Saturday, April 13, 2013

Characteristics of a good fund manager

I have a theory about hiring smart people to work for you. Once you hire people with the right talent, you can just sit back, relax and wait for good results as long as you drive him with the right incentives. On the other hand, if you drive him with the wrong incentives, he will destroy you despite paying him top dollars. We have seen this phenomenon happened in Wall Street and this almost destroyed the world financial system in 2008. Closer to home, would it serve Singapore better if our smart civil servants were incentivized to raise the inflation-adjusted median income of all Singaporeans instead of raise the GDP? By focusing on absolute growth, the government took the easy way out to grow GDP by importing foreigners without considering the quality of growth. Quality of growth should raise the purchasing power of the masses. Today's unequal world delivered great wealth mainly to the top richest 1% who already have more than they ever need even if they live up to 150 years old at the expense of the rest who have to suffer rising cost of living.

The lesson from Wall Street is that smart people with wrong incentives will destroy. Therefore, when choosing the right fund manager to manage my money, I will first focus on the incentives that drive him, then on his ability.

First and foremost, fund managers should not charge you fees if he loses your money. This means rejecting the standard fee on asset under management(AUM) . This is exactly the kind of incentive that drives intelligent fund managers to harm their clients. Bigger fund size kills investment performance. It is easier to make investment gains of 15% with $200k than $200m. With $200b, it is virtually impossible. How to find investment opportunities that yield 15% if the fund size is a substantial percentage of the economy when the economy itself is mature and slowing down? If the host is not growing, how can the "parasite"? When fund managers are focused on growing their asset size, they are not acting in their clients' interest. Unfortunately, such bad behavior is the norm in the fund management industry. This is not the person's fault but the system's fault (bad incentives). Instead of spending money on core investment activities, they spend money on marketing to grow their asset under management (which leads to poorer performance). For fund start-ups, they may even take excessive risk to have a great year so that they can market the hell out of it next year. Then, once the marketing succeeds and the asset size grows large enough to throw up comfortable cashflow to the fund managers, they start to become risk-averse, be contented with mediocre results as long as they do not underperform the benchmark.

The safest and perhaps most rewarding strategy on a risk-adjusted basis (career risk, not investment risk) for an established fund manager to pursue is to follow the crowd. If they follow the crowd and get it wrong, clients are more forgiving. If they go against the crowd and get it wrong, clients flee and the managers will earn lesser management fees or even get fired. If you want to hire a fund manager, would you want him to focus him to focus on his own career risk or on the actual investment risk which will determine how much money he makes or loses for you? The standard fee on AUM is the culprit for this sort of undesirable anti-client behavior.

Secondly, fund managers should eat their own cooking. In other words, they should invest in their own fund substantially. Preferably, they should invest so much of their net-worth into the fund that if they cause pain to their client by losing money, they should feel the same pain multiplied by 10. This will discourage the kind of short-term risk-taking behavior in Wall Street that led to 2008 financial crisis. Of course, the same euphoria from making money will be felt by them multiplied by 10 and clients will be more than happy to congratulate them. Let's make money together. This way, fund managers will concentrate on the risk and opportunities that really matter in the investment process.

Thirdly, the performance target should be set reasonably high but not unreasonably too high. In other words, fund managers should have a high watermark. The watermark is a performance target that has to be exceeded before the fund manager gets paid a bonus. This ensures clients do not pay for under-performance. The watermark should not be set too high as this could lead to two undesirable outcomes (1) Close down the fund and open a new one to reset the watermark after a series of bad losing years (2) Take excessive risk to hit the watermark. This is not likely to happen if fund managers eat their own cooking.

