How Investors Choose Hedge Funds

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How Investors ChooseHedge FundsAdvent Industry IntelligenceResults of the Advent HedgeFund Investor SurveyAugust 2013Key Findings1. Investors say they often see managerswho cannot clearly differentiate theirstrategy2. Many investors decide within the firsthalf hour of a pitch whether or not tocontinue3. Operational quality is one of themost important considerations wheninvestors and consultants evaluate ahedge fund4. Large institutional investors are notlikely to choose hedge funds that donot have a system of record in place fortheir investment process5. Three out of four investors want to seeresearch management systems in placeat funds they are consideringWith 10,000 hedge funds competingfor the attention of investors, raisingcapital has never been more competitive.Demonstrating an edge is increasinglydifficult in an environment whereovercapacity means opportunities toproduce alpha are being crowded out.Despite institutional commitmentto hedge funds, recent widespreadunderperformance has many investorsin a more skeptical frame of mind. Theintroduction of advertising to whathas historically been a word-of-mouthbusiness may further muddle messages.And success does not necessarily begetsuccess. Because hedge funds are oftenthought to be most successful beforebecoming too large to effectively executetheir strategy, investors tend to hunt foremerging managers. The playing field iswide open.Investors and consultants all have theirown ways of meeting, evaluating, andchoosing the hedge funds with whom theywant to invest. There is no prescriptionfor success, but hedge fund managerswho take the time to better understandindustry best practices and the needs oftheir prospective investors will be severalsteps ahead of their less well informedcompetitors.

2 How Investors Choose Hedge FundsHow hedge fund investors andconsultants evaluate and choosefunds.% of respondentsAdvent surveyed hedge fund investors and consultantsin early 2013 on how they evaluate and choose hedgefunds. A total of 152 responses came from investmentadvisors, funds of hedge funds, family offices,foundations, endowments, and pension plans. Assetsunder management ranged from less than 100million to more than 50 billion. Individuals respondingto the survey were typically employed in investment oroperations functions.Hedge fund managers who take thetime to better understand industrybest practices and the needs of theirprospective investors will be severalsteps ahead.29.6%31.6% Consultant Investment Manager Fund of Funds Family Office Foundation of Endowment6.6%15.8%6.6% Other Institution9.9%Advent surveyed hedge fund investorsand consultants in early 2013 on how theyevaluate and choose hedge fund managers.In this brutally competitive environment,the 150 responses to the survey shedlight not only on what investors look forwhen making new hedge fund investments,but also what stumbling blocks fundmanagers should take pains to avoid asthey make their pitch.Connecting with CapitalIt used to be that hedge funds couldpick and choose investors like high endnightclubs selecting the most desirableclientele. The velvet rope is now gone, andinvestors are in the enviable position ofbeing able to invest with managers of theirchoosing. The new paradigm is not withoutits disadvantages, the most obvious beingthe question of how to find the rightmanager in the first place.Personal networks remain the mostuseful channels for sourcing hedge fundmanagers according to most investorsand consultants (Figure 1). It may seemcounterintuitive to rely on the relativelylimited perspectives available amongfriends and acquaintances, but the trustembedded in such relationships is valuable.Market reputation is also widely seen as auseful channel. If managers wish to be topof mind on the cocktail circuit, they shouldconsider a range of promotional activitiesthat could raise their profile. PR strategies,sponsorships, and thought leadershipcampaigns can all create buzz.Manager databases present a morestraightforward way of getting investorsto take notice. Databases from firms likeHFR, HFI, and Morningstar are all seen asuseful channels, with consultants indicatingthat they are particularly avid users.Hedge fund managers using third-partymarketing firms may not want to makethem a centerpiece of their distributionstrategy. Only one in four surveyrespondents view these firms as animportant way for them to source hedgefund managers.Conferences can play an important rolein connecting funds to capital, but fundmanagers will not want to limit theirfundraising strategies to the conferencecircuit. Many investors participating inthe survey made a point of saying they donot often attend or source managers atconferences. Foundations and endowmentsare the least likely to attend conferences,while family offices, investment advisors,and consultants are the most likely tofind conferences useful in identifyinghedge fund managers. Events sponsoredby GAIM and Goldman Sachs are themost likely to be attended by investorssearching for new hedge funds. Otherconferences of note include those hostedby AlphaMetrix, Bloomberg, InstitutionalInvestor, HedgeWorld, Morgan Stanley, andMorningstar.

