The Asymmetric Risk Profile: Preparing for the Hedge Fund Interview

Hedge fund interview questions typically are trying to uncover how you think as an investor. One of the best ways to demonstrate your knowledge is to highlight that you look for investments that offer the greatest odds of success – investments with an asymmetric risk profile. This strategy was invented by Graham and Dodd and made famous by none other than Warren Buffett. Often, without even thinking we employ this strategy in our every day lives. We are constantly making decisions that minimize risk and maximize our probability of success. Choices related to education are great examples of seeking an asymmetric risk profile.

Having had the good fortune to take the unusual path of corporate strategy to a hedge fund and the opportunity to sit on both sides of the interview table at both my corporate job and my current fund at such a young age I feel that I have a rather unique perspective on the interview process and what makes a candidate successful.

My experiences have led me to believe that the most successful candidates in interviews for any industry or position actively seek to create an asymmetric risk profile for themselves. While many of the specific points I will make are going to be geared towards interviews in the HF industry they are easily applied to general interviewing.

The All Risk – No Reward Questions

Tell me about yourself? Walk me through your resume?

Your answer to this question should flow nicely, but not sound rehearsed. I have had people tell me a proper answer lasts no longer than forty-five seconds and others tell me no shorter than three minutes and preferably five whole minutes. Personally, I try to keep my answer around one minute in order to further minimize my risk. Your story should lead the interviewer to think that based on your previous experiences it is logical for you to apply for that position and him/her to be interviewing you for the position.

Specifically, for a HF interview you want the interviewer to know you have the ability to break down and evaluate businesses, know your way around financial statements and have the reasonable assumption that you can handle the pressure of putting large sums of money behind your ideas.

Why investment management? Why Hedge funds?

I cannot overstate the importance of your answer to this question. The interviewer, ideally, should not have a doubt that you want to be in investment management for the long haul. You should come across as mature, steadfast in your decision and appear as though you have thoroughly researched all your options and come to the decision that IM is for you.

The answer to this question is very personal and if you can’t come up with a sufficient answer pretty easily than, honestly, this job is probably not for you. I will say, however, that this is a great opportunity to let your interviewer know that your personality lends itself favorably to being successful in the capital markets. Humble people who are competitive, inquisitive/perpetually seeking to learn, and intellectually honest often do well in this business.

Technical Questions

It is important that you are able to answer any technical questions you are asked well. In my experience, the level/amount of technical questions you are asked is directly correlated with what you project on your resume. Obviously, this is used as a BS detector in many situations. As a hypothetical example-- if you say on your resume that you can build an lbo model with both eyes closed and one hand tied behind your back be prepared to be asked to do it during an interview.

Because the amount of technical questions can vary wildly by fund and because they have already been discussed quite a bit on the site I’m not going to list many actual technical questions. However, there is one question that you will almost certainly get that I feel needs to be discussed:

If you could only be provided on piece of information (read: metric) about a company before making an investment-decision what would it be?

The answer to this question at my fund, and consequently any other fundamental L/S fund I am aware of is Return on Invested Capital [ROIC]. We will also accept Normalized Free Cash Flow Yield.

ROIC is the return a company earns on each dollar invested in the business. Therefore, obviously, the greater ROIC is the better. ROIC is used as a quantitative measure of competitive advantage and, as such, if you are going to make an investment decision based on a single factor it would serve you well to choose the business with the greatest competitive advantage.

I call these questions the “All risk – No Reward Questions” because, simply put, answering them well will not earn you an offer, but answering them poorly can very well get you dinged quickly. Therefore, it is important that you prepare judiciously for these types of questions, but do not expect even amazing answers to earn you an offer.

