where he claimed that he could pick 5 (hedge) fund-of-fund managers which would outperform the S&P 500 over the next 10 years. He already admitted to have lost before the 10 years end.
By coincidence I found out that he wrote a book on how to start a hedge fund in 2015/2016.
The book itself is written both, from the perspective of the aspiring hedge fund startup as well as from the perspective of the “allocator”, usually some pension plan or endowment officer (or consultant) who decides which hedge fund gets money from an institution.
The book starts with a lot of famous names (Swensen, Ellis etc.) that have “influenced” the author and maybe also to make him appear more important.
Trying to summarize his major points of what makes a startup hedge fund in the US successful (my summary):
- start with very good performance
- then market the hell out of that performance
- continue to deliver great performance
- never stop marketing
- Don’t underperform
- look at your fund primarily as a “business”
- “Allocators” are very important people. Don’t waste their time as a hedge fund manager start-up
The author gives a few other tips, such as not keeping a large cash position when starting, avoiding “co-manager” structures and use more focused strategies because fully flexible strategies are difficult to explain to the allocator’s clients.
To be honest,I think I have oversimplified the points from the book, but in my opinion the book is a good summary what went wrong in the Hedge fund industry in general and the under appreciated impact of the “allocators”.
Seeing a Hedge Fund primarily as a business
The author even encourages founders to see starting a fund mainly as a business. In my opinion this creates a myriad of problems. Running it as a business, you want to increase your revenues as quickly as possible which means you need to show positive performance as quickly as possible. This in turn in my opinion leads to momentum chasing strategies with the well-known “hedge fund hotel” positions. In the long run, this behaviour is clearly not the best strategy for the actual clients. In such an environment it is very difficult to run contrarian strategies as you need to show positive alpha all the time. In my opinion, many HF managers who start succesfully with a certain “edge” lose this edge quickly when AuM increase. As assets still tend to be quite sticky, the hedge fund manager will still do Ok (with fees) compared to his clients.
Allocators as additional resource of momentum
After reading the book I realized that I didn’t really factored in the role of allocators in my understanding of capital markets. In the same way as Hedge fund managers are chasing hot stocks, allocators are chasing hot Hedge Fund managers. This basically then produces a “double whammy” to the underlying momentum stocks. On a micro basis this clearly explains why some hot stocks go so far above any reasonable valuation as money keeps pouring into such stocks, both via individual HF managers as well as increasing allocations from allocators.
“Allocators” are in my opinion an under researched aspect of the capital market. Having had such a role myself in the past I can admit, that allocation of investment mandates is important but more often than not, the decision makers (and the allocators themselves) are not really qualified.
There are clearly exceptions such as David Swensen and a few other US university endowments, but in my experience, allocators are often people who came into that role by chance or didn’t make it into a “real” asset management role. Many allocators are simple “performance chasers”, trying to put money into the best performing asset managers without really understanding what is driving returns.
If I were a allocator these days, my major focus would be if the fund manager is interested in making good returns or increasing his assets. I would stay completely clear of asset gatherers and invest only into funds which focus 100% on long-term performance. Those guy are not easy to find but worth the efforts in my opinion.
All in all, I would recommend the book to anyone who wants to get a little insight how Hedge Fund managers and allocators are “ticking”, but I am not sure if the book is really useful to start a fund. Maybe for the US market, but I am not so sure about this.
Finally a few points on Seides’ comments on why he lost the bet:
His main argument is that the last 10 years were just a “bad luck period” for Hedge funds and for sure, the next 10 years would much better. I highly doubt this (or even call this BS). The major reasons in my opinion are clearly: Fees and the issues described above with regard to “herding”, “momentum chasing” and the incentive to gather assets.
I have just listened to Barry Reitholtz interview with Ed Hyman, Chairman of Evercore ISI and Vice Chairman of Evercore. More importantly he is head of Evercore ISI’s Economic Research Team and for the past 41 years has been ranked by the Institutional Investor poll of investors for Economics, as # 1 for 36 years.
I liked him and he mentioned ISI, which he founded, sort of went public by being acquired by Evercore. These guys are the elite and own a third of the company and they have something like a lock up period of five years. They deliver strong returns, buy back shares to compensate for options.
You should take a look at them:
I haven’t looked very deeply into the stock, but I think it should be at the very least interesting.
