These days, investors are demanding more transparency into their investments. But what do they do with the data once they have it?
The trend of increased transparency in alternative investments is building momentum. Investors and prospects looking for the right fit for their portfolio value transparency second only to low fees. But what are investors doing with all the data that managers (reluctantly) hand over? In working with dozens of managers and asset owners, we found that managers’ fears of transgressions against them are never justified. Asset owners—at least the hundred or so that we work with—don’t steal, trade on, or pass on manager data. They don’t talk about manager short positions either. Doing so would actually hurt their interests, reputationally and directly in terms of their investments. But a few do keep a little data secret—something that only comes out in cocktail conversation.
The overwhelming majority of hedge fund managers (80%, as our prior study found) don’t share their full portfolios with investors. Managers are reticent to share their secret sauce. The rationale being that if their positions passed to competitors, their process could be emulated or even reverse-engineered. Their apprehensions are even more intense when it comes to short positions—where a manager could fall victim to a deliberate short squeeze engineered by other hedge fund managers.
In our experience, this fear has never been realized. Every single investor that we work with has only two real uses for manager data (discussed in detail below). And of course, the intent is noble and actually good for both them and the manager.
There are some managers who prefer operating under the radar and rarely talk to anyone, relying on a certain air of mystery to attract investor interest. Building trust through openness and transparency, however, often leads to longer, more meaningful partnerships. Managers who rely on mystery to generate interest may find retaining assets difficult in tough times. In today’s asset raising environment it does not pay to be secretive.
With that said, let’s talk about the two common uses of hedge fund transparency data.
Many asset owners, such as foundations and pensions, must adhere to specific investment guidelines. Thus, their primary use for manager data is aggregation across their entire portfolio. They must monitor their exposures and risks across various dimensions like geography, sectors, and asset classes to ensure they stay within guidelines. This is easier said than done, given managers provide data at varying levels of transparency. As aforementioned, few managers provide positions, but most do provide exposure breakdown by asset class and other detail in their risk reports. Some allocators tap technology providers like Novus to help systematically aggregate and normalize data across their portfolios, but others do this work as well, mostly in excel.
Taking this a step further, some investors use this information to actively adjust their positioning. They may find, through aggregation of their manager data, that they have high exposure to a certain risk factor they want to avoid.
This could be—for example—a concentrated position in a single stock. While one large position from a single manager isn’t a concern, it becomes an issue if multiple managers have the same exact large position. Importantly, no single manager knows the extent of their client’s concentration. We’ve seen cases where large investors with over forty managers in their portfolio carry a 7% position in a single security on a look-though basis. Our allocator clients run an analysis called Novus Overlap to screen for this particular risk factor. Managers, who represent the other half of our client base, also use the overlap analysis—in addition to tracking the most crowded hedge fund securities through Novus—to manage this risk before it becomes a problem.
Investors—pensions, fund of funds, wealth funds, and endowments—try to avoid surprises. Especially the bad kind. They don’t necessarily want to avoid all downside volatility, but they want to minimize unexpected loss. Investors we work with go to great lengths to understand their managers’ investment process and even estimate their performance on a regular basis. In the short term, they strive to understand how a manager is fairing in light of a certain event—like a biotech crash, emerging markets rally, or a global energy sell-off. It’s okay for a manager to be down when it’s expected based on the investor’s portfolio models.
Portfolio positions are great for this sort of analysis, but even tracking a manager’s broad exposures from a risk report goes a long way. In this regard, it’s actually beneficial for managers to provide good transparency. An investor who understands (and even predicts) the source of a drawdown is more likely to stick it out than one who’s blindsided by even a modest loss.
There’s a longer term implication here as well, and it’s equally important. Investors use transparency to evaluate the manager’s ability to create alpha, rebound from a drawdown, and sustain attractive returns in light of shifting styles.
For this sort of work, our clients use a wealth of analytics tools on the Novus platform or invest heavily in home-grown technology. Investors scrutinize alpha generated over time in a particular market, monitor style drift like a shift up the market capitalization spectrum, and study investment metrics like batting averages and win/loss ratios in context of their other managers.
All of this is good for the investor and manager alike. At the end of the day, investors view managers as partners in their goal of achieving attractive, risk-adjusted returns. As for the managers, they see their investors as partners for entrusting them with their capital. A partnership grounded in understanding and transparency is always more sustainable then one shrouded in mystery and based on guesswork.
The Dirty Secret
So what’s the worst managers should (reasonably) fear when an investor requests more transparency? A friend of mine who runs a sizable family office and invests in dozens of managers has, on occasion, mentioned that his managers and prospective funds are more and more open to sharing detailed, timely transparency with his small team. When I asked him what they did with that influx of data, he let me in on a little secret under the condition of anonymity. To be fair, their particular case is very different from most allocators, for whom the data helps with both of the above mentioned activities. For his lean team though, the answer was surprising. What do they ultimately do with their managers’ risk data?
For more of our research on investor transparency, take a look at the articles below.Published on March 8, 2017