A new report that comes to us jointly from EY and the AIMA indicates that hedge fund industry leaders believe that one of the secrets to success in the field is investment in, and thus retention of, talent.
When the report was released, Dan Thompson, partner in the EY financial services practice, explained its findings this way: “It seems that for a hedge fund, as much as any business, success is in large part driven by articulating a clear message in advance, delivering what you have promised, and doing so reliably over time. This applies to relationships with both investors and staff.”
In terms of the relationship with the staff, one crucial component not surprisingly turns out to be the hedge fund’s internal compensation systems. The EY/AIMA report, Traits of Success, says that misalignment “between the remuneration of investment and non-investment staff at [a hedge fund] firm is likely to be harmful to team cohesion.” This insight produces something of a dilemma: collective incentives for good performance may be conducive to the necessary team spirit when times are good, but they may be excessively punitive when timers get rocky, for the market or for a particular strategy and attendant funds.
More generally considering questions about investing in talent encouraged us at AAA to look again at a November 2015 paper from Georgetown McDonough School of Business, Managerial Talent and Hedge Fund Performance, which sought to quantify the significance of management skill.
The authors of the Georgetown study were: Turan G. Bali, Stephen Brown, and Mustafa Onur Caglayan. They looked at maximum monthly returns for hedge funds over given time intervals (MAX). After controlling for the four Fama-French-Carhart factors they found a significant remaining return spread between the high-MAX and low-MAX and they tested whether that is a predictor of superior fund performance in the future.
The method seems analogous to that employed by Sherlock Holmes, as chronicled by Arthur Conan Doyle in The Sign of the Four, “once you have eliminated the impossible, whatever remains, no matter how improbable, must be the truth.” Once one has eliminated all other known factors via statistical legerdemain, whatever remains must be managerial talent, especially if this hypothesis has predictive power.
Intriguingly, Bali et al also found that “for hedge funds with no derivatives and low leverage usage, the next month return and alpha differences between high-MAX and low-MAX funds are not significant, while the return/alpha spreads are positive and highly significant for funds with high leverage and derivatives usage.” So under those specified conditions (absence of derivatives or leverage) the talent spread, so to speak, effectively disappears. What is the talent doing that the less talented can’t do? Evidently it involves making good use of derivatives and debt.
Back to the ‘80s
Talent matters for performance, for survival, and for inflow. Further, MAX as a measure of such talent “can be effectively used by investors when selecting individual hedge funds.”
This fact sent Bali et al back to a 1981 study in which Roy D. Henriksson and Robert C. Merton contended (in the Georgetown group’s paraphrase) that “directional funds willingly take direct exposure to financial and macroeconomic risk factors, relying on their market and macro-timing ability to generate superior returns.” In two papers in The Journal of Business Henriksson and Merton set out a market timing model designed to allow identification of the gains generated for a portfolio by market timing skills even if the timer’s forecasts are not observable by the analyst.
The Bali findings are consistent with the older Henriksson-Merton model. To test further the connections involved, the Georgetown group ran a market-timing skills test at the fund level. It found that “the next month return and alpha spreads between high-MAX and low-MAX funds are not significant for the funds with low market-timing ability, while the return/alpha spreads are positive and highly significant for the funds with high market-timing ability.” This again supports the Henriksson-Merton view.
In short: a positive talent spread exists, and what the talent does specifically to make that spread statistically significant is (a) to time market moves and (b) to use derivatives and leverage in order to get the most out of the timing of those swings. Thus, the more directional a hedge fund firm’s strategy or strategic mix, the more talent matters to its success.
So, yes, to return to where we began … invest in and retain good talent.