In other news, I’ve had the opportunity to go on a fabulous amount of travel recently. My job is finally living up to the “global travel” mentioned in the posting I responded to on Monster.com over 3 years ago. Sometimes, consulting is alright.

Apropos of places I can’t tell you I’ve been and clients I can’t tell you I’ve met, sovereign wealth funds are very interesting. After dealing with commercial or otherwise regulated money managers for so long, it’s quite an epiphany to realize that a SWF answers to no regulatory body and has no duty of care to any client, even its own government. They are measured on one thing and one thing own: profit. Further, no matter how successful the investment team, the whole operation can be liquidated if the government faces a shortfall.

I might think working at a SWF is pretty risky, but I honestly don’t have enough experience to confirm or refute this idea.

People still look at me and think “software guy”. It’s frustrating. I recently worked with a client who, similarly, had responsibility for business applications and IT decisions, and had completed CAIA certification around the time of its inception. He actually appeared to be dead set on leaving the industry completely. I guess I’m saying that in the end, it isn’t an indicator of much.

Still thinking about business school. I had an opportunity to visit Kellogg and Chicago Booth the other month. Booth was awful. Really. The students were snobby.  The fancy new b-school building was really not that impressive on the inside.  The few administrators I met proudly proclaimed that the school was changing nothing in the wake of the recession. That was disturbing. From an admissions standpoint, they talked a lot about how “fit” was important. I left feeling like that school was a very bad fit for me.

My experience at Kellogg couldn’t have been more different. The students were friendly and humble. I didn’t deal with hardly any admissions people. Everyone seemed pretty engaged in what was happening to the economy. Most important, however, was the other potential students. When I go to info sessions, the thing that turns me off the most about business schools is the other prospective students. They reek of hollow ambition. They stink of outsize expectations.

The prospective students that I met at Kellogg, though, felt like people with whom I would actually want to be friends. It could have been coincidence, but it has definitely been the most striking thing about any school that I have visited.

Making a representation of position-level transparency does not yield any insight into the quality of the manager’s operations. The obsession with knowing exactly what the fund manager is doing runs counter to the entire idea of outsourcing your wealth management decisions, a.k.a. investing. You don’t need to understand what the fund is doing so long as the fund adheres to its mandate.

Goodbye, FFG.

So here’s where I am: got my study materials for CAIA level 2 a few weeks ago. I’m somewhat behind schedule—didn’t manage to make up as much time over xmas as I thought I would. Still, finding level 2 a bit more enjoyable than level 1.

I’ve expanded my horizons slightly as regards school. While I’d previously dismissed UC and Kellogg because of the weather in Chicago, I met an alum who managed to put me at ease with the prospect of freezing my ass off. I’m also going to visit Yale at some point, pretty much just because I can. I was intrigued by their hedge fund class, though the fact that it is run from the perspective of a fund manager and not an investor means it’s not really my thing.  And for what it’s worth, I’m going to go ahead and check out info sessions at Columbia and NYU again.  I hope that, by this point, any info sessions will touch on applying in the coming fall.

Last but not least, there’s Madoff.  It’s still too early to distill any serious implications out of the Madoff fraud.  So far, the media’s focus appears to be on the damage and not the inevitable regulatory response.  One of the most interesting things I’ve found is the wildly divergent fees various people charged just for access to Madoff—access that came without the added benefit of oversight or diversification.  Check out this article at the WSJ to see how different middlemen charged ridiculously inconsistent fees for access to Madoff.  It’s just more evidence of how seriously broken the whole “pay for access” model is.  Doesn’t even matter that Madoff comitted fraud, the fact that one guy can charge me 3 times as much as another for the same investment is ridiculous and inefficient.  I’ve been kicking around a number of ideas about how to improve this model and, more to the point, the whole fund of fund concept.  I hope to post on that soon.

I do not believe we have seen the full effect of hedge fund redemptions yet.  We don’t know everything about every fund’s redemption terms, but Dec 31 is a fairly common redemption date regardless of the fund’s liquidity.  Most redemption notices were probably due 9/30 or will be due 11/15.  So, at this point we can only guess as to the extent of redemptions that have been requested.  Also important to keep in mind: most funds promise return of investor capital within a certain number of days after the redemption date, not on the redemption date itself.  In all likelihood, much of the money requested for 12/31 won’t have to be paid out until 45 to 90 days after that date.

What I’m saying is, it’s possible that we haven’t begun to see the full extent of forced selling.  If forced selling by hedge funds is really going to have a significant impact on the market, we’ll see it most in early 2009 as managers scramble to come up with cash at the last minute.  Right now, it’s still plausible to suggest that managers are simply trying to accumulate cash in anticipation of redemptions and do not yet have their backs up against the wall.

So, here’s an idea I’ve been kicking around: is it really so bad to be a midsize hedge fund?  Conventional wisdom (also: several McKinsey, E&Y, and PWC surveys) says that size is one of the most important indicators of fund success.  As I’ve mentioned before, a lot of assets is important for soothing institutional investors who worry that the fund might blink out of existence after a few trades go bad.  So, high AUM is part of a self-sustaining cycle where size alone makes it easier to grow your assets ever larger.  Also, your return expectations in fact DECLINE seeing as your investors are primarily institutions.

Which is to say, Joe Pension Fund just wants 8-10% returns net of fees with low volatility.  Small funds have to promise so much more.

Anyway, I’m wondering if the conventional wisdom is maybe a little wrong.  Maybe there are advantages to being midsized, especially in difficult markets.  What advantages could a midsize fund possibly have?

