Interview with Dion Friedland
Q: You are recognized for your expertise in selecting funds and hedge fund managers. What do you look for in making your choices?
A: We look for hedge fund managers who can convince me they have an edge. Once we are able to understand why the investment manager has an edge - be it through having access to superior research or information flow, better analytical skills or intelligence, or to contacts in industry, Wall Street or among investors, we can then understand why the investment manager is likely to outperform his/her peers. This ability to understand the qualitative factors that differentiate successful hedge fund managers eliminates, to a large extent, the need to see long-performance records. So many times I've heard of investors who will not consider a new manager unless he has a five-year track record, etc. I do not agree with this approach. In the past I would have missed out on some of our best-performing fund managers if I'd waited for long performance records. Often, too, the most successful fund managers attract large assets so that by the time they have a five-year track record they have stopped accepting additional investments or no longer are able to produce the outstanding returns they enjoyed while managing a smaller asset base.
As it happens, research seems to indicate that hedge fund managers tend to have some of their best returns during the initial few years of running their funds … before they attract a lot of money and have to start delegating decision making and management of parts of the portfolio to others. Also, during the first few years the typical hedge fund manager is hungry and ambitious and will work backbreaking hours to succeed.
Q: What constitutes an edge?
A: There are many examples. One is the Galleon Omni Fund, managed by Raj Rajaratnam, former Needham & Company president, whose area of specialty is emerging growth opportunities in technology. During the 11 years Raj was at Needham, the company raised more than $9 billion for emerging growth companies in more than 150 public offerings, building a network of relationships with venture capitalists that Raj still maintains, giving him access to timely investments in expanding private and public companies. Furthermore, most of the investors in the U.S. Partnership which Raj manages are senior managers or CEOs of technology companies, allowing him to form close relationships with experts who provide valuable background for the Galleon Omni Fund's technology holdings.
Raj's network of experts extends to suppliers and customers of technology companies. One August, for example, he traveled to Malaysia to visit with makers of motherboards for PCs. Every one of the six or seven companies he met with indicated they'd increased their production rates from their earlier plans, which told him the PC market would be very healthy for Christmas. So that September, while many tech-fund managers remained net short after the summer downturn, Raj profited by going net long on PC-related stocks. Raj maintains an office with 3 analysts in Silicon Valley and spends one week a month there visiting 20-25 technology companies each time, thus keeping his finger on the pulse of the industry. With Raj's grass-roots-style research approach, Galleon Omni Fund's Series A shares more than doubled in value from its March 1996 inception through the end of 1996, without a single losing month and was up 434% through December 1999 (46 months).
The South Africa Omni Fund, up 196% in its first 2 years, takes advantage of BOE Asset Management's experience and information network as a major asset manager in South Africa. BOE's researchers and portfolio managers have been recognized for their intensive research and expertise in identifying profitable investment opportunities on both the long and short side.
Q: How do you discover these funds?
A: Magnum has a number of sources. Database information is useful, as are industry newsletters and journals. It's also worthwhile to listen to marketing people and to encourage them to call about good funds. Successful hedge fund managers seeking new investors often call us directly. Input from peers in the business is crucial. We take advantage of industry conferences to meet, listen to, or be told about good fund managers. I formed the Hedge Fund Association to expand networking in the hedge fund industry for all participants.
Another source is our existing fund managers. We often ask them which of their competitors they most respect. Is there anyone else in their business they would give money to? Along these lines, we talk to existing investors in our funds -- ask them if they have or know of any good funds they'd like to see Magnum invested in. In addition, the brokerage community often steers promising fund managers our way.
Q: How do you evaluate the funds and the fund managers?
A: First, we check out the performance data we may have on a fund or manager on a database, looking especially for audited numbers. But you want to keep in mind past performance is not necessarily a good predictor of future performance. Results of certain strategies are far more predictable than others - for example, results from relative value arbitrage or distressed securities strategies tend to be more predictable than results from aggressive traders or macro managers.
We read the private placement memorandum carefully, analyzing the fees, the strategy, the risks, although usually they are boilerplate. We look to find out how much money the money manager has under management, and how much the strategy can handle without diluting the results or forcing a change in style. We also speak to our peers - do any of them have experience with the manager? Have they invested? What have they heard about the manager?