Advent Industry Intelligence 3Personal Network71.2%ReputationFigure 153.8%Fund manager databasesWhat are the three mostuseful channels for sourcinghedge funds?Consultant “gatekeepers”% of respondentsConferences45.5%36.4%PB cap intro session31.1%28.8%Third-party marketers25.8%PB index list7.6%0%Long-winded presentations are acommon problem.Two thirds of all investors andconsultants decide within the firsthalf hour of a pitch whether or notthey intend to continue.20%Making the PitchIntroductions are only the beginning,leading to pitch presentations that canoften make or break budding relationshipsbetween investors and fund managers.Consultants and most types of investorshear fewer than ten presentations aweek, underscoring the fact that pitchopportunities should not be taken lightly(Figure 2). Family offices tend to attendmore pitch presentations than otherinvestors, a fact that fund managers shouldbe aware of if raising capital from thissegment of the market.There is broad consensus that pitchpresentations are best when 11 to 30slides in length (Figure 3). Fewer than20 slides are preferable. Consultants inparticular like concise decks. Pensionfunds, on the other hand, are more patient,with almost half saying 21 or more slidesare appropriate.About two thirds of all investors andconsultants decide within the first halfhour of a pitch whether or not they intendto continue evaluating a fund (Figure 4).Of these, one in four makes a decisionwithin the first ten minutes. Family offices,which see the most pitches, tend to reacha decision the most rapidly. FoHFs andinvestment advisors are also quick topull the trigger. Endowments and pensionplans tend to take the longest time makingdecisions, with more than a third waitinguntil after the initial meeting. Whether or40%60%80%100%not they change the actual length of theirdecks, fund managers may want to pacetheir presentations according to theiraudience.Presentation MistakesOverly complex or long-windedpresentations are a problem, but blithelyabridging a presentation can lead toother problems. Half of all investors andconsultants say it is all too common fordata to be presented without sufficientexplanation.Despite strides in the right directionover the past few years, transparency ingeneral remains a problem. More thanhalf of those in the survey say there is notenough of it in the pitches they attend.Transparent investment processes arelikely to score points for managers makinga pitch. Research management systemsmay be used by astute managers wishingto illuminate some of the more complexaspects of their investment processes.Fund managers will be even moresuccessful if they take the time to doa little homework on their audience.Highlighting an approach that is probablyan artifact of an earlier time when fundmanagers held all the cards, more thanfour out of ten investors say too manymanagers do not know enough about theirneeds.

4 How Investors Choose Hedge FundsFigure 210 or less per weekHow many pitches do you attend inperson or via phone/online?11 to 20 per week% of respondents21 to 30 per week31 or more per week80.1%15.9%2.6%1.3%0%Figure 331-40 slidesHow many slides do the mostsuccessful pitch books contain?21-30 slides% of respondents11-20 slides% of 0%After how many minutes into aninitial pitch presentation do youdecide whether or not to continueevaluating a hedge fund?40%3.8% 10 slidesFigure 420%20%After the meeting40%60%22.1%31 to 60 minutes11.5%11 to 30 minutes48.1%Less than 10 minutes18.3%0%20%40%60%

