Hedge Fund Strategy and Design
Tobias Cozzolino The Vanguard Group
Elton G. McGoun William H. Dunkak Professor of Finance Freeman College of Management Bucknell University
Address correspondence to:
Elton G. McGoun [email protected] Hedge Fund Strategy and Design
Abstract
Hedge Fund Strategy and Design
I. Introduction
Finance in general portrays itself as an objective, no-nonsense, numbers-driven activity, and no corner of finance is more likely to subscribe to this characterization than hedge funds. Aggressively seeking whatever profitable investment opportunities might be lurking in the dark, labyrinthine alleys of the myriad global financial markets, they have no time to devote to such frivolous matters as aesthetics. This paper uses multiple hedge fund metrics from Internet sources to classify hedge funds into behavioral categories of transparency and innovation (Section II) and the color, content, typography, imagery, etc. of their logos and home pages to classify them into aesthetic categories (Section III). If there were no correlation between strategy and aesthetics, we might suspect that providing minimal input, the fund simply gave a designer free reign to create the site. But if there is a stronger correlation, we can be more confident in assuming that the fund, and most likely the more senior managers of the fund, devoted a fair amount of time and attention to the design. Statistical analysis confirms that there are provocative positive correlations, negative correlations, and absences of correlations (Section IV); therefore, it appears as if hedge fund investors are not simply “seeking alpha” and hedge funds not simply delivering it. Rather, there are more complex forces at play. The risk/return bundle that hedge funds deliver has to be appropriately packaged to send the right message to discerning customers.
II. Hedge Fund Strategy
Thirty hedge funds were selected for analysis, and information on each of them was assembled from Bloomberg, WhaleWisdom, and a variety of other online and print data sources. Certain basic information is straightforward: date founded, number of employees, location of headquarters, and number of offices. But keeping with what one might refer to as an “aura of mystery” surrounding the industry, other publicly available information is not so easy to interpret. Hedge funds do publish the total value of their assets under management in both the U.S. and the U.K., allowing the public to gauge the size of each firm’s investment footprint. Regarding the composition of firm portfolios, however, the SEC only requires hedge funds to report specific investments in publicly-traded equities, options, warrants, closed-end investments, and certain convertible securities. Firms are not obligated to reveal private holdings and certain other types of securities.1 For example, Adage Capital has $49 billion in assets under management, but only $36 billion of that $49 billion is invested in instruments that need to be reported in the fund's 13•F filing with the SEC. And what makes a characterization of a hedge fund’s strategy especially difficult to categorize is that it might itself manage multiple individual investment funds, each of which might employ a different strategy. Along with this data, it is also possible to identify the ticker symbol of a hedge fund’s largest holding and the percentage of the hedge fund’s assets concentrated within its top ten holdings. This can be considered a proxy for portfolio concentration, which reveals something about a firm's investment strategy and can used with some accuracy to predict a hedge fund’s strategies. For example, quantitatively•focused firms, which traditionally have thousands of computer•selected stocks in a given fund, will likely have a much lower concentration of their portfolio in their top 10 largest holdings. Pershing Square, on the other hand, has 100% of its assets under management concentrated in its top 10 holdings, from which one can deduce that the firm must have 10 or less total holdings. However, portfolio composition data is obtained from the 13- F filings, and if these filings are a relatively small proportion of total assets under management, the conclusions one might draw from the information are limited. At one end of a continuum, Baupost reports 100% of its holdings in its 13•F filing, but at the other end Bridgewater only reports 5%. Finally, the top three self-described investment strategies employed by the hedge funds were extracted from public information. Bearing in mind that the terminology is not standardized, these strategies include:
1 Companies House—the U.K. counterpart to the SEC—does not require any such detailed reporting for hedge funds; however, U.K. hedge funds having holdings and/or dealings in the U.S. are required to file a 13-F.
Activism • using large amounts of capital to create change in a firm's strategy, management, etc. These firms typically acquire enough shares to obtain seats on an acquisition’s board of directors and then demand changes to eliminate inefficiencies and benefit shareholders. This is similar to what Gordon Gekko promises to do with Teldar paper in the movie Wall Street.