High Risk – High Reward Questions

The Pitch

The stock pitch is always a staple of the HF interview and you should prepare accordingly. I come prepared with one long idea and one short idea as I think being able to demonstrate that you understand the nuances of shorting is a great way to differentiate yourself from other candidates. If you are interviewing for a specific sector/industry I suggest that you pick a business from that industry to pitch. Yes, your interviewer will likely know more about the industry and/or company, but as long you stick to stating this you know and not trying to BS your way through you should be more than OK. I use a pitch structure similar to what WhiteHat outlined here , but I will discuss it quickly:

1) Industry: Why is the industry attractive? [I suggest using a quantitative metric to show you did your homework here, such as, “ABC Industry has the ability to grow xyz% in the next 3-5 years. This is also a good place to highlight changing competitive dynamics, etc.]
2) Company: Why is the company attractive? [I suggest something like, “The business has sales of $30 in a $3000 industry representing a 3% market share despite being recognized as the product leader and having an exceptional management team.”]
3) Catalyst: Why is the market wrong and how will the market realize the intrinsic value of the business? [This is the most important part of the pitch. I usually begin, “ABC is currently valued at 10x [insert multiple], but is being unfairly discounted because of the incompetency of the prior management team. Since the current management team has taken over [insert metric] has improved XYZ. As of right now the market has not recognized the improvement in XYZ or the overall business, but I expect that [insert catalyst] will demonstrate ABC’s true value to the market within [insert time frame].”
4) Valuation: What is the intrinsic value of the business? [I suggest saying something like, “If my assumptions [discuss them here] about the effect of [insert catalyst] prove true than the market will realize ABC’s intrinsic value of [insert valuation].” You can then speak about contingency valuations, etc.]

I try to keep my pitches as short as possible and as high-level as possible. This allows me to minimize the chances of putting my foot in my mouth and allows the interviewer the chance to ask more in-depth questions where he/she feels necessary. You do need to be prepared to answer in-depth questions about anything pertaining to your pitch – the industry, competitors, the company, etc.

If at some point you are asked a question about a company/industry that you do not know the answer to DO NOT try to BS an answer. It is acceptable to say, “I do not know, but I will find out and follow up with you.” or “I am unsure, but my first thought would be [insert educated guess].” There is an old saying in the industry that, “You have to know what you don’t know.” Knowing what you don’t know is almost a badge of honor and acting like you know everything is certainly not.

Knowing what you don’t know is the key to doing well with the High Risk – High Reward Questions. Like I said in my networking post the key to being successful in breaking in to the buy side is demonstrating a higher level of thinking and being willing to admit what you don’t know goes a long way to demonstrate higher level thinking to interviewers.

This post suddenly became incredibly long so I will move a couple topics to my next write-up. As always – questions, comments and dissenting opinions are not only welcomed, but are encouraged.

 
Best Response

Yes, in my experience the HF recruiting process is much less structured than PE. I think this is mainly because the HF business model is scalable in that a dramatic increase in head count is not necessary even as AUM increases exponentially and because there generally is not a defined two years and out structure or mentality at the junior level like there is in PE.

Unfortunately, I cannot offer much insight in to recruiters as I did not use one in my transition. I wish I had and it would have likely made my transition quite a bit easier, however, my corporate background and non-target undergrad institution was not conducive to getting the attention of recruiters.

My transition was rather bland even though the recruiting process at my fund took the better part of a year. My corporate job was located in the South and while I was applying to funds located in the usual suspects (NY, Bos, Chi, SF) I came across a smaller and less established fund in my current city. Luckily, they had a job posting listed on their website and I submitted my resume and cover letter and received an interview invitation a few weeks later. I had, I think, four interviews total meeting with the entire investment team multiple times. Interestingly enough, I was never asked to complete a case study or modeling test despite my non-traditional background. I think part of this had to do with the fact I was lucky enough to make a good impression on the founder in my first interview. Our simple first round interview ended up being a conversation lasting ~2 hours. Another thing that most likely helped was that I was lucky enough to have the opportunity to manage money for a few small businesses beginning my sophomore year of undergrad. The amount of money I managed was enough that I did not look dumb putting it on my resume and the insights I learned about investing and specific companies allowed me to speak intelligently to interviewers about the market/businesses.