Advent Industry Intelligence 5Unclear strategyFigure 575.8%Long-windedWhat are the top three mistakesthat funds make when pitching toprospective investors?Lacking transparency% of respondentsDidn’t know enough about61.4%52.3%Too much unexplained49.2%40.9%Not energetic20.5%0%Three out of four investors say theyall too often see presentations bymanagers who are unable to clearlydifferentiate their strategy.20%The most common mistake? Three outof four investors say they often seepresentations by managers who are unableto clearly differentiate their strategy oreffectively communicate the advantagesof their fund (Figure 5). This is a call toaction for hedge fund managers. Investorswant to know how you plan to invest theircapital, but they also need to know howyour approach is distinct and superiorto the thousands of other investmentstrategies available to them.Evaluation CriteriaHow do investors evaluate funds in whichthey are interested? Risk-adjusted returnsare commonly used as an early screen.Many also look at volatility statistics.Liquidity terms became another commoncriterion in the wake of the financial crisis.Beyond these commonly used measures,investors are most likely to look at thecaliber and integrity of the professionalsrunning a fund (Figure 6).40%60%80%100%the apparently insatiable appetite amonginvestors for more transparency may beheartened by the tradeoff; fewer investorsare looking for investment teams to bereadily accessible.Investment consultants are more likelyto appreciate demonstrably efficientand repeatable processes, once againunderscoring the benefits of systematicapproaches and tools like researchmanagement systems. Consultants alsoplace slightly more emphasis on duediligence, saying that a manager witha proven ability to perform exhaustiveresearch would boost their confidence(Figure 7).Investors, on the other hand, are morelikely to highlight transparency in theresearch process. Half say it boosts theirconfidence. Some types of investors aremore likely to need hand holding. Familyoffices, for example, are the most likely tosay that better reporting capabilities wouldinspire confidence in a manager.Transparent and Robust OpsMission Critical SystemsHighlighting the growinginstitutionalization of the business,investors say the quality of fundoperations is the next most importantevaluation criteria. Over half of thoseresponding to the survey say transparentreporting is one of their top threeevaluation criteria. Managers lamentingSupply and demand dynamics have shiftedand investors are in the driver’s seat. Acharming personality and a black boxapproach is no guarantee when raisingcapital. With an increasingly attentiveand demanding audience, hedge fundmanagers need to be able to demonstratea differentiated strategy, solid operation

6 How Investors Choose Hedge FundsIntegrity/caliber of people66.7%Quality of operationFigure 6What three characteristics are mostimportant to you when evaluating afund (beyond risk/return, volatilityand liquidity)?61.4%Transparency of reporting52.3%Risk management43.9%Differentiated strategy37.1%Accessibiity of key people17.4%% of respondentsExisting relationships12.1%Background check9.1%0%Figure 7What factors would improve yourconfidence as an investor mostbeyond performance?% of respondents20%40%More transparent processBetter reporting% of respondents100%80%100%80%100%38.6%Exhaustive due diligence34.1%20%40%Very high importanceHow important is it for funds to havea portfolio management, reportingand accounting system in place?80%47.7%0%Figure 860%60%49.6%High importance29.8%Important17.4%Low importance0.8%Very low importance0.8%0%20%40%60%