One Singaporean fund which meets my criteria of a good fund manager is Aggregate Asset Management. They first caught my attention on Business Times as a fund that does not charge any management fee. Zero AUM fees. When I had a brief exchange with Mr Eric Kong on fund managers not being well-regarded because most of them under-perform their benchmark and still charge their customers management fees, he honestly admitted so. This is also one reason why he has decided not to charge any management fees for his hedge fund. I think this is not only ethical but it also makes business sense. Clients of hedge funds are unlikely to be fools, otherwise they could not become rich. They will not remain as suckers for long and will opt for a better and fairer deal for themselves, if there is such an option. Aggregate Asset Management has started the ball rolling.

The founders do not get paid unless they deliver results to their clients. Meanwhile, the administrative cost of running a fund are borne entirely by the founders. They make a strong impression when you compare them to the robbers who committed the biggest bank robbery in banking history on Wall Street in 2008 (robbers being the banksters themselves).

Aggregate Asset Management has a high water mark mechanism (read the FAQ) which demands that the fund managers earn an absolute profit for their clients before they start to earn the first dollar from their clients. This is far superior to the current (and dominant) payment scheme in which fund managers charge their clients management fees on top of the losses they heap on the clients during bad years.

The Founders and their close circle of friends/family have put $3 million into the fund. Although I am not sure what percentage of their net-worth is invested in the fund (the more the better), the fact that their loved ones have entrusted their money with them is reassuring. Once a person is comfortably rich, family relationships become more precious than mere dollars and cents. There is little risk that the fund managers will take unreasonable risks with their clients' money. It is not just money now.

Right incentives alone are not enough. The next ingredient is ability. Mr Kong's personal portfolio return was 17.8% a year between May 2005 and June 2012. This is certainly impressive performance in an 8-year period which covered a business cycle that included the worst global financial crisis for the past 50 years. However, it is not likely that the same performance can be repeated in a much larger-sized portfolio. To the founders' credit, they have humbly and honestly lowered their target to 12% annual return which is still highly desirable. I wish I could match their lowered targets.

(Source: Business Times Nov14 2012 article. Also available from fund website)

Apart from a good performance record, the amount of risks taken to attain the good performance is even more important. High gains achieved as a result of high risks is luck. High gains achieved despite taking on low risks is skill. Would you prefer someone who employs a concentrated portfolio to achieve 17% annual gain or someone who uses a diversified portfolio to achieve the same result? I would prefer the diversified approach because it is lower risk. Aggregate Asset Management employs a diversified strategy.

There is no right or wrong as to which approach(diversified or concentrated) is better. Advocates of the concentrated strategy will say that it is better to focus your funds on your ten best investment ideas than to spread it across 100 ideas. Since it is your best ideas, the probability of getting it wrong is lower. However, as Mr Eric Kong mentions, when a stock occupies a substantial percentage of the portfolio, an investor may get emotionally attached which distorts his judgment. When facts point that he may be wrong, the investor may be too proud to admit it or find it too painful to make the cut. This is a lesser issue in a diversified portfolio which enables the investor to be more objective. I would like to add further that there is such a thing as bad luck. You can be right in your analysis, in your judgment of character, in everything but still lose money when bad luck hits. Good risk management means good damage control when bad luck strikes. An investor who puts all his eggs in one basket and diligently watch the basket very carefully is still not protected from bad luck. Without further elaboration, I have had more than my fair share of bad luck. Hence, I am allergic to a concentrated (and leveraged) portfolio.

I wish Aggregate Asset Management a good start to their investing year in 2013. Unfortunately, I will not be able to share in the prosperity because I am not qualified to be their client.

PS: This is not a paid advertising post. Nobody knows my real identity except my wife. I like to share good financial products/services, particularly from fellow Singaporeans. Other similar posts are (Link) and (Link)

20 comments:

  1. Hi bro,

    It's been such a long time since I heard from you. And what an article! Great stuff but honestly I don't believe in fund managers. Why let others play with your money? You won't learn any investment lessons at all if you let others manage your monies. I invest and even if I lose monies, at least I learnt something.

