Episode 12: Show Notes
Choosing the right hedge fund manager can be a difficult choice. In today’s episode, we speak to Mark Kress, the Chief Investment Officer at Arden Advisory, about what to look for when choosing a hedge fund manager.
Mark brings valuable portfolio management expertise, a record of building strong relationships, and experience employing risk management and asset allocation strategies to maximize risk-adjusted returns. His unique background includes identifying unique investment strategies, introducing technology solutions, and providing research to support decision-making. Mark holds a BS in Managerial Economics from the University of California at Davis, an MBA from the University of California at Berkeley Haas School of Business, and is a Chartered Financial Analyst (CFA).
Key Points From This Episode:
- An Introduction to our guest, Mark Kress.
- Opportunities that can be found in hedge funds.
- Mark’s screening process for identifying funds from a large set that are worth pursuing as investment opportunities
- The process Mark uses to select hedge funds that will add to his client portfolio’s overall risk adjusted returns
- How Mark thinks about a particular fund’s volatility and it’s impact to the portfolio
- The advantages of small cap managers that stay small and true to their knitting
- The importance of separating managers who have repeatable strategies versus those who have benefited from luck
Hi, this is Andrew from Pitchboard, and I had a great conversation with Mark Press from Arden Advisory. He explained how he selects hedge funds for his clients by how smaller funds can outform larger competitors. I think you will enjoy our chat. Arden is a wealth management firm serving high net worth individuals, families, and institutions.
Mark researches and selects hedge funds for his clients. We are very excited to hear some of his wisdom today, so with that Mark, welcome to the show. It is great to have you on.
Thanks for having me.
Do you want to give our listeners a sense of your background and how you came to have a particular expertise and interests in hedge funds?
I have been an investment professional for close to 30 years. You know, some of the highlights include, I spent 10 years at a global long, short equity hedge fund as a portfolio risk manager and that started out as a long, short equity hedge fund, but transitioned over the decade. We were managing close to a billion-dollar spread across long, short both global and international. I also manage my own market neutral fund as you will see as I approach the hedge fund space specifically, I kind of borrow some of the quantitative techniques that I used to manage those portfolios.
So, my role was to systematically optimize the names in every portfolio that we ran, including running my own market neutral fund, to build risk managed portfolios that were consistent with the mandates set out. Back in 2013, I transitioned to the Family office space, so I saw an opportunity to add some value to portfolio management as it relates to the family office space using technology but also using some kind of asset allocation and optimization.
So, I spent a year working with a multi-family office at Amarin and I completely revamped how they approached their asset allocation methodologies, how they assessed what they owned, how to incorporate other asset classes and managers from an asset allocation standpoint. And, you know, assessing new managers for inclusion.
After a year, I found that you know the family office space in a lot of cases, especially the small multifamily offices and the single-family offices kind of lack the expertise to build out those types of solutions.
So, I took my experiences at the Family Office and created a consulting business. I have consulted with close to 20 different family offices over the last seven years, pretty much about doing the value add that I did at the first family office that I worked with. Concurrently, I have also worked with probably 6 hedge fund launches over that period, given the backdrop of having ten years of hedge fund experience but also having some family office experience, you know the idea is that smaller hedge funds need assistance to market themselves to the institutional community, including family offices. So, I have consulted with a lot of startup hedge funds over the last seven years to get them to market. So, three years ago, a family office asked me to put together a hedge fund allocation.
So, I created a firm called Arden Advisory which is our IA firm. The IA firm allows me to get paid management fees on allocations that I make, so this particular family office needed a hedge fund allocation to kind of complement what they already own. They are heavily invested in venture capital and private equity. And they wanted to diversify as part of their overall asset allocation.
Arden Advisory was born right now.
I am sorry we did the allocation in 2019. So, we worked through the allocation in 2019. The money we got put to work at the tail end of 2019. The performance has been exceptional. I think 2019 was a great year for hedge funds, and the hedge funds I chose did well during that year and they continue to do well this year and currently my goal is to parlay that track record into funds under the Arden advisory umbrella.
So what Opportunities now do you see in the hedge fund world space for investors?
You know, I think there are a lot of great opportunities in this current market environment. Given the volatility, and that runs the gamut of every asset class, you know.
Of course, we have given my backdrop. I choose to focus on the hedge fund space, but what is great about the hedge fund space is that there is a variety of things to choose from. You know from Global Macro to arbitrage, long short equity, and a lot of very niche strategies. So, it is an interesting place to be.
I will tell you the 10-year experience that I had at the hedge fund and then also working with emerging hedge funds. I kind of have an insight into what drives consistent alpha for a particular strategy or particular group of people? Of course, the hedge fund space has changed a lot over the last 30 years.