Advent Industry Intelligence 7Figure 9How important is it for managersto have a system of record for theirresearch and investment decisionmaking process?% of respondentsVery high importance28.1%High importance38.0%Important25.6%Low importanceVery low importance6.6%0.8%0%It is critical that hedge fundmanagers have a system of record inplace for their investment process.20%backbone, effective reporting capabilities,and thorough risk management.A well-rounded operation requires robusttechnical underpinnings. Investors andconsultants are almost unanimous insaying they would like to see portfoliomanagement, reporting, and accountingsystems at hedge funds where theyconsider investing their capital (Figure 8).They are also inclined to agree it is criticalthat hedge fund managers have a systemof record in place for their investmentprocess (Figure 9). This is a particularlycritical issue among larger organizations.Not a single investor administering morethan 5 billion says that a system of recordis of low importance, and all of those with 50 billion or more say it is of “high” or“very high” importance.Managing ResearchResearch management systems (RMS) arealso important. A research paper releasedby Advent in 2010 (Bringing Order toChaos: Managing Investment Researchin an Era of Change) highlighted someof the challenges confronting managersfaced with an unprecedented volume ofinformation. A thorough study of researchprocesses found that two thirds ofinvestment professionals were overloadedby information and concluded that:“Despite being at the very core of mostorganizations’ value proposition, research40%60%80%100%often remains scattered, disorganized, andlargely unmanaged. The costs cannot beoverstated. Intellectual capital evaporates.Institutional memory is constrained.Collaboration becomes more difficult. Timeand expensive resources are wasted.”Effectively integrating and leveragingmeeting notes, expert commentary, sellside research, market data, and internallydeveloped models is challenging at thebest of times. Increasingly demandinginvestors and regulators make the casefor an RMS even more compelling. It is nowonder that three out of four respondentslike to see such systems in place (Figure10). Systems from external vendors arepreferred, particularly among consultantsand larger investors.Hitting the Right NotesToday’s hedge fund investors are nodifferent from their predecessors in thatmost are simply looking for exceptionallytalented teams who can deliver superiorrisk-adjusted returns. How they go aboutfinding, evaluating, and choosing theseteams, on the other hand, is worlds apartfrom the relatively casual approachesemployed in the past.Personalities and investment strategiesmay or may not resonate, but in thisultra-competitive market, institutionalinvestors have raised the bar and hedgefund managers need to step up their

8 How Investors Choose Hedge FundsFigure 10Which type of research managementsystem (RMS) or support doyou prefer to see at funds forprospective investment?% of respondentsVendor-based RMS38.0%Internally developed RMS36.4%Email/shared drive14.0%Don’t know what RMS is11.6%0%Increasingly demanding investorsand regulators make the case for aresearch management system evenmore compelling20%game in order to meet heightenedexpectations. Understanding the needs oftheir prospective investors, articulatinga strategic edge, and having theappropriate systems in place should help indistinguishing themselves in a crowded andcompetitive, and challenging market.40%60%80%100%Who We AreOver the last 30 years of industry change,our core mission to help our clients focuson their unique strategies and deliverexceptional investor service has neverwavered. With unparalleled precision andahead-of-the-curve solutions, we’ve helpedover 4,500 firms in over 60 countries—from established global institutions tosmall start-up practices—to grow theirbusiness and thrive. Advent technologyhelps firms minimize risk, work togetherseamlessly, and discover new opportunitiesin a constantly evolving world. Togetherwith our clients, we are shaping the futureof investment management. For moreinformation on Advent products communication is provided by Advent Software, Inc. (“Advent”) for informational purposes only and should not be construed as or relied on in lieu of, and does not constitute, legal adviceon any matter whatsoever discussed herein. Advent shall have no liability in connection with this communication or any reliance thereon.Advent Software, Inc.[HQ] 600 Townsend Street, San Francisco, CA94103 / PH 1 800 727 0605[NY] 1114 Avenue of the Americas, New York, NY10036 / PH 1 212 398 1188[HK] Suite 3118–3120, Level 31, EntertainmentBuilding, 30 Queen’s Road, Central, Hong Kong /PH 852 3103 1000[UK] 127–133 Charing Cross Road, London WC2H0EW, UK / PH 44 20 7631 9240Join the conversationCopyright 2014 Advent Software, Inc. All rights reserved.Advent is a registered trademark of Advent Software,Inc. All other products or services mentioned herein aretrademarks of their respective companies. Informationsubject to change without notice. Printed on recycled paper.IIHFIS0114

How hedge fund investors and consultants evaluate and choose funds. % of respondents Advent surveyed hedge fund investors and consultants in early 2013 on how they evaluate and choose hedge funds. A total of 152 responses came from investment advisors, funds of hedge funds, family of

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