Well, first, lower overhead.  Large firms must necessarily hire employees to fulfill administrative and operational roles that smaller companies can outsource, such as IT and HR (for the record I am strongly opposed to outsourced-only IT teams.  If you have internal systems, you need a little internal IT).  Large firms have more real estate–not just larger offices in general but more offices overall, primarily to support asset raising.

A smaller fund has fewer nonessential employees and lower real estate costs.  If these don’t seem like real advantages, consider the fact that payroll and real estate costs DO NOT SCALE.  There’s no economy gained in hiring 30 people as opposed to 20, and when it comes to office space, you can’t buy just what you need–you end up paying for a whole other floor or office suite just to seat the marginal next employee.

Granted, technology and counterparty costs do scale, but these costs also vary widely from firm to firm.  However, all things being equal, whatever your reduced cost from buying additional Bloomberg licenses, the extra employees using those licenses need to generate value in excess of their pay etc.  If this was a reliable formula, every firm would just hire tons and tons of traders because your profit would be directly related to your number of employees.  Obviously this is not true.

I would love to say that smaller firms can be more “nimble” and get out of bad investments, but this is also patently untrue.  AUM and headcount has nothing to do with the liquidity or timing of a fund’s investments.

Another thought I had on this topic was that midsize firms might be less dependent on large investors.  That is, a fund with assets under $500 million probably has a lot of individual investors and/or investors that are personally known to the manager.  The small firm might have an advantage in retaining assets due to personal relationships and the vastly different objectives of individual investors.  A large firm is likely to have more institutional investors and FOF investors who will walk when peformance is bad.

At this point I can still see how it would be better to be larger–especially in an environment like we have today where large AUM is necessary for spreading your exposure to counterparties, investors, and asset classes.  Nonetheless, I do think it’s interesting to consider that being a big firm does have some disadvantages.

In other news, a number of sources latched onto HFR’s report that September was the Worst Month for Hedge Funds Ever.  Check out some of the better stories on Friday’s Abnormal Returns.

Had a good chat last night about the market’s response or lack thereof to the bailout.  I was glad to see a small dip because it means investors are still in the business of assessing the long term prospects of companies instead of just gaming the system.  Monday’s fall and Tuesday’s recovery, to me, made it apparent how market movements are driven by speculation. The long term effects of the bailout are nearly impossible to guess.  If anything, it has been interesting to learn that many companies are very much affected by the overall health of the credit/mortgage industry.

I’m semi-serious.  I’d like somebody to explain to me why coca-cola’s prospects are any dimmer because Wall Street is dying and nobody can pay off their mortgages.  I don’t necessarily choose between paying my rent and buying a soda, yknow?  I have completely different economic thought processes for discretionary spening on consumable goods vs. larger expenditures.

I’ve spent most nights and the last couple weekends locked away in my apartment studying. That said, it really hasn’t been so bad.  The Schweser question bank is enormously helpful and I’m geting 70% give or take on the practice exams.  Should be enough to pass & it’s just one more week of studying (and the stunted social life + poor diet that comes with it) until the exam.

You have to make some tradeoffs in studying I think.  Like Real Estate, Private Equity, and Credit Derivatives–I know that there will be one or two questions each on DCF, IRR, and CDO structures.  I will never, ever use any of that stuff in real life.  I don’t think it’s worth it to memorize the keystrokes on my calculator.  I’d rather focus on concepts that I already sort-of know but am more likely to use practically.

Of course this also bodes ill for the level 2 exam which involves even more esoteric math.  A central problem with all of this is that I don’t actually do any of the quantitative stuff at my job.  In what I do, there’s a big focus on the the nature of funds, due diligence, and other “fundamentals”, but no math.  On my practice exams I’m getting perfect scores on those sections but maybe only 50% on quantitative methods.

Hell, I got a C in statistics in college.  I hate math.

So here’s hoping the distribution of questions leans towards concepts and not applications.  Good luck to everyone else if you haven’t taken the exam yet.

This makes a lot of sense when you consider the average fund of fund investor.  A Fund of Fund is not a vehicle for obtaining excess returns.  The idea is to gain the risk protection of hedge funds as an asset class while avoiding the idiosyncratic risk that causes occasional fund death (Ospraie, Atticus, Ore Hill, and others are today’s headline failures).  What I’m saying is, outperformance doesn’t matter as much as exposure to a large number (some say 20, others recommend as many as 40) of hedge funds, especially good hedge funds that are hard to get into if you don’t have a lot of money or the right connections.

Joe Pension Fund doesn’t have the money or the connections, but he can pool his resources with a number of other investors and take advantage of the fund of fund’s economy of scale and dedicated research department in order to gain exposure to hedge funds that otherwise would have been out of his reach.  When this is your goal, size matters.

In order to compensate for lack of access (and consequently, less risk budgeting), smaller fund of funds need to have better performance.

But why doesn’t the investor just go for higher performance, isn’t that the only thing that matters?

Think about why a fund of fund might be large even at its inception.  Talented, well-connected management, a team and business plan capable of attracting a lot of capital, and guaranteed access to some desirable funds.  Size alone is one of the most important indicators of fund stability.  Right now a few large, well known funds are struggling.  What you don’t read about is the fact that tiny funds die all the damn time.

So for the beleaguered pension fund manager, if you care primarily about exposure to hedge funds in a sort of portable alpha/downside protection way (and you should), a fund that promises stability through its size requires less due diligence and is ultimately a preferable long-term investment.  A large fund, though it underperforms, can still be attractive.