The View from Within

I had the opportunity to sit down with Gary Ostoich, the President of Spartan Fund Management Inc. to ask him some questions about his thoughts on the hedge fund industry. Below are the results of that interview. My questions are in bold, with answers given in unformatted text.

 

Q: How has the industry changed in the last 5 years? Do you see it continuing in the same direction?

There have been significant changes within Canada and globally.

First, on a global basis, some of the changes include the following;

  1. Institutional participation has increased dramatically.  You continue to see an increase of allocations by institutions into the alternative area. Historically, family offices and high net worth investors were driving a lot of the growth in hedge fund area.  Today institutions are clearly driving most of the growth.
  2. The industry has become more bifurcated.  There are a small number of very large funds (greater than $5B-10B) and lot of small funds.  The majority of the inflow into the hedge fund industry is occurring with very large funds.  Some stats suggest that 95% of the inflow is going to 30 funds or so globally.
  3. The size of the fund of funds industry continues to decline as more and more investors are going directly to hedge funds as opposed to going through fund of funds.  However, some funds of funds are carving out niche strategies that are attractive to investors such as fund of funds that are focused on emerging managers.
  4. An increasing trend toward “retailization” of hedge funds.  What I mean is that hedge funds are becoming more accessible by retail investors.  This trend is still in the early stages but you have been seeing it in Europe through use of UCITS (Undertaking for Collective Investment in Transferable Securities) structures and no doubt it will gain steam in North America.

On the Canadian side, some of the changes include the following:

  1. The Canadian industry has grown considerably.  Although the Canadian industry is quite small compared to the global industry, the Canadian industry has more than doubled in 5 years.  Currently Canadian resident managers are managing in excess of $30B.
  2. Better businesses are being built.  The industry has become more institutionalized, which doesn’t necessarily refer to the type of investor but rather the requirements that investors place on their hedge fund managers which include operational practices, risk management and reporting etc.
  3. High Quality of entrants.  New managers continue to enter our industry and many of these individuals are high quality entrants from banks and other institutional areas.
  4. Changing shape of the strategies available in Canada.  Five years ago, the AUM of the Canadian hedge fund industry was dominated by long biased managers.  Today we continue to see a broadening of strategies gaining AUM momentum.  To be clear long biased managers aren’t going away and will continue to grow but other strategies are gaining significant AUM within Canada

Q: What is the most important thing you have learned in the industry that you had not considered previously?

I think the industry provides a number of important reminders regarding the financial industry in general:

1) the importance of integrity – once you squander it, it’s very difficult to get it back.

2) markets constantly change – the markets today are quite different from the markets 5 years ago and no doubt this trend will continue in the future.  The governments’ involvement in markets since 2008 has been quite remarkable – it will be interesting to see how it affects markets going forward.

Q: What advice would you give to someone interested in the industry from your perspective?

There are many different ways to enter the industry.  Many people go down a traditional route of getting into the money management area as a junior analyst (working on a CFA designation) and work your way up. Others may become investment bankers and migrate over to private equity opportunities.  Some become traders on bank desks and eventually strike out on their own. I didn’t come from a finance background; I came from legal background and science undergrad. I had a roommate in law school who was interested in the markets and wanted to be a floor trader (when floors existed on the TSX). It piqued my interest and I read far too many books and I continue to read far too many books about trading, investing and finance. Even though I practiced full time as partner in a downtown law firm, I immersed myself in the hedge fund area learning everything I could from books, clients, conferences etc.  I left law in 2004 for the hedge fund area.

If you are interested in the area then try to learn as much as you can.  Some of the information you can pick up from classes but don’t hesitate to go out and talk to people, get involved if you can.

The US is huge part of the hedge fund industry, Canada is a much smaller part of it, so it’s harder to knock on the door of a hedge fund and say “hey can I have a job?” but there are some opportunities out there like working a summer for a fund, a prime broker, administrator or perhaps volunteering for various associations..

Q: How do you deal with investors concerned with poor fund performance? How do you manage investor expectations of fund performance?