I personally know Ted, and also guys at the Yale endowment. While they are nice people, I do not understand why anyone would care for their views on anything. The returns of Yale endowment have been lousy given the exposure to venture capital, private equity, and opportunities available in emerging markets in the past couple of decades. Heck, they barely outperformed a 30 year Treasury. As for Ted, well, what is the record at Protege? The fact that the funds he chose trailed so badly behind S&P 500 speaks for itself in my opinion.
Thus, it baffles me as to why anyone pays attention to their words. As for why on average hedge funds underperform, well it used to be that only true superstars – Soros/Rogers, Steinhardt, Cohen ran funds. Today, any punk with ten year experience at Goldman feels entitled to run one. Talent is worse in my opinion, and most hedge fund guys I know either do not work hard enough or are not smart enough to overcome the tremendous drag of high fees.
Thanks for the comment. I don’t think that Yale’s returns are that bad, but I didn’t do a deep dive.
According to Yales endowment homepage:
During the decade ending June 30, 2016, Yale’s investment program added $7.0 billion of value relative to the results of the mean endowment. The University’s 20-year market-leading return of 12.6 percent per annum produced $22.1 billion in relative value. Over the past 30 years, Yale’s investments have returned an unparalleled 12.9 percent per annum, adding $26.6 billion in value relative to the Cambridge mean.
Thirty years ago, a thirty year US Bond would have yielded about 15%.
But that was literally the height of the crisis and I think David Swansons performance is out of question.
Who cares about the mean endowment? That’s like comparing yourself to a bunch of idiots. All it means is that the average endowment did a terrible job, and Yale did a poor, but not a terrible job.
Investors do not compare themselves to other investors, they compare themselves to indices. The proper comparison is to S&P 500, adjusted for the greater risk the endowment took by investing in venture capital, real estate and private equity. After all, private equity is a leveraged bet on the stock market.
Given the choices available to Yale: farmland, timber, commercial real estate, private equity, emerging and frontier markets, venture capital, distressed debt, including access to the best managers that most of us cannot even give money to if we wanted, the performance of Yale endowment is quite poor.
You claim that Swensen’s performance is out of question. Why? If you just bought shares of Nestle 30 years ago for instance, you would have made 14% per annum. Phillip Morris, a US tobacco giant returned around 20% per annum over the past 30 years, and the list goes on and on. Investors in distressed debt certainly did better than 12.9% per annum over the past 30 years, and so did investors in top tier venture capital and private equity did better as well. Investors in commercial real estate in the US did much better than 12.9% per annum over the past 30 years as well. Oh, and do not forget, Yale endowment used leverage in years past, not just at investment level (private equity), but at endowment level. That should have boosted returns even more.
thank you for the comment.
One remarr: A “capital allocator” in a company is somrthing very different form a guy who allocates investment money into different hedge funds.
I agree thet “company capital allocators” can add tremendous amount of value. “Investment allocators” in my experience rarely do so,
Totally agree. In fact there are in the USA some pension schemes (also municipalities) that employ hedge funds because this allows them to calculate with higher expected return and thus they can get along less capital reserves. No matter if these guyes perform or not.
I get most of these ideas from Barry Reitholtz’s MIB podcast, which is just tremendeous.
your picture of Ted Seides seems quite negative, but I guess he has also “a positive side”. For example in his podcast “Capital Allocators”
he talks with guests a lot of sensible stuff.
I am certainly just as critical about the hedge fund industry as you, but lets be honest, in the end it is a business…
Furthermoore the 0.1% of strong hedge funds don’t need that marketing stuff and attract funds with performance, some of them have even a fee structure with a hurdle rate of some % above index similar to the early Buffett partnership.
And there is certainly another point to Seides’ bet with Buffett in connection to the rise of ETFs. There is some controversy about the “dumb money” pooring into ETFs which favors large caps regardless of valuation especially since the S&P 500 is market cap weighted. For example weigthing the index in any other way performs better. You could also weigh it according to any other metric, reverse that metric and both outperform. That is because marcet cap is cyclical.
Some point about Buffett that I think is often not seen. He is and has been the bull on America. But Americas bull market in the last century is almost an anomally. It has been the economic power house and elading the world with regards to economy and the dollar.
Of course that takes nothing away from Buffett.
A point about capital allocation: This is huge. Buffett is an allocator. The Outsiders (https://www.amazon.de/Outsiders-Unconventional-Radically-Rational-Blueprint/dp/1422162672) CEOs are phenomenal allocators and would rather have depressed stock prices and buy back piles of shares to deliver returns afterwards…
Capital allocation becomes especially important for really long term CEOs.
By the way, you are the #1 investing blog out there!