You know it started out as talented investment individuals. This was back in the 70s and 80s. Talent investment individuals were kind of governed by MRSA and other government agencies, and they could not do what they wanted to do in the existing investment structures. So, they created LPs and LPs were created to pull money together so these managers could execute on the strategies they wanted to implement, and they had extraordinary results. I mean, I think originally there were a lot of small CAP micro long short equity managers, but it is transformed into just such a variety of strategies in a variety of methods of delivering returns, and I think you know originally there was not like an idea that a billion, 10 billion, $20 billion hedge funds would exist. That is not what their function was, right?
So, You know what I look for is I go back to the roots. I look for very talented individuals that are doing something relatively niche that they have an edge on because not many people can do it. You know, I look for smaller managers that can execute on their strategy and capacity constrained strategies, and I think that is a better recipe for delivering superior risk adjusted returns and you will not see a lot of brand name hedge funds in My Portfolio. You will see, you know extremely talented hungry individuals that are doing something very different from the rest.
So what is your approach when you are determining what hedge funds to add to a portfolio?
Yeah, I consider myself a small cap hedge fund investor, right? So, as I mentioned, not household names by design. You know the sourcing once you have been in the industry, as long as I have, becomes relatively easy, you know family offices or inherently incestuous that there is a lot of word of mouth associated with great strategies. Upcoming strategies. I go into context, but you know, I have worked for the last three years, and of course most of my career but three years concentrated trying to identify these diamonds in the rough right? You know, there are 10,000 hedge funds out there finding.
You know 75 funds actively looked at hundreds, but finding those is, you know it is a job. It takes some concerted effort. The hedge funds I identify have kind of some specific characteristics. I do look for returns, right? That is important.
The way I approach the problem is that volatility is a secondary concern for me, and I will let you know why that is.
But I am looking for consistent returns and I look for a track record of at least two years and I look for some sort of critical mass from a business risk standpoint associated with the hedge fund that I am looking at. So I am not looking to be the first check in a strategy. I look for someone who has had some success raising money and I you know will be a 6th, 7th check or more.
So, once I have identified the strategy, you know I focus majority on low beta, low correlation strategies. I do long short equity. So, I can introduce some beta, but I diversify away a lot of the beta, right? So, I am really looking for primarily absolute return strategies and very niche strategies and what you can do if you can find as an example, 25% return with a 25% watt, that by itself for a
Family office is not something they usually invest in, because the volatility is too high right, they will pass, and they will look for the 10% return with a 6% ball, right? So, what I do is I take a you know a 25% return with 25% risk and combine it with a 25% return and 25% risk and if they are relatively uncorrelated with each other, you are going to get a 25% return with a lot less risk.
Now I do that 15 to 20 times so much more diversified and what it allows me to do is take advantage of the diversification benefit of having many, many managers, some of them negatively correlated each other and I could put together a return stream that has a close to a 6-7% ball but with much better returns than what people are used to getting from a hedge fund portfolio.
And so, how do you decide whether or not you’ve got your current list of included hedge funds. If you see one that interests you that excites you, how do you decide whether it should be included in the portfolio?
No, it is a great question and I think initially you know over the last three years, you know it has definitely been an evolution, right?
So, you are looking at strategies you know 5 to 10 of them a week trying to kind of assess whether or not what they are doing is replicable and their team is strong, and their business. This is, you know, there is no business risk there, but you start building a database of funds that you feel good about that have a certain risk and return characteristics.
Now, I want to preface my approach to this in my own right. There are plenty of ways to put together hedge fund portfolios, so I am not saying my way is the best way, but it has produced the right kind of results, right? So currently to answer questions specifically is that I have a short list of, close to 20 hedge funds that I feel super confident about that have the risk and return characteristics. So right now, when I meet a new manager, I First off look at their returns and their risk profile and incorporate that in my analysis I use mean variance regression or just a fancy way of saying efficient frontier. And I see whether or not that return stream will add any value to my existing allocation, right? And then if that is the case, then I do the deep dive that I think everybody does for hedge funds is, you know, making sure they have the right administrator, making sure they have a good accountant and a good lawyer and talk to the team, and you know do background checks and you know, call their administrators and call investors.
But like my first screen is whether or not they are going to add value to my overall risk adjusted returns given what I currently am following, that is the first screen.
And it sounds a bit like you have an existing team and you are looking at a potential player to add to the team and what you are looking for is like, is this going to make the overall team better, right?
No, that is right. And then you know one thing that happens, and it has not happened often yet, but what my biggest concern about the hedge funds that I own is they are going to get too big, right? So, they have gotten great performance early on because they are managing a small amount of money.
So I monitor their AUM trajectory very closely and see the correlation to what returns they are generating. so the other situation, consistent with what you described, is that I might have to fire a manager or let go of a manager, and then I have to incorporate a new one and I will go through that same process for that purpose.