Education is an important part in dealing with investors.  It’s important that investors understand what strategies are being traded in a fund and how those strategies should act under various market environments. For example, if you’re a long-biased manager and the equity markets are up 20% and you’re down 10%, you’re probably doing something wrong (or perhaps is a severe losing streak) and your investors would be right in questioning why you are underperforming. You’re also trying to educate investors before they come into your fund as opposed to once they’re in your fund. Typically, people will go into your fund because they see performance. It’s important to educate them on what strategies your funds are trying to capture and is the current marketplace in line with that type of strategy? If you’re a dedicated short seller and market is up 10% you probably won’t likely be up. Investors shouldn’t be upset with you in those circumstances as they shouldn’t be purchasing your fund to capture upside in the stock market.

Communication is another area that is important with investor.  Make sure that you communicate with your investors notwithstanding you may be going through a tough period. Communication is important before they come into your fund and while they’re in your fund.  Communication helps in those down periods because everybody’s going to go through them, no strategy makes money forever, and it doesn’t make it every month unless you’re Madoff.

Q: Inflows and outflows of capital into a fund are highly correlated with short-term fund performance. How does Spartan mitigate the tendency of investors to withdraw money from the markets at the most inconvenient time, such as what has been seen over the last 5 years?

One way is to get a lockup. That helped people through 2008, some had investors locked up for 2-5 years. Although they were dying to get out, it might have been the best part that they couldn’t get out as many markets returned to new highs

Lockups can help but realistically it’s hard to convince investors to invest in a fund with a lockup in a liquid strategy. If a strategy is liquid, it’s very difficult to argue for a lock-up. You can put penalties in to say “we’re not locking you up but you suffer a 5% penalty if you get out within a year” to prevent short term trading of a fund.. You should also consider diversifying your investor base.  As much as people like to have “large chunks of investments” is it good, from a business perspective, to have $100 million made up of 3 investors? You love it when it comes in but you really want to diversify your investor base. Across the funds at Spartan we have maybe 600-700 investors with no outside investor making up more than 5% of net asset value of a fund. That’s a lot of investors. If 1 person pulled or 10 people pulled it’s not going to materially affect the business of any particular funds. So in terms of methods, lockup is one, another is a fee that could apply to get out, another is diversification of investors size-wise. Another area to consider is to diversify geographically. Do your investors all come from 1 region? As a result, if everyone in Germany wants to get out of hedge funds because the DAX is having a terrible year (or perhaps a fantastic year and therefore people don’t want hedge funds), then that can cause issues for your business.

Finally, you want to consider the type of investors that make up your investor base. A family office investor is quite different from an institution which is quite different from a high net worth investor investing through his or her RRSP   Each can act quite differently with respect to investment horizon, factors that could affect redemption etc.

Q: How has your career progressed to this point? Is this the usual path or are there others that are more common?

More common path is through a finance background, working at a bank, getting exposure to the trading side, then going from there. The tough thing about a lot of hedge funds in Canada is the larger ones have opportunities for more junior guys but for the most part they get them from banks or other funds. You need experience which will typically come from working with larger institutions or businesses. To be hired as an analyst at a hedge fund they will likely look to hire someone with more experience. It might be from mutual fund or bank desk or elsewhere. That tends to be the more common way. Having said that, traders and portfolio managers do come from a variety of backgrounds. We have one guy on our trading desk who was a professional musician who traded on his own account for 20 years. Another person left a bank desk and traded his own account. Another 2 people were managing large portfolios at pension funds

Q: What are the things you value most in a prospective PM/Analyst?

In the hedge fund area, historical performance and track record are critical and therefore when looking to hire a PM it’s important to see what the person has done previously especially if you are looking to launch a dedicated fund.  Track records not only speaks to your ability to generate upside but also how you deal with risk management,

As we know, there are a range of strategies in the hedge fund area and therefore positions would require different skill sets.  The skills sets for an analyst for a long/short fundamental strategy would be quite different from an analyst for a quant fund.

Q: Are some skills more important for investments in certain asset classes relative to others? What skills?

You won’t have the same skill set for all strategies.

For example, you can see  in people what they enjoy doing – some analysts really like to pull apart prospectuses and focus on event strategies.  Other people like to focus on fundamental value of companies and work on cash flow modeling. Still others are very focused on programming and black boxes and trade in the quant area.  Computer skills tend to be very important for quant and CTA strategies.

 

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