    Regards,
    www.sgwebreviews.blogspot.com

    ReplyDelete
    Replies
    1. Hi Greatsage,

      Thanks for dropping by. I see you have done a great job with your blog based on the number of page views!

      I don't believe in most fund managers either because most of them under-perform the benchmark. It is cheaper and better to directly invest in ETF that tracks country indices. However, I believe the best investors out there are still the hedge fund managers. Unfortunately, they are out of my reach because I do not have enough $$$ to be qualified.

      Even for a DIY investor like you, engaging a hedge fund manager can be an option to consider when your assets have grown too large to be managed easily. Should that day arrive, you can consider outsourcing a portion of the assets to a hedge fund manager who meets the criteria I listed (if you agree with them).

      Delete
  2. Hi do you have any idea where I can get audited confirmation of Aggregate Asset Management's founder's supposed returns of 17.8%p.a. from 2005 - 2012?

    I went to their website and checked out their fund sheet which really doesn't say much at all nor did the performance excel spreadsheet available for download covered anything more than a few months in 2013.

    Thanks.

    ReplyDelete
    Replies
    1. The 17.8% annual returns from 2005-2012 was mentioned in a Business Times Nov14 2012 article. You may wish to email the fund managers if you are interested in their fund. Their emails are available on the website.

      By the way, don't mean to sound rude. Only accredited investors are eligible to be clients of a hedge fund. Most people, including me, are not qualified. So, please check if you are eligible first before wasting both parties' time.

      Delete
  3. Oh so I take it that you have never really gone and verified what they say besides what is published as cursory information in newspapers?

    Not to sound rude, but you wrote such a blushing puff piece for them I was expecting a little more due diligence. Even if not audited accounts, maybe a sharing of a personal experience from one of the earlier investors whom you know and trust. To be honest, after reading such fantastic rave reviews from you, I was quite disappointed when I visited the website.

    It was poorly designed, not very informative in terms of their mandate and strategy other than the usual investment truisms that you see put up in most investment roadshows. I agree their 0/20 incentive structure instead of the usual 2/20 sounds laudable, but surely there must be more than that to convince you to post their link flatteringly not less than 5 times in this article?

    The fund appears to be quite new with only months of history and the fact sheets and performance analystics offer only bare basic NAV with hardly anything else. Of course one can argue that what counts is portfolio skills not websites or reports, but I cannot phatom how in this day & age creating a decent website using simple freely available tools, publishing a one-page proper fact sheet and articulating their investment strategies can take up much time or resources.

    Eligibility is not an issue for me, but just to highlight that I was scouring through their website and found no mention of this being a hedge fund (as it is defined in the usual sense). A few atypical features did strike me as odd for a hedge fund besides the 0-20 fees.

    1) Low minimal investment of only $150k
    2) No defined hurdle
    3) Strategy does not seem to fit into what is usually seen in hedge funds (i.e. solely long public listed equities)
    4) No mention of any methodology towards defining risk metric

    This seems to me more like an open ended private pooling fund rather than a hedge fund per se. Can you direct me where you got the idea that this is a hedge fund?

    ReplyDelete
    Replies
    1. JLX,

      I apologize if my initial reply "Only accredited investors are eligible to be clients of a hedge fund" sounded offensive to you. It was meant to save time for you and them just in case. My circle of friends are not eligible to be hedge fund clients. So, when they ask similar question about hedge fund, my first reply will be just that. Absolutely no condescension meant as I myself am not even qualified to be a client.

      Please email directly to them if you are still interested since you have already done much work browsing through their website.

      In the FAQ, the fund is only for accredited investors. So, this is how I get the idea that they are a hedge fund.

      Oh so I take it that you have never really gone and verified what they say besides what is published as cursory information in newspapers?
      Not to sound rude, but you wrote such a blushing puff piece for them I was expecting a little more due diligence.