Right, and just going back to what you said about the size of the AUM, I think it would probably, you know, surprise a lot of people. Because I think alot of people would instinctively think well, the more a fund is managing, clearly the more successful they are. But I think as you have described, sometimes the more they manage, that really becomes a hindrance to their returns, right?
Yes, there have been a lot of studies empirically that show that the larger the manager gets, the less alpha that they deliver.
I think it is well-known and I think what happens is that smaller family offices do not have a dedicated resource to find these smaller hedge funds and put together a portfolio of them and they have I think historically relied on the fund of funds offerings.
But I think they kind of woefully underperformed. And you know, there’s secondary fees and that they just did not earn their feats. The thing about adding Alpha specifically is that you know the smaller, the nimbler you are the better you are able to do that, and arguably some of the opportunities like you know I have somebody who trades energy right? Or, you know, I have somebody who does. Munir R right, you know the size of that opportunity. You throw a billion dollars with that opportunity, there is no value to generate from that, right? So, if you stay nimble at a 100 – 200,000,000, you can execute on a lot more strategies than if you are a billion-dollar hedge fund and you are trying to do the same exact strategy.
Right? Because if you end up becoming so big that basically you cannot make any moves. Significant moves of moving the market, then you have a liquidity issue, right?
That is exactly right, so every strategy is capacity constrained. You know most managers would say, oh, I can trade a billion dollars, and that is usually not true. Usually, it is probably 500 million Max.
I have worked with dozens of strategies, all claiming that, but if you do the numbers, it is clear that you know if you start plowing a bunch of money into the strategy, you are going to move the market against you, and it is not going to look good.
Historical or traditional fund of funds. Have they focused on oh, I guess what we will call the large cap hedge funds?
No, they definitely have brand awareness as it relates to what hedge funds they incorporated so you know you cannot get fired for employing a fund that everybody knows, right, right? So, I think that has been the big issue with the fund of funds, and I think also the fund of funds tends to cater towards large institutions. So, they needed capacity, so the fund of funds was getting big right. $10 billion or something in a fund of funds.
Now again, that is just not what I am doing, so I am actually not planning to grow more than you know to about 500 million in stock, right? Because even in my situation when I am diversifying across 15 to 20 funds. You know I do not want to have a ton of money in each of these, because that will actually do my investors a disservice. So again, I’m a small cap manager of hedge funds, and I am keeping it small, and I am investing in things that have capacity constrained and they are to stay still on purpose. And the idea is to consistently deliver alpha over time.
So right, what do you see as the role of a hedge fund allocation in a portfolio, either generally or right now.
Again, I will go back to that original value proposition for the hedge fund space. Most people have a core portfolio of stocks, bonds, real estate, and private equity venture capital, especially in the family office space. There’s obvious beta in their stock portfolio, you can argue you know, private equity and venture capital are just a factor of beta exposure, so it can be like a 2 beta for each of these portfolios.
So, you know you want as part of an overall allocation, an uncorrelated return stream. So, the portfolio I put together literally has 0 beta and you know very little correlation to the market you want. If you add a return stream at any percentage, it does not. You know, a great service to the risk adjusted returns for the overall allocation, so you know that is the root of why hedge funds exist?
Yes, so that is my intention. So, and I think it plays a huge role in, you know, superior risk adjusted returns for an overall asset allocation. People are getting nervous, right? You know they are seeing equity. Valuations get close to what it was in the dot com right, and that does not bode well, I mean, we have seen what happened to you know, both private equity and venture capital in that situation.
We have potentially rising interest rates that could affect real estate returns like there are all kinds of things that are going on right now in the marketplace that say you want to get into something that is uncorrelated to what is going on in the marketplace to market risk factors. So, I think right now is a really great time to consider hedge funds generally and a portfolio of hedge funds that deliver.
Returns without exposure to the market I think is the ideal situation.
Right, and so as you mentioned, you spent ten years at a hedge fund as a hedge fund manager from your experience. But what did you learn about? What does it take to be a good hedge fund manager?
A really great question. I think there are two main factors to being successful, right? One is the niche, right?
Being a successful long, short equity manager is extremely difficult, right? Just generally large caps. Long short equity is a very difficult thing to do right? So, most of the people that I look for in the equity space are micro small caps so that they have a group of stocks that they can actually add value on through their research, right? So most and I do long short equity, but most of my stuff is a little more esoteric than that.
So, you know trading power or the spec. There is a spec manager that I am looking at, right? There is somebody that focuses primarily on biotech and Pharma. He is a long only manager, but he does not have a lot of data so I can incorporate those. He has done extraordinarily well, so the niche of what they are doing is extremely important and I am going to expand this to three because I think the second most important thing is if it is replicable. If it actually can happen now and moving forward if what their process is doing is something that is continued, can continue to be replicated.
