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How to Evaluate an Alternative Investment Manager
Jon Stein is the CEO and founder of Kettera Strategies, which operates the Hydra manager platform, based in Chicago, Illinois. The Hydra platform is an online-based marketplace for alternative investment programs, currently focusing more on global macro, managed futures, FX, and commodities strategies.
Q: With so many managers out there, how do you pre-screen the ones Hydra is interested in? We initially look at four things: The instruments traded; an indication of the manager’s competence in their type of strategy; the manager’s performance that indicates its competence; and a lack of material regulatory or reputational issues.
Q: You say “the instruments traded.” What do you mean? When screening a manager for our Hydra platform our practice is to consider strategies that transact in markets and instruments that can be priced independently, on a frequent basis, and with reliable pricing sources. This means instruments that include exchange-traded derivatives, liquid bank-traded derivatives, and cash or cash-equivalents.
Q: So essentially futures and OTC bank derivatives – no equities or cash bonds? Yes, our current focus is on managers that trade futures and OTC bank derivatives.
Q: And what types of strategies does this result in for the Hydra platform? It’s a broad and deep range of strategies that we refer to as “Tactical Strategies”. Here’s how we typically list them out:
Global Macro Strategies
Systematic Trend Strategies
Currency Only Strategies
Commodities Only Strategies
Q: In essence, your platform recruits only CTAs. Not exactly. Yes, technically all of the managers on the US platform are registered with the CFTC as CTAs. However, some investors confuse the label of CTA with only one strategy’s style. It’s like saying “all runners are athletes so all athletes must be runners.” We prefer to use the term “Tactical Strategies” to cover global macro, managed futures, FX trading, discretionary commodities, and volatility strategies.
Q: But doesn’t “Tactical” often means something else in the hedge fund world? That may be the case, but the point is the variety of strategies available on the platform allow investors to allocate to strategies that help them diversify away from equities and bonds. And too often, “hedge funds” end up being too much like long equities and bonds and just don’t do the job.
Q: Don’t worry, maybe it’s just me. So how do you source and recruit those Tactical Strategies that you end up putting on Hydra?We estimate that there are roughly 300-400 established Tactical Strategies programs that qualify based on the initial criteria. This universe can be expanded to more than 500 programs when we consider emerging managers. Our Kettera team encounters a new strategy in one of several likely ways: (1) We approach a manager that we believe our Hydra investors would find compelling; (2) an investor wants to allocate to a particular manager and encourages us to review the manager with a view of adding them to our platform; or (3) the manager approaches us directly.
Either way, each candidate manager program is subjected to the same rigorous screening process. We don’t list a manager simply because an investor has pledged to fund the program (or the manager itself will fund). We are research driven. This is a point of emphasis as other groups have different standards and/or business mission purposes. We take a long-term view and with several team members being former CIOs we always consider what is attractive to the investor community.
Like our more detailed due diligence process, the initial screening process is both qualitative and quantitative. After a review of the firm’s performance, the uniqueness of its strategy, and a conversation with its key principals, we then look to our vast network of industry contacts and our lengthy experience in assessing these kinds of programs. The result is a decision to move forward with due diligence, to wait-list the manager pending further developments, or reject the program. Depending on the circumstances (e.g. regulatory issues or unverifiable track record) a disqualification is often permanent. We are rigorous and want to put forth compelling programs.
Q: OK, so you green-light a manager for moving forward. Now what’s your general approach to due diligence on that manager? We begin with a quantitative analysis. However, our decision is largely dependent on our qualitative analysis. The goal of our quantitative analysis is to understand the manager’s program and how it stands both in absolute terms and relative terms to peer strategies. This involves daily data covering both profit and loss history as well as a history of manager’s margin usage. Monthly data is insufficient.
On the qualitative side, we first confirm that the quantitative information is correct (e.g. audits, etc.) and then get dig in to understanding the manager, their people and their strategy. This usually involves at least two or three lengthy meetings, with at least one of these being “on site,” and collecting information on the manager’s business and background.
Once this information has been collected it will be reviewed by our Investment Committee. Before spending additional time or resources on the analysis for a trading strategy, including scheduling any further visits, a member of our manager research team prepares an internal-only, preliminary summary of the program to the committee. This preliminary assessment is an objective summary of the manager’s risk-adjusted performance, risk management, style category confirmation, performance relative to peers of similar style, and the originality of the strategy and diversification benefits to the Hydra Platform. The relative “pros” and “cons” of on-boarding the manager are also considered.
Q: Can the Committee go against the recommendation of the analyst that prepared the report? Yes, as this is a rigorous and spirited process given the depth of industry experience on the committee. The investment committee can accept or supersede the recommendation of the preliminary summary for multiple reasons. If the manager is approved then a more in-depth review is begun. Ultimately, if a manager is selected to be on-boarded by the committee, the Kettera team will prepare a full Manager Report covering the manager and the program.
Q: What’s in the full report that wasn’t in the preliminary summary? The difference is considerable in terms of depth of analysis. The full Manager Report covers both qualitative and quantitative aspects and is often 18 to 25 pages in length.