      I don't think I will go to the extent of verifying statements from a source as long as the source is stated clearly in the post. That is expecting too much from free work. I urge readers who are interested to invest in the fund to do their own due diligence like what JLX has done and not rely on a blog post from an anonymous blogger posting for free. I am not the one investing, you are. My money is not at stake, so whatever I write will definitely fall short of the due diligence required of someone who is intending to invest in the fund.

      As a blogger, I am more concerned if there are factual errors in the post.

      I agree their 0/20 incentive structure instead of the usual 2/20 sounds laudable, but surely there must be more than that to convince you to post their link flatteringly not less than 5 times in this article?

      The laudable incentive structure alone was enough to win my respect (A total stranger). They used a fair incentive structure for their clients when the rest of the industry is not. They must be quite unpopular among fund managers. They have started the ball rolling in the right direction for clients. I wish them every success so that they will add pressure to the fund management industry to follow suit. Ultimately, it is the clients who will benefit.

      Delete
  4. Hyom,

    Thank you for your write-up on us - even though we haven't met. Do drop by our office, and we can tell you more on how you can achieve double digit returns on your portfolio - even if you are not accredited. (You can implement it yourself!)

    ReplyDelete
  5. JLX,

    The BT states my personal track record - which is NOT audited. I don't intend to spend money auditing it.

    The fund is new - just started in Dec 15 2012. So its about a quarter year old!

    As for the website design - some have commented on its elegance - and some on its ugliness.

    Our mandate and strategy is value. There is not a lot to elaborate - except we try to buy low and sell high. I can't think of anything more intelligent to add.

    Are we a hedge fund? I checked investopedia for the definition of a hedge fund. Looks like we are not - as we don't short, borrow money, use derivatives, requires large committments and not initial paltry amounts like $150K. Nope - we don't look like a hedge fund.

    Heck - we don't even look like any fund - with no sales charges, management fees or extensive distribution channels.

    Hyom must have pasted 5 links to our website due to his over enthusiasm - but the truth is - I blackmailed him that if he don't do that - I will reveal his true identity. Hyom is actually Batman, and I am Eric Kong of Aggregate Asset Management.




    ReplyDelete
  6. Eric,

    Indeed we cannot judge a book by its cover. But then a book with good cover can sell better. Don't be naive and think that without proper website marketing, your business can succeed. Don't be stupid. Come on, if your fund is only four months old and don't have consistent track record to shout about, at least provide a content rich website like SG Web Reviews (www.sgwebreviews.blogspot.com).

    Based on JLX comments, I don't even want to waste my time checking out your website. You are really crap. So what if BT interviewed your business? As far as I am concerned, you have achieved nothing, yet.

    ReplyDelete
  7. Great sage,

    Thank you for your comments.

    My wife would definitely agree with you. She always call me stupid.

    My mother used to call me dumb-dumb, but she has since given up.

    Wow, I love your website. It's great. Keep up the good job!

    Yes, I admit to being stupid, because I tried my best to design the website, but nothing intelligent came out of it. The only thing I can do now is to double my dosage of fish oil and hopefully the omega 3 can salvage whatever is left of my mental faculties.

    ReplyDelete
  8. the reply is quite funny, self deprecating style humor. having said that, last week i bumped into an old friend from college, and he is into the fx business now. in short, he invited me to put money with him, but can't promise any returns. unbelievable! there is no shortage of lessons from the last decade such as gold gurantee, genneva gold, sunshine empire, option trading guru, mf global, minibonds, etc.hedge funds? a bit crowded now? unless you could get rogers and soros for quantum fund II, otherwise dun risk it.

    ReplyDelete
  9. Hi,

    My name is Sage and I have really enjoyed reading your blog. I love how useful a lot of your topics are. I was wondering if we could exchange shout-outs. Would you please consider mentioning my website on your next post? I’ll be sure to mention yours on my blog. Thanks and hope to hear from you soon!

    Cheers,

    Sage
    sage.harman123 at gmail.com

    smartphone

    ReplyDelete
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