Rafet Eriskin of AP4, Part 2: The New Transparency
Greater transparency leads to better returns‚ whether you're dealing with the simplest fund strategies or the most complex.
In the first installment of our series on Rafet Eriskin, Senior Portfolio Manager at AP4, we observed how his method of selecting managers drives better diversification and returns. In this installment, we’ll take a look at Rafet’s unique history in getting transparency from fund managers, and how he uses that transparency to optimize his portfolio.
Transparency on the Rise
The importance of transparency for institutional investors became crystal clear with the 2008 financial crisis. When the markets sank, dragging many funds with it, quite a few investors had to face the fact that—at the most granular level—they didn’t know what was going on in their portfolios. This ignorance left them unable to properly manage risk profiles, account for position overlaps, or make accurate predictions of future returns.
Since then, the industry as a whole has seen transparency improve. Figure 1 below shows the difference in transparency between 2013 and 2017.
Figure 1 – % of HF AUM at position-level transparency vs. ticket size (USD mn) – 2013 vs. 2017
As the graph demonstrates, the larger your average stake in the hedge funds you’re invested in, the more transparency you get. This was true in 2013 and remained true in 2017. But the amount of position-level transparency you get at any level of investment increased significantly over those four years. For example, a 2017 portfolio of hedge funds with an average ticket size of $150 mn could be expected to achieve position-level transparency with 80% of its holdings, whereas a 2013 portfolio of the same size could expect just 20% position-level transparency.
Even in a climate of increased transparency, Rafet has unique access to the fund managers he works with. In fact, he has pushed the transparency agenda further than any Novus allocator clients. For Rafet, demanding transparency is a key part of executing his fiduciary responsibility of managing the retirement assets.
At one point, he demanded daily transparency from his managers, eventually even moving to intraday updates. This requirement, while extreme, succeeded in uncovering unexpected and undesirable behavior among some fund managers.
Rafet recalls one fund in particular with a long/short equity strategy, “It looked like the most vanilla strategy imaginable,” he said. “But the hourly updates revealed some options usage that we didn’t think were warranted by the investment mandate, and we took action immediately.”
The Ideal Level of Transparency
Over time, however, Rafet saw that in most cases such a high level of transparency was not only unnecessary, but potentially harmful to his portfolio. Between 2010 and 2015 he estimates that 95% of AP4’s assets were subject to daily transparency. But even at that level, not all managers are willing to provide the transparency he demanded.
“We moved to manage the risk of adverse selection bias,” Rafet said. “We thought that if we relaxed our constraints we could still get the transparency we needed without compromising our ability to succeed.”
The right type of transparency, he discovered, largely depends on the type of funds you are investing in. For a fund with low turnover, low trading activity, and a long-term investment horizon, monthly position files make more sense than daily snapshots.
“Monthly reports still allow us to analyze investment behavior and risk profile distribution with a high degree of accuracy,” Rafet said. “Moving to this model helped us expand our investment universe and improve our confidence.”
Transparency Into Sophisticated Strategies
For funds with relatively simple strategies, more transparency generates data that is easy to interpret and use. But what about funds with more complex strategies? Is transparency worth as much when you’re dealing with fund managers with esoteric strategies?
Rafet’s answer is an emphatic Yes.
“Humans have solved far more difficult problems than interpreting tricky data sets from hedge funds,” he said.
Working with Novus has given Rafet access to tools that reveal the fundamental logic behind even the most apparently complicated fund strategies. A global macro manager, for example, might provide you with 55 line items that, upon manager guidance, are all part of a single idea. A report with 550 line items might therefore contain just 10 ideas.
“When a manager is willing to provide guidance on how to bundle the many securities into ideas, their strategy and analytics are no different than a stock picker,” says Rafet.
Novus specializes in translating complex, large data sets into easily understandable and highly actionable analysis. “It didn’t really make sense for us to spend our time doing the sort of programming or analysis necessary to analyze the data we were getting from fund managers,” Rafet said. “Working with Novus has allowed us to spend our time putting the data to use to manage downside and generate upside in our portfolio.”
In the next installment of our series of posts on Rafet and AP4, we’ll talk about when it makes sense to build systems externally rather than internally, and the impact such a move can have on your organization.