You know, that also includes whether or not they are choosing to stay small, right? So, if they choose to stay small, it can be replicated going forward, but if they get too big, then that is a threat to replication as an as an example, but you know I had one guy who you know has a core portfolio, but then he swings for the fences on, you know, a single name.
And for him, luckily, he got it right twice. And his performance looks extraordinary. But that is not a replicable strategy. You know, that is not something I am into. I do not want to be on the whim of one decision you make right as an. example of a non-replicated credible strategy.
The third of course, and everyone will say this is the people. Now I have a spin on the people that I am not sure are going to be well received, but I have worked with probably 20 to 30 different hedge fund managers over my career, and I think one of the common denominators is very consistent with a niche market.
Is the person has to be pretty niche themselves like borderline savant, right? They actually have to see the world in a whole different way than the rest of the world, and that is the way you deliver alpha, because if you go with the crowd, that is a recipe for disaster. So, the individual that is running the show must be pretty exceptional and he can be a little bit odd, which is great. I mean that some of the best managers in the world are a bit odd, but that person that is actually making the decisions, putting together the strategy is paramount. So, I look for odd savant type managers because I think that is the way you can deliver exceptional returns on an ongoing basis.
It reminds me when you mentioned that it reminds me of the big, short right because some of the some of the managers that were featured there were definitely savants, right? That they did not go with the crowd at all. And that is ultimately why they succeeded massively.
I think another thing that you mentioned earlier that was really interesting and I do not think a lot of people maybe give enough thought to is aspects of due diligence that might be considered boring but are actually really essential. You know when you were talking about, you know, calling up the administrators and knowing like who the lawyers are and that sort of process you just talk for a bit about that? Why is that so important? Because I think a lot of people would sort of think well, you know if you just meet the manager and you see their performance, you’re kind of good to go, but there is that whatever you want to call it the back-office stuff is also incredibly important, right?
Yeah, especially with how I am approaching this investment, right? So, if you are going with brand names.
With some exceptions you know you are good, right? So, you can invest in a brand name hedge fund, and you know again not get fired or they are not going to, you know, fold or, you know, get invested by the SEC. Or you know, like all the bad things that can happen to hedge funds. Now of course, there are some exceptions, but for the most part you know the bellwether of hedge funds are pretty safe. I am investing in small hedge funds, right? So, hedge funds that you know dont have alot of AUM which means that they do not have a lot of revenue, right? So, you know, there is a lot more business risk associated with the managers that I invest in, versus you know, people that are investing in bellwether hedge funds, so for that matter, the operational due diligence is critical, right?
Is to make sure they are going concern and you know, to make sure there is no fraud, so all the things I mentioned you know, you know you cannot get rid of that risk completely, but you have to mitigate it as much as you can. And I do that by doing a pretty rigorous, you know, operation, operational due diligence, and then the 2nd way I do that is through diversification, like there is no manager that I am going to go heavy in, right?
You know my positions are small, like 8% as a Max position in any one name so that you know.
I limit the business risk associated with each of the managers or the blowup risk or whatever, so those are the two ways that I, you know, mitigate, kind of the business risk associated with it. Due diligence and diversified portfolio and smaller position sizes.
Do you ever have clients who sort of come to you and they say we really like the risk and return profile of the funds that you want to put me in, but we do not understand exactly how some of these strategies work? You know there is that Warren Buffett quote, only invest in what you know. How do you respond If a client has that kind of concern?
No, That is actually the way I am functioning currently.
So right now, I am an advisor to a family who had some existing hedge funds they liked who had some other positions they wanted to throw in, and I worked in conjunction with them in collaboration with them to put together a hedge fund portfolio that they got comfortable with. So that is an advisory service that I provide currently, and I will continue to provide that going forward. So, the fund of funds would give me carte blanche to allow me to invest in the managers that I want to invest in.
So, it is two different services, because you know, arguably there’s a lot of families that already have a hedge fund portfolio, and they might want to add to their existing allocation so I can use the technology I have created and optimize in a number of strategies that I have and just create a portfolio with what they already own. That is better diversified and set up to deliver better risk adjusted returns.
OK well I have other questions, but this has been a fascinating discussion. I think it occurs to me that this is the first interview I have done for the podcast where we have interviewed someone who is I mean you have been a manager, but who is your perspective right now is on how to choose a manager rather than rather than having a direct fund itself, so I think this is really important for our listeners who are considering an allocation to hedge funds or about how to go about doing that.
So, with that said, thanks so much Mark Kress, we really appreciate your time and thanks as always, to our Pitchford listeners, we will be back again here soon. OK, thanks.
Thanks so much.