[quote=patternfinder]Of course, I would just buy in scales. [/quote] See my WSO Blog | my AMA
 

I think you are reading -- unnecessarily -- too much in to my statements. If I clarify what I was saying I think you'll see that we largely agree.

Going Concern:
Every L/S fund does not think ROIC is the most important metric for making an investment decision lol, and the fact that your team is looking for a specific answer instead of the justification/thought process is pretty hilarious.

No where did I say that every L/S fund thinks ROIC is the most important metric for making an investment decision nor did I even say that my fund thinks that ROIC is the most important metric for making an investment decision. My exact words were:

Simple As...:
If you could only be provided on piece of information (read: metric) about a company before making an investment-decision what would it be?

The answer to this question at my fund, and consequently any other fundamental L/S fund I am aware of is Return on Invested Capital ROIC. We will also accept Normalized Free Cash Flow Yield.

There is a distinct difference between saying EVERY L/S fund and every L/S fund THAT I KNOW OF -- Again, huge difference. Even further, I stated that ROIC is the answer to a very hypothetical question. That is a far cry from stating that it is the most important metric in making an investment decision. Your assertion is even more ridiculous because any thoughtful person with even the smallest amount of investing experience would know that it is ludicrous to even think about making an investment decision based on a single metric. I would argue that knowing what a person would want to know if he/she could only know one thing about a business offers a great deal of insight in to his/her thought process. As a value-oriented fund businesses with a durable competitive advantage are a pretty big deal to us and I would imagine that most fundamental investors at the very least view competitive advantage favorably. Of course, special situations and the like are a whole different animal. It is one question designed to get a small look in to the way a person looks at businesses and investing. Please don't make it more than it is.
Going Concern:
Although "No Risk" implies "No Return", which is not true.
Literally no where did I say anything about "No Risk". In fact, I classified both groups of questions as highly risky.
Going Concern:
A solid answer to "Why Investment Management" for example would get some points in my book. If two candidates stock pitches are similar quality but one was really passionate about describing why he wants to do investment management (really showing his interest in markets and companies, talking about his PA, etc) and the other candidate just gives a generic answer that minimizes his risk but doesn't wow anybody, I'm pretty sure the first guy is getting the job.
I agree with your statement, but I think I did not get my point across clearly. I specifically said that I cannot overstate the importance of the question, but that even an excellent answer is unlikely to earn you an offer. Even further, the whole premise of this post and my previous networking post is that thinking at a higher level is tremendously important and that canned questions/answers should be avoided at all costs.
[quote=patternfinder]Of course, I would just buy in scales. [/quote] See my WSO Blog | my AMA
 

Even though I enjoyed having my thoughts challenged by Going Concern last night I would like to stand by my comments concerning ROIC to ensure that only the highest quality content is on WSO. I do not do these posts to massage my own ego, but to give back to a community that has helped me a great deal in the past several years.

Please note the eighth comment on the thread below by WhiteHat [a respected Certified User]:

//www.wallstreetoasis.com/blog/whs-interview-stock-pitch-checklist

[quote=patternfinder]Of course, I would just buy in scales. [/quote] See my WSO Blog | my AMA
 
Simple As...:

Even though I enjoyed having my thoughts challenged by Going Concern last night I would like to stand by my comments concerning ROIC to ensure that only the highest quality content is on WSO. I do not do these posts to massage my own ego, but to give back to a community that has helped me a great deal in the past several years.

Please note the eighth comment on the thread below by WhiteHat [a respected Certified User]:

//www.wallstreetoasis.com/blog/whs-interview-...

Simple As...:
If you could only be provided on piece of information (read: metric) about a company before making an investment-decision what would it be?

The answer to this question at my fund, and consequently any other fundamental L/S fund I am aware of is Return on Invested Capital ROIC.

WhiteHat:
By the way, unrelated to this post but if an interviewer asks you the "if you could have just one piece of information about a company to tell if it's a good business or not, what would it be?" ...the answer is Return on Invested Capital. Your welcome.

