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)