The Truth About Hedge Fund Marketing
How do the best hedge funds showcase their skill sets? Discover how rigorous quantitative techniques are used to build compelling narratives.
Pedigree and branding are important elements for hedge fund marketing, but reputation alone is not sufficient to win an allocation from a savvy investor. This is well known in the hedge fund world, which is why managers will often attempt to highlight their prowess through semi-quantitative statements like the following:
"We deliver superior risk-adjusted returns"
"We generate diversified alpha”
“We excel at portfolio management”
These are some of the primary assertions hedge funds make, and they do so because descriptive statistics such as returns, beta, correlation, and volatility are easy metrics for potential investors to digest and even easier for managers to calculate. However, the reality is systematic risk or manager skill can’t be quantified with top-level returns alone. At SEI Novus, we help our manager clients create potent messaging that reflects their true investing expertise. Quantifying skill is a lot more powerful versus talking about skills. And at the end of the day, telling a powerful story through deep-dive analytics is what differentiates the best hedge funds.
Let’s take each statement, and investigate how to actually substantiate each.
“We Deliver Superior Risk-Adjusted Returns”
Demonstrating this point is the number one objective for managers when it comes to hedge fund marketing, but what does it really mean, and how can it be proven? Managers may talk about VaR or a variety of other volatility-based descriptive statistics. They can also compare their portfolio’s historical returns to a benchmark or highlight their Sharpe and Sortino ratios. While these statistics can be useful, the reality is they become borderline meaningless when markets implode and cross asset correlations converge towards 1.
A better approach is to paint a broad picture by highlighting dynamic risk mitigation abilities such as exposure management skill. The willingness to move exposures around might go against conventional wisdom, as it often results in very high (or low) betas over short periods. However, it is possible to prove that this manipulation of exposure has allowed a manager to maximize returns during strong equity market environments, while protecting value during downturns. In doing so, the narrative around how risk is managed and where returns come from becomes much richer. There are a few ways to accomplish this—the first is by showcasing actual returns vs. theoretical returns keeping the portfolio’s exposure constant.
Figure 1 effectively showcases the value created through market timing and willingness to move exposures. This skill set should also translate directly to an upside / downside capture ratio that is above 1.
Another effective way to highlight risk-adjusted performance is to isolate the spread between contribution across long and short exposure within a category such as a sector. Managers who deploy low net exposure within a sector should seek to demonstrate that on a per dollar basis their longs tend to outperform. Let’s take a sector that has experienced serious disruption over the last few years, such as communication services.
This highlights the ability to identify the relative value of securities within a specific category. It also demonstrates a focus on maximizing upside while minimizing downside.
In general, standalone risk metrics such as betas and correlations can be manipulated through the smoothing effect of historical averages or even window dressed by screening long and short bets for beta before investing.
Concerns evaporate when you can present a series of key data points that demonstrate why returns have been superior on a risk-adjusted basis.
“We Generate Diversified Alpha”
If an investor asks “How much alpha have you generated?” the typical manager would likely present the classic excess return statistic which combines beta, a risk-free rate, and a benchmark’s return over a period. But what if the question becomes more nuanced, such as “Where does your alpha come from, and how do you measure it?” A question like this requires a different approach, especially for a diversified portfolio with exposures that shift over time.
The ideal tool for answering this sort of question is the Novus Framework. By running an opportunity cost style analysis, investors can break down contribution into active and passive components. This analysis isolates the impact of market and sector exposures as the passive contribution, while identifying security outperformance and the impact of trading as the active contribution. The chart below shows how this can be used to demonstrate at a category level (sector level, in this case) exactly how much alpha was captured and when it was accumulated.
Why is this not a standard feature in hedge fund marketing materials? The simple answer is that doing so is difficult without the right tools. It requires daily position level P&L and exposures, as well as a market and category specific benchmark for each position. These are used to calculate daily alpha, which is then grouped by category and compounded over time.
This analysis can be performed at many levels, linking the most appropriate benchmark to each bucket within your chosen category. Whether you want to show sectors, market caps, geographies, or an entirely custom group of position tags, the result is a more intricate method of quantifying alpha and identifying underlying pockets of outperformance.
“We Excel at Portfolio Management”
Security selection is not the only tool in a manager’s tool kit when it comes to driving returns. There are a variety of crucial decisions to be made after the investment committee agrees to add a security to the portfolio. Managers know this but often have a hard time articulating what sort of portfolio management decisions they’ve made and the impact they’ve had. A manager could point to a few levers to strengthen a statement like “We Excel at Portfolio Management.”
One portfolio management lever is trading. If you can prove that the timing around position entries, exits, or rebalancing actually added value, you have an opportunity to tout a hard-to-come-by skill set. There are a few ways to do this. First, start with highlighting a stock’s price return vs. the manager’s position level ROIC for the same security. Bundled into any delta that emerges is a cumulative product representing when investments were made and how they captured value or protected from downside loss. Next, look at the portfolio level to show actual returns compared to a version of the fund that had no turnover on a daily or monthly basis.
Another key decision managers make is how to size their positions. Some companies might not get the “high-conviction” stamp, in which case they end up as small research names that are often less than 1% of total exposure. Conversely, a high confidence position might be sized up to be a much larger bet than other names. Demonstrating that these decisions lead to positive outcomes is essential. As with Exposure Management and Trading Acumen, this skill can be highlighted by comparing actual returns to a hypothetical portfolio, in this case with the comparison made to a portfolio where all positions are equally sized.
The above chart can be effectively combined with a review of how ROIC changes as you move up the conviction spectrum, ideally showcasing that the biggest bets tend to be the best picks. Crucially, this sort of analysis must take into account the organic growth of positions to avoid a self-fulfilling prophecy bias. This can be achieved by bucketing positions by average position size or their initial position size at entry.
Surfacing a Win-Loss-Ratio can be used to blend these last two concepts together. Dividing the average contribution from winners by the average detraction of losers over a period helps to quantify the efficacy of how position sizing and trade timing interact. The below chart reflects this idea.
Differentiating Hedge Fund Marketing
We've successfully explored a few examples of how sweeping statements could benefit from more quantitative rigor. Certainly, this list is not exhaustive. For example, if a manager states that they have identified a “unique and scalable opportunity set,” why not drive the point home by showcasing uniqueness relative to peers, crowdedness at the fund and position level, exposure by ESG scores, or specific scalability metrics to prove their strategy can absorb additional capital?
After a decade and a half serving both asset owners and asset managers, our observation is that sophisticated quantitative analyses make for the most compelling narratives, and are the primary way to break out of the crowd. When such rigor is applied, managers often even learn something about themselves and their portfolios in the process.
And speaking of showcasing—a compelling narrative requires a compelling medium. Unfortunately, most investors still rely on the classic PDF to tell their story, forcing our industry to cope with inflexible user experiences with no opportunities to interact or engage. SEI Novus designed the Snapshot format to help investor relations practitioners craft digitally rich experiences for stakeholders.
A Snapshot is a curated view of a Novus Dashboard, which features analytics from The Novus Platform. This format is more secure and intriguing than a PDF, and digitally shareable via link (including with non-Novus users). Snapshot owners can set permission levels and are then provided with metrics on who is viewing and when. Check out this Snapshot example to see for yourself how SEI Novus clients are standing out by crafting next-gen hedge fund marketing experiences.
And if you want to see details on how one of our manager clients used The Novus Platform to improve investor relations and grow their fund, take a look at our recent Incline Global Case Study.