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Survival Skills for the Hedge Fund Apocalypse

GrimReaperThere’s an increasing volume of negative news regarding the “exodus from hedge funds,” in favor of less expensive alternatives such as liquid alts and “engineered equity” products. Although many large investors still maintain significant assets in hedge funds, the industry’s ratio of contributions to withdrawals has turned south, and the near-term outlook for hedge fund growth is not encouraging. Small and medium sized funds are likely to be hardest hit as the asset class falls out of favor.

There’s no short-term marketing panacea to offset what may be a rough road ahead for hedge funds, which is a storm that hedge funds have helped to create. More specifically, the industry’s collective lack of basic communication skills is a major contributing factor to the increased levels of investor dissatisfaction. Contrary to what’s reported in the Wall Street Journal, hedge funds are not helpless victims of volatile markets, poor performance or high fees. Instead,hedge funds are now paying the price for their own inability or unwillingness, over at least the past three decades, to explain themselves properly.

Although there are exceptions (which include those funds most likely to fare well over the long term), hedge funds are notoriously inept at expressing to prospective and current investors the “what, why and how” of their value proposition. Collectively, fund managers may be geniuses at left-brain, quantitative skills; but often fail miserably at managing right-brain storytelling skills, or at hiring right-brain people to manage those tasks properly. And unfortunately for fund managers, it’s those right-brain-related communications skills that can have the most significant influence on investor interest and loyalty.

Here’s the underlying problem: most managers continue to believe – despite a growing mountain of evidence – that investor engagement and longevity is based exclusively on fund performance. So that’s the basis on which they pitch their fund, as well as the standard by which they communicate its value to investors over time. In their opinion, nothing but performance really matters.

What those managers won’t acknowledge is that investors seek fund characteristics that have little or nothing to do with performance. In fact, what investors really want is validation that their allocation decision is sound, that the fund manager is transparent and accessible, and that relevant issues are discussed immediately and honestly.

The most recent de-bunking of the performance myth was produced by Chestnut Advisory Group (Investors Want Hedge Funds to Hedge), which further validates that high returns are not the top reason why investors allocate to hedge funds. Nearly 80% of the investors they surveyed indicated that “risk management” played the most important role in manager selection.

And that’s the fundamental marketing challenge for fund managers: building investor trust through clear and consistent communication, regardless of whether their performance meets, exceeds or falls short of benchmarks.

Building trust through communication in any profession – whether you’re selling accounting services, running for public office, or managing a hedge fund – means establishing and managing customer expectations. Here are three ways your fund can accomplish that goal:

Explain what you believe in. Investors care about what you do, how you do it, and even how you are different from other funds. But explanations of features and benefits do not drive behavior. What actually incents them to allocate and remain with you is based on the power of why. Investors need to know what drives you, what inspires you, what excites you. Your fund’s goal is to do business with the people who believe the same things that you believe. So you need to explain what you believe in.

The power of “why” goes far deeper than marketing strategy; in fact, it’s a human need deeply rooted in our biology, and serves as the foundation for all of our decision-making. To gain a better understanding of the concept, watch this 18-minute TED Talks video (Start With Why) by Simon Sinek. There’s a reason why it’s been viewed more than 26 million times since 2009.

Tell them exactly what you’re thinking. Too often, investor communication consists of boiler-plate, generic language that regurgitates news media headlines on the macro-economic factors that influenced portfolio performance. It’s a rationalization of why (most often bad) things happened, and provides no real perspective on the manager’s thought process. There’s zero insight into the quality of the manager’s thinking, or whether any thinking took place at all.

The investing world is well aware of the frank, detailed explanations in the annual report shareholder letters of Warren Buffett and Jamie Dimon, but a more relatable example of effective investor communication is available from Phil Goldstein of Bulldog Investors, an activist hedge fund focused on extracting value from under-performing closed end funds. Drill down into this newsletter’s (The Brooklyn Investor) coverage to get a sense of Phil’s no-nonsense communication to investors. His communication is simple, sincere, fun to read, and most importantly…builds investor respect and trust.