All•weather • a fund name coined by Bridgewater Associates indicative of good performance through all market environments— clearly an ambitious endeavor.
Distressed securities • investing in companies, institutions, etc. that are not financially sound or are on the verge of financial ruin. These investors often swoop in and pick up assets for pennies on the dollar, turning a profit with or without the intention of turning the acquisition around as a going concern.
Event•driven arbitrage • arbitrage (taking advantage of differing prices for the same/similar asset in different markets) driven by a specific market event. For example, there are rumors that Facebook will announce that it plans to acquire Twitter for $40 per share. The market, however, can only speculate if it will be blocked by regulators, if another company will outbid them, or if something else will influence the acquisition. As a result, Facebook stock does not automatically rise to $40, reflecting the probability that the deal will not take place. In this example, arbitrage investors might use the event of an acquisition to profit from the difference in Facebook and Twitter's prices before the official announcement, after the announcement, and after the deal does/does not go through. This is an example of merger arbitrage, which is a prominent form of event•driven arbitrage. Risk arbitrage is generally considered synonymous with merger arbitrage. Other forms of event•driven arbitrage involve bankruptcies, spinoffs, etc.
Fundamental vs. Technical • fundamental investment is predicated on assessing a potential acquisition’s financial condition through statements, ratios, reports, etc. Technical analysis uses charts to discern past patterns in the price movements of a security to predict future ones.
Growth vs. Value • growth investing focuses on companies that promise superior future growth (ex. Netflix), while value investing looks for companies that for whatever reason appear to be undervalued by the market. Value companies tend to be more mature than growth companies.
Long/short • the hedge fund takes related positive (long) and negative (short) positions with its investments, hoping to profit from changes in the relationship between them. For example, if General Motors is believed to be undervalued but the fund does not want the greater market risk of simply holding its stock, the fund can go long (purchase) General Motors and short (sell) the rest of the auto industry in equal dollar amounts. With such a hedged position, the firm is only exposed to General Motors' performance relative to its peers and not to the overall performance of the automobile industry or the broader stock market. The first hedge funds were named after this strategy, which they pioneered.
Macro • using economic data and/or other economic indicators to make predictions about the broader economy and invest based on beliefs about future economic trends.
Pure alpha • simply the name of Bridgewater's flagship fund, which invests in multiple asset types to provide excess risk•adjusted returns to its investors.
Quantitative • using computers/algorithms to outperform the market, which often involves a large number of holdings.
Special situations • this is something of a catchall category. Special situations arise when something is happening that would inspire investors to buy/sell a security, but the event does not fall firmly within the scope of one particular strategy. Firms define the term differently, but it often involves elements of multiple strategies.
Structured credit • structured finance but with credit assets. An investor can rearrange the debt portion of a target company’s capital to alter the pecking order of who gets paid first, how much they get paid, risk vs. reward, etc.
Venture • providing capital to early•stage companies. Because any one company is a high•risk/high•reward investment, the strategy requires investing in twenty or more early•stage companies in the hope that two of them will be successful.
