Why Starting a Hedge Fund Is Like Opening a Restaurant
By: Nicholas Kapur | Published: December 07, 2018 | Be the First to Comment
My name is Nicholas Kapur, and I am SumZero’s COO and head of the firm’s internal fund manager program called Cap Intro. I am honored to be joined by Mr. Anders Hall, the Chief Investment Officer of Vanderbilt University’s Office of Investments and the associated $5.6B Long-Term Investment fund responsible for overseeing the future growth and financial well-being of the Nashville-based university.
SumZero Cap Intro is an internal platform designed to direct high-quality exposure toward SumZero member fund managers for the purposes of capital raising. Vanderbilt University’s investment team is a long-standing member of the program. We reached out to the Vanderbilt team to learn more about their approach to manager selection and to share those insights across the broader SumZero community. Mr. Hall’s bio follows:
Anders was named Vanderbilt University’s vice chancellor for investments and chief investment officer in July 2013. Anders joined Vanderbilt from Duke University, where he served as head of public securities. He earned his bachelor’s degree from Duke University in economics and public policy studies, going on to the Stern School of Business at New York University for his MBA in economics and finance. He worked at Duke for 11 years, and prior to that he held positions at Hewitt Investment Group (now Aon Hewitt) and Prudential Financial.
NICHOLAS KAPUR, SUMZERO COO: Anders, first and foremost, I want to thank you for taking the time to chat. To begin, there is relatively little background information available online about you and your approach to endowment management. Can you tell us how you came to be in your current position?
ANDERS HALL, VANDERBILT UNIVERSITY: Sure, and thanks for the opportunity. My first job out of college was at Prudential, where I was in a management training program that included rotations in a number of different departments. My last rotation was in their institutional marketing group, which led me to investment consulting at Hewitt. After seven years helping pensions and endowments with their investment programs, I received a call from a recruiter about going to work for an endowment. I told her that I enjoyed investment consulting, and I’ll never forget her saying, “Okay, I’ll tell Duke you’re not interested.” Once I learned the position was at my alma mater, I quickly changed my mind.
All three of my kids were born at Duke’s medical center, and our family had season tickets for Blue Devil football and basketball. There was no reason to leave Duke, but then the opportunity came up to turn around Vanderbilt’s endowment, and I jumped at the chance.
NK: Letting go of those tickets must have been difficult, but it sounds like you picked up at Vanderbilt right where you left off from at Duke. That leads me to the following: Fund selection is a terribly complex process, but especially so in the emerging manager space where there is less data, shorter (or perhaps no) track records, and greater firm turnover. Why does Vanderbilt focus on this space?
AH: Oh, I’ve kept the season tickets for Duke basketball. I give them away to friends to help keep me popular back in Durham.
So, manager selection is difficult because the measurement of variables and outcomes is imprecise. It’s important to note that while a significant amount of our effort is centered on sourcing managers early in their life cycles, we seek long-term relationships. I joined Vanderbilt just over five years ago, so our portfolio will age as the duration of our new relationships extend into the future.
We focus most of our sourcing efforts on managers early in their life cycle, because we believe it makes for better relationships and a better alignment of interests. Our approach is about sourcing relationships with great investors across asset classes, globally. We do everything possible to leverage these relationships with intelligent structures.
What does a track record tell you, really? It’s a measure of past performance, but generally not statistically significant. Our goal is to assess the probability that a manager will generate strong results in the future, not to hope that what happened in the past will persist.
NK: What makes the Vanderbilt approach to emerging manager selection unique?
AH: If something is unique then it’s unlike anything or anyone else. I don’t necessarily view our approach as unique. However, we do have firm beliefs in our approach to investing. Perhaps more importantly, we know what we do not believe, and we are conscious about figuring out where we are disadvantaged or otherwise not in a position to handicap or underwrite outcomes.
We have a bias to fundamental investing across public and private companies. We also prefer being an equity owner rather than a creditor. We do things like commodities, or arbitrage and reorganizations as strategies. However, we believe that owning operating companies with the ability to invest and internally compound capital is the best way for us to generate long-term returns for Vanderbilt’s endowment.
NK: To your point about ‘knowing what you don’t know’, fundamental investing is partially, perhaps largely, an exercise in human and animal psychology. How do you attempt to objectively measure what is inherently subjective, i.e. the temperament, the behavioral element of
AH: We make every attempt to be objective in our analysis, but we make little effort to perform quantitative assessments. We approach behavioral elements by aggregating our observations, and then continuously constructing and deconstructing what we believe in search of reality. We seek to learn a lot about the backgrounds of our partners, often as far back as their childhoods.