“Man Up” when things go sideways. It’s difficult to believe that any fund manager would be so short-sighted as to report performance when it’s positive, and then go silent when it’s not. But this spineless communication approach happens with some frequency, and most often involves managers who peg their value to investors solely on performance. For investors, in terms of trust, this is equivalent to playing a round of golf with someone who only writes down his score for a hole when he shoots a par, birdie or eagle. “Good times only” fund managers will always have difficulty finding any investors willing to play that game.

The medical profession provides an interesting corollary that demonstrates the potential benefit of communicating bad news. The University of Michigan studied the impact of improved communication related to medical errors. When their doctors began to explain to patients why an error had occurred and what steps would be taken to avoid it in the future, medical malpractice lawsuits dropped 65%. Customers – whether they be patients or investors – understand that the there are no guarantees in life, and most will respond positively to honest communication.

There’s a tangible payoff for setting and managing investor expectations. According to the Chestnut Advisory Group’s research, trusted asset managers will:

  • Raise significantly more capital
  • Be engaged more quickly
  • Be retained far longer
  • More easily up-sell and cross-sell

That’s a fairly decent return for any hedge fund manager, in exchange for an investment in clear, forthright, consistent communication with current and prospective investors.

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Managing Brand Alpha: The Next Frontier for Investment Firms

Performance remains a critical selection factor for investors; but increasingly in a post-Madoff world, it’s not what’s most important to them.

Although investment firms understand this, many choose to ignore the qualitative factors that have significant influence on investor decision-making, which include:

 

  • What You Stand For: INTELLECTUAL CAPITAL is what motivates investors to place their capital at risk. This does not involve how much you know. Investors need to understand what you believe in, and to appreciate what you’re attempting to achieve.

What does “intellectual capital” sound like?

Here’s a letter to investors from Phil Goldstein of Bulldog Investors, regarding one of his funds: “As these statistics suggest, we are risk averse. Thus, we tend to outperform in down or choppy markets. On the other hand, we expect to underperform the stock market when it booms…For the most part, we eschew any attempt to predict the markets. Instead, we focus on trying to find investments where we think we have an edge. By seeking out and exploiting inefficiencies in the marketplace, we hope to generate above average returns for our Fund with reduced risk. We also will use activism when necessary to try to unlock the value of our investments. This strategy has worked quite well for us in the past and we see no reason to alter it.”

  • Who You Are: PERSONAL INTEGRITY qualifies you for consideration by investors. Lacking confidence in your character and reputation, both as a firm and individuals, they will dismiss your performance and your ideas.

What does “personal integrity” sound like?

Here’s what Ray Dalio of Bridgewater Associates stated in an interview, “I started Bridgewater from scratch, and now it’s a uniquely successful company and I am on the Forbes 400 list. But these results were never my goals—they were just residual outcomes—so my getting them can’t be indications of my success. And, quite frankly, I never found them very rewarding. What I wanted was to have an interesting, diverse life filled with lots of learning—and especially meaningful work and meaningful relationships. I feel that I have gotten these in abundance and I am happy.”

  • What Others Think of You: CREDIBILITY must be validated by respected third parties, to provide investors with the confidence they require to consider you as their financial fiduciary.

What does “credibility” look like?

Media exposure in objective, respected publications is one of many ways to achieve third-party endorsements. Here’s the head, subhead and opening of a recent Barrons’ profile: A Top African Hedge Fund Is Buying Markets Others Are Deserting: Andrew Lapping, who runs the Allan Gray Africa Equity fund, has been moving into markets like Zimbabwe and Nigeria that others are deserting. “Investing successfully in Africa’s volatile and illiquid stock markets requires as much patience as courage. Andrew Lapping has acquired a bit of both as the South Africa–based portfolio manager of the Allan Gray Africa Equity fund…”

Investment firms with the talent and discipline required to generate consistent risk-adjusted returns are entitled to investor interest on that basis.

But firms that focus exclusively on their performance to attract and maintain assets — without addressing the selection factors that build understanding, trust and loyalty among investors and their advisors — demonstrate a reckless approach to enterprise brand risk management that not only compromises their financial acumen, but should provide current and prospective investors with some cause for concern.

How an investment firm manages its enterprise brand alpha should be part of the due diligence process for investors.

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