Provided everything else has checked out up to now, we make a visit to the manager. Here we try to find out everything we can about his back room, about how he runs his show. Has he had any changes to his team? How much of his own money does he have invested? In other words, does he "eat his own cooking"? How hungry is he to succeed? Does he have any personal negatives - any distractions in his life? How experienced is he? Has he lived through a crisis, through a market correction? It is important to attempt to eliminate the risk and luck factor from his results, and obviously the longer the track record the more you would tend to eliminate luck. Though as I've said before, understanding why the manager was successful, and whether he is likely to be successful in the future, is crucial -- we are looking for the Michael Jordan or Andre Agassi of each investment strategy. In good markets, lots of funds seem to do well. The tough times separate the men from the boys, which is when you need to be invested in funds with an edge.
Q: How do you make allocation decisions for your various funds of funds?
A: It is important to have clear objectives in mind when allocating money. Let me use an example from soccer, or European football: If you were choosing a soccer team you would, as a good manager of the team, need to understand who your competition was - what were their strengths and weaknesses? This is equivalent to the macro environment. You need to have a point of view about the macro environment when allocating money if you want to have better-than-average performance.
You then choose the team from your best available players, understanding exactly what your objectives are. Are you going to play a fast-attacking game, or a defensive game? This gets back to the objectives you set for your fund. At Magnum, we have 16 funds of hedge funds, each with differing objectives, employing different strategies, and having different characteristics of return, volatility, and risk of loss. Some are complete investment vehicles. In other words, they could form a complete investment portfolio - either conservative, diversified, or growth. Other of our funds should form part only of any investment portfolio and may be complementary when used together. These differences are created primarily by the asset allocation decisions we make to the underlying funds.
I say primarily because use of leverage within a portfolio of funds is also an important distinguishing factor. To use another metaphor: If allocation can be likened to ingredients in baking a cake, the use of leverage would be your baking temperature. Too much leverage can burn the cake. Too little and the cake is underdone -- a fund may underperform its potential if it uses no leverage.
The objective of course is not only to build a fund, but to deliver the targeted return with an acceptable level of volatility. To build a bulletproof fund over a sustained period of time that will outperform all the indexes used for comparative purposes. To do that the fund should be diversified by style and asset class. In a complete investment vehicle such as the Magnum Fund, diversification means diversification of investment managers and asset classes as well as investment styles in order to lessen risk of loss in the event of a major market downturn.
Q: What red flags do you look for in deciding to withdraw your investments in a fund?
A: One indicator is when the manager deviates from his agreed strategies and objectives. One of the funds we were invested in deviated from their proven strategies and had a bad year in the process. As a result, a major part of the money they had under management was withdrawn. We immediately cut back half of our investment. After subsequent in-depth discussions with the manager, who undertook to return to his proven approach, we have reallocated funds, and the manager is once again doing well.
But even if changes occur for the better, say, if a manager cannot adequately explain why there was an uncharacteristic increase, this too is cause for concern. We watch out, too, for managers taking on too much money. Returns may start to drop or they may try additional strategies. Inconsistencies in what a fund manager is saying are also cause for concern. If we get feedback from people in our network that differs from the messages we get from the fund manager, it's a red flag and may be a signal to redeem our investment.
Another indicator is when you hear that other investors have started redeeming their investments from a fund. You don't want to be the last one out of the restaurant because you may be left with the bill.
Q: What do you do when a fund is delivering poor results?
A: While I am the biggest investor in the Magnum Funds, it hurts me more when my investors and friends lose money. As a result I have a low tolerance for continued poor performance. Strangely enough, my personal time horizon is much longer than my tolerance for poor performance for my investors. I suppose it's because I have an obligation to deliver good results to my friends and investors who have entrusted me with their savings.
If a fund manager starts delivering poor results without a really good explanation, it's time to get out. We retired a manager who had a poor year after being up more than 100 percent the previous year. He responded to my questions by saying, "We hope not to lose any money this year." He seemed to lack confidence, and we withdrew our investment immediately. Incidentally, he kept his word - he never lost any money that year, but he never made any for his investors either.
Q: What other conditions affect your investment decisions in hedge funds?
A: Our macro view of the markets. The manager may be doing exactly what we hired him to do, but our macro view may have changed and we may no longer wish to be invested in a particular strategy. For example, going into 1995 we were invested in a fund with a short bias that showed gains of over 30 percent in 1994 -- when most funds lost money. A leading researcher we respected came out with a call predicting that 1995 would be the best year of the decade and that Wall Street would be the strongest market in the world, led by technology stocks. Substantial discussions finally convinced me that the U.S. stock market was set for a period of good performance, and we made a macro-induced decision. We redeemed our investment and reallocated the proceeds to other U.S. equity fund managers who had a long bias. The fund we redeemed ended down more than 30 percent, while the managers we invested with ended up over 30 percent. Macro considerations should play an important part in the constitution of a fund of hedge funds.