In order to facilitate a quantitative analysis of the relationship between a hedge fund’s strategy and the aesthetics of its website, all of the information available on these hedge funds—with the exception of their own web sites—was synthesized into an admittedly subjective assessment—on a five-point scale—of the hedge fund’s transparency and innovation. Regarding transparency, some firms engage regularly with the media, some post YouTube videos about their product offerings, employee recruiting, investment theses, and other topics, and are featured in online forums revealing tidbits about their culture and what goes on behind closed doors. Bill Ackman's Pershing Square takes this public profile to an extreme, regularly appearing on CNBC to discuss holdings and even publishing videos that lays out his entire thesis about a company. On the other hand, firms like Lone Pine have a "no press" policy because they want to keep their investments as secret as possible. Regarding the scaling of firms on the basis of transparency and innovation, the more information a firm is willing to publicly reveal about itself and its operations, the more transparent it is—not at all transparent (1), shows average transparency (3), or is especially transparent (5). Innovative practices can include the use of new technologies to govern investment decisions, the creation of unique product offerings, or the employment of distinctive people management, revolutionary client relations, or other unique qualities. As with transparency, a 1•5 rating scale reflects whether a firm exhibits low (1), average (3), or high (5) levels of innovation compared to its peers. More specifically:
Transparency Innovation 1. Practically no engagement with the press 1. Practically no innovative practices as they or social media. Little to no information relate to investment strategies, client about business operations, client base, engagement, company culture, fee firm culture, strategies, etc. structure/business model, etc. 2. Trace engagement with the press or 2. Trace innovative practices as they relate social media. Trace information about to investment strategies, client business operations, client base, firm engagement, company culture, fee culture, strategies, etc. structure/business model, etc. 3. Average engagement with the press or 3. Average innovative practices as they social media. Average information about relate to investment strategies, client business operations, client base, firm engagement, company culture, fee culture, strategies, etc. structure/business model, etc. 4. Frequent engagement with the press or 4. Significant innovative practices as they social media. Significant information relate to investment strategies, client about business operations, client base, engagement, company culture, fee firm culture, strategies, etc. structure/business model, etc. 5. Very engagement with the press or social 5. Very significant innovative practices as media. Very significant information about they relate to investment strategies, business operations, client base, firm client engagement, company culture, fee culture, strategies, etc. structure/business model, etc.
III. Hedge Fund Aesthetics
Two expressions of hedge fund aesthetics are considered—the logo and the web site home page. As with transparency and innovation, each was rated on a 5-point scale from least (1) to greatest (5) apparent interest in and attention to design and impact as indicated by a variety of elements. For the logos, these were the use of color, initials along with names, geometric elements (outlines, underlines, overlines), abstract graphics, literal graphics, and other script annotations. Examples of noteworthy use of each of these elements are:
Color and Names and Initials
Geometric Elements
Abstract Graphics
Literal Graphics
Other Script Annotations
For the home pages, the relevant elements were color, photographic images (from no illustrations to a few generic finance pictures to full screen/full color), animation, content (from simple descriptions and disclaimers to descriptions of available reports and commentaries), and number and variety of links.
IV. Analysis
The following table shows the correlations between the strategic variables (transparency and innovation) and aesthetic variables (logos and home pages).
There are three noteworthy observations regarding these correlations: the moderate to high correlations between the home page and transparency and innovation (and between transparency and innovation, although only the correlation between the home page and innovation is fairly reliable), the somewhat negative correlations between the logo and transparency and innovation (although the correlation between the logo and transparency is quite unreliable), and the absence of correlation between the logo and the home page (which is very reliable). Considering the latter observation, it is likely that the logo is created when a firm is founded and retained throughout its life while the home page continuously evolves, arriving over time at what is visible on the Internet today. Furthermore, one might hypothesize that the logo is one of many decisions (and not one of the most important) to be made at the birth of a firm, while there is more time available later to pay greater attention to the firm’s web site, and it is certainly possible that different persons are responsible for those decisions. These same factors could account not only for the lack of correlation between the logo and home page but also the slight negative correlation between the logo and strategy—the strategy maturing while the logo remains constant. Especially pertinent to the topic of this paper is the positive correlation between the home page design and strategy, largely innovation but also to a lesser extent transparency. The positive correlation between the home page design and transparency is not unexpected, as the home page is the gateway to the firm on the Internet, and an attractive and engaging one invites people in. The stronger correlation between the home page and innovation could be explained in a number of ways: (1) If one of the values of a firm is to push the boundaries, it will do so wherever those boundaries are found, whether in investment strategy or web site design.
(2) The highest-rated home pages often have descriptions of and links to a firm’s published reports, not only on financial and economic topics but also on political and social affairs. It would not be surprising that an innovative firm would want to market the innovative thinking that drives its investments.
(3) The highest-rated home pages often make specific appeals to prospective employees, advertising their openness to new ideas and creative thinking. It is certainly to an innovative firm’s credit that it would recognize that continued innovations requires attracting new minds.
Overall, these correlations support the conclusion that as they mature, hedge funds appear to consider aesthetics and marketing, acknowledging its value to its continued success appealing to the right future employees and the right future clients.