Q: Has your Committee ever gone the other way – approved a program that the summary had discouraged on-boarding? Not that I can recall. In the unlikely event that it were to happen, the committee would to spell its rationale in the full Manager Report. This is not a binary process with the initial report and over the course of further due diligence and preparing the detailed Manager Report additional details are discovered about the manager and the strategy. This may lead the Committee to reconsider a prior impression or decision.
Q: Isn’t that sort of laying out the dirty internal laundry Independent opinions are valued and if there was internal committee disagreement about a particular manager or program, we would want to reflect that in the assessment section of the full Manager Report.
Q: Tell me more about the quantitative process. Particularly the use of daily data. Isn’t that pretty unique? I think it’s less unique in the Tactical Strategies area. Most managers – and allocators – in this space are focused on their daily performance records. And if they’re not they should be, as the data is all there. The instruments they trade are liquid and easily priced. I suppose in the illiquid and less transparent strategies of some hedge fund strategies where there are daily pricing constraints it may not be as available.
The manager’s daily P/L data and the daily margin history are the cornerstone or our quantitative analysis. We have collected a significant proprietary database of daily data for roughly 250 trading strategies, including many “dead” programs that may have been forgotten by CIOs. We also have monthly data for more than 400 managers.
The reason for our focus on daily data is two-fold. First, we want to understand the manager’s returns on a “stand-alone” basis and then relative to other managers and benchmarks associated with that strategy’s style category. Second, we obtain an assessment of the “risk envelope” for the trading advisor. This profile is used in our determination of the appropriate level of nominal leverage to apply to the program should it be offered on the Hydra Platform.
Q: You really think this gives you extra insight? Absolutely. The literature of a manager may portray the program as one type of trading style, while our analysis, particularly the factor analysis and regression studies we conduct, may reveal that the program is linked more to other market factors. This is not a reason to reject a Trading Advisor, but to make sure that we are comparing their performance to the right peer universe and also that the strategy is properly disclosed in our offering materials.
Q: Can you cite an example of that? Yes, from time-to-time a manager will describe their program as being “global macro” but when we examine the program it may turn out to be more akin to a systematic trend follower.
Q: Sorry to reveal my ignorance, but is there a big difference? Yes there is difference. In our view, to be a true “macro” program it ought to have a discretionary component to the strategy, and that the strategy’s edge should be largely based on economic and fundamental inputs. I have nothing against systematic trend following, I have allocated more money over the years to this style than any other, but it’s not “macro.”
Q: Some of your best friends are systematic trend followers. Hah. Exactly.
Q: So what about the qualitative due diligence. We lever the experience of our team. We have a depth of experience that I believe has few rivals. We have two team members who have conducted manager due diligence for over twenty years and have the industry “chops” to understand what “under the hood of the manager”.
We analyse the manager’s due diligence questionnaire (or DDQ) and other disclosure materials. We accept the AIMA format of DDQ, as well as the manager’s own format as long as it is comprehensive and accompanied by a signed representation. To support the returns data, the manager must also provide a track record that has been either audited or screened by a reliable third party.
We conduct multiple telephone interviews of the manager and try to do an on-site visit prior to on-boarding a manager. We often conduct several meetings with the manager over time prior to their being on-boarded to the platform. We meet at our offices or at conferences. We always prefer an on-site meeting with the manager to gather other impressions that are useful in the qualitative review. We prepare for the meeting with a thorough review of the manager’s due diligence materials and focus on both the “advisory/strategy” and the “operations/infrastructure” aspects of the manager.
Q: Does this include background checks? Yes, we conduct background checks as well. We use third-party service providers for some aspects and handle confirming research in-house. We try to discover the unexpected to “get to know our managers”.
Q: Do you require references from a manager, or perform your own reference checks on the manager? If so, how are these done? Yes. One of the benefits of having a team of “industry veterans” (a nice way of saying that we’re not exactly spring chickens any more) is that between us we like to believe we know practically everyone in this space by now. We reach to our own extensive set of industry contacts to obtain independent references on the manager and its key principals. We also contact the manager’s supplied references but recognize such a reference’s commentary may be less than objective.
Q: All of this analysis deals with getting managers onto the Hydra platform. Do you have “research only” clients that are independent of your platform? We do. Within our first few months of operating the platform we had some in-bound requests from clients and other investors wanting to know more about some “global macro” managers. They were thrilled with the level of detail in our Manager Reports and felt they were are great value. This has led to some word of mouth requests for our Manager Reports. Over time this has led to our reviewing numerous managers of various strategy types. Some of the reports that investors have purchased were prepared for managers we were in the process of on-boarding, others were not. For example, we researched an equity long-short manager for an investor to provide it with an objective view of the hedge fund manager.
Q: Equity long-short? Given the focus of Hydra on these “Tactical Strategies” of yours, wasn’t that out of your wheelhouse? No, not at all. Our team is comprised of diverse backgrounds. Most have Tactical strategies backgrounds but mixed with and one has a purely hedge fund background.
Q: How do clients obtain these reports? On a per request basis. If an investor is interested in purchasing one of our reports they can call us or reach out via our website, at http://ketterastrategies.com/?q=Research , and someone from our team will respond.
Interview with Jon Stein, CEO of Kettera Strategies originally published on medium@TwentyThreeTrillion