The comment you're referring to by WhiteHat (who by the way lost a lot of respect after his Tesla debacle) says that ROIC is useful to identify a "good business". I agree with that. However, the question you posed in the OP was around an investment decision. From that context, being a good business doesn't mean much. There are tons of good businesses. Large blue-chip companies that just print money...but that could all priced into the multiples they're trading at. I'm assuming the goal is to make money, in which case it doesn't really matter if the business is currently good or not, what matters is what you think is going to happen with the business vs what the market thinks, assuming of course that it's a going concern...

 

Yes, this is the point that I tried to get across many comments ago, but apparently it hasn't clicked yet.

The question is similar to a brainteaser like, "Tell me how many baseballs it takes to fill up a school bus." You are never going to have to find out how many baseballs it takes to fill a school bus for your job and you're never going to have to make an investment decision based on a single metric for your job. It's all about getting a look in to how you think. The difference is that with the school bus question your answer is irrelevant because you're working the problem out either on paper or verbally for the interviewer while the answer you give to the question I posed gives insight in to how you think.

I'd also argue that the question gives a great deal of insight in to the interviewee's critical thinking ability as well. Making any investment decision is complex and requires deep thinking, but what often separates great investors from average or even good ones is an ability to distill a complex problem/situation/idea down to its simplest form. Take David Tepper's CNBC interview from the other day as an example, even though he is a terrible public speaker he is able to take a great deal of information about the market/economy, make sense of it and communicate what he learned in a clear and concise manner. The same goes for Dalio and his 30 minute economics 101 video and 200 paper of the same topic. A successful interviewee is able to understand the scope of the question and answer accordingly.

[quote=patternfinder]Of course, I would just buy in scales. [/quote] See my WSO Blog | my AMA
 

There's really nothing useful about this thread and it should be deleted, in my view. Nevertheless, I shall contribute:

To be totally and absolutely clear, ROIC is not a bad answer (necessarily) to this question, but it's arguably not a good answer, and it is certainly not the only/best answer. Folks here that have taken econ 101 might argue that companies earning high ROIC are often just over earning, and that competition will eat away returns and thus trailing earnings may be inflated. Conversely, a low ROIC company could be underearning for one reason or another, and poised to experience growth in profitability. Additionally, high ROIC companies may not have reinvestment opportunities in their core business, and so will not compound earnings growth. It is really a myth that high ROIC companies are necessarily, or even frequently, great businesses/investments (that is to say, most high ROIC are not endlessly growing franchise businesses like coke, see's candy, etc)

I will never have to interview again, but if I did and got this question, I would probably ask for estimated unlevered FCF yield in 3 years or 5 years. If the company is trading at 3x forward unlevered FCF, it's probably a good buy. If it's trading at 50x forward unlevered FCF, it probably isn't.

 

What in your opinion makes this thread worthless? Obviously you think there is some misinformation so please share.

You make a good point except by the terms of the question you don't know what multiple at which it is currently trading. Interviewing 101 says to answer the question at hand, since you're implying that either are retired or run your own shop of some kind I would guess that you understand that.

Edit:

Did you get FCF yield for year five when you did your DCF lol?

[quote=patternfinder]Of course, I would just buy in scales. [/quote] See my WSO Blog | my AMA
 

Thanks for the kind words. No problem, I have no problem being called out when someone thinks my ideas are sub-par. The networking post was admittedly a little weak, it's a hard subject to tackle, I think.

Great points. I never meant to discount FCF yield as I think it is a great answer. Admittedly, I am partial to ROIC because I personally don't mind paying a higher multiple for a good business with an excellent management team.

Edit:

Generally, we use it as a BS detector and/or a way to see how well a person prepared for the interview basically because it is such a hypothetical question. For instance, if you answer with P/E multiple than you either have no idea what you're talking about or weren't really prepared for the interview. In truth, it is not really that important of a question, but it can -- and often does -- give a little insight in to how the person thinks about businesses and investing in general.

[quote=patternfinder]Of course, I would just buy in scales. [/quote] See my WSO Blog | my AMA

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