We try to create a profile of our partners by mapping people across many dimensions. We want to know what motivates investors. Are they intrinsically or externally motivated? How do they spend their day, both before and after work? What do they read? Is there evidence of probabilistic thinking? Can they see alternative outcomes, or are they locked into one view of the world? What are their prior mistakes, and how do they learn from them? We try to build mosaics of our partners as investors, and as people.
NK: A 2017 study "Sensation Seeking, Sports Cars, and Hedge Funds" identified a meaningful (and perhaps obvious) relationship between the types of cars that fund managers drive, risk preferences, and corresponding impacts on performance. I will refrain from asking the very, very tempting question about what you park in your own garage, but I do think the study brings up an important related question: How deeply do you dig into the personal lives of a prospective manager? How much does the 'out-of-office' element matter?
AH: Investment managers should assume their investors know, or will find out, everything. Not every investor will find everything, but many will dig for anything. We dig pretty deeply in a variety of ways. We care about the complete picture of risk. I mentioned how focused we are on process and judgement. Since investing is inherently a probability-oriented exercise, we have to understand other issues that could alter one’s judgement or break an investment thesis.
NK: Given all this, what is an immediate disqualifier for you when considering a fund or manager?
AH: Since we are fundamental investors, statistical and quantitative strategies are inconsistent with our core approach to investing. The other common disqualifier is finding too much diversification in a manager’s portfolio. We diversify the endowment ourselves, so we don’t need our managers to be overly diversified. We want them to know each and every one of their positions extremely well.
NK: From one of our Twitter followers, “Have you ever invested with someone who says the right things, seems to do all the right things, more or less ticks all the boxes for a great manager in your DD -but the existing track record has delivered negative alpha i.e. underperformed?”
AH: More often than you might imagine. We talk with many managers that have limited or no formal track records. We like investors that focus on process to drive outcomes. Even the best processes have some probability of producing weaker results over shorter periods of time. To control for this, we diversify our risks across investment managers and asset classes, and try to maintain a long-term time horizon.
NK: On the subject of poor performance, managers in this market with fewer than 10 years of experience have not yet been exposed to a complete economic cycle, which is unusual statistically speaking. How does this factor into your approach? Do you even consider managers that are younger than their mid-30s?
AH: This is a very topical issue among our investment team. We do not have many investment managers below 35 years old, but we have a few. I think this issue extends to large segment of the investment manager universe. Being an analyst requires a different skill set than managing a portfolio, and many older portfolio managers were not in this position through prior cycles.
One of the reasons I say this is topical is we debate what our more inexperienced portfolio managers could have learned in periods like 2011 or 2015-2016. From mid-2015 to early 2016, the median S&P 500 stock was down 25%, and emerging market equities were down roughly 40%. While new 52-week lows were at the highest point since 2008, the S&P 500 only fell about 15%. The point here is there are periods of significant risks in actively managed portfolios that can serve as a basis for understanding one’s process, without having to go through a recession or broadly recognized bear
NK: Looking at the next generation, I know a good number of talented investors sitting at large, established firms who are considering the launch of a new fund. What advice would you give them? What do you think is the most important thing these individuals can do to increase their chances of being a viable target for a respected institution like Vanderbilt?
AH: We take many calls and informational meetings with people. Some people are already determined to start their own funds. Others are merely curious, or desire some feedback on their current situation. Importantly, we do not do lift-outs, and we do not take economic ownership stakes in investment managers. When people are deciding whether to sell an economic stake in their firm to a third party in exchange for an early investment, or taking capital from a top-15 research university like Vanderbilt, we think we can make a compelling case to choose Vanderbilt as a long-term partner.
The most important thing an aspiring entrepreneur should know about starting his or her own fund is that the world does not need another asset management firm. I think most understand this, but many believe themselves to be unique or different. This may or may not be true for each person, but it doesn’t matter. Starting a hedge fund is similar to starting a restaurant in the sense that most will fail within a couple years. If the person accepts the world does not need them, they can accept the opportunity costs and incremental costs associated with running a lean start-up business for a few years. They should not assume investors will soon join them in the effort.
As for emerging managers increasing their chances with Vanderbilt, we’ve talked about how we think and what we value in investing. We’re always looking for great partners to support research and scholarship at Vanderbilt. Approximately 45% of Vanderbilt’s endowment is dedicated to financial aid, and it’s important for our managers to understand and embrace their role in how they’re helping make a Vanderbilt education affordable for all.
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