Which are the most creative hedge funds?

dazedmonk

Been thinking about the future (and present) of the hedge fund industry lately. Many of the tools of the trade are so well-known that it is increasingly difficult to outperform. To that end, I have two questions:

1) What are the most creative/entrepreneurial funds you know of? I mean creative in terms of strategy (e.g. Coleman's drift into pre-IPO P/E , Ackman's turnarounds) or research process (e.g. Einhorn's sleuthing). I'm less interested in baller quants(e.g. Renaissance) unless you can actually explain what they do.

2) What can a typical fundamental L/S shop do to gain an edge (e.g. Analyze faster? Only invest into market dislocations? )?

3) What do you think of the state of the industry? In particular, are L/S equity managers basically turning into L/S mutual funds?

Would appreciate insight from some of the HF guys on here.

On your #2: One big thing is being disciplined and intellectually honest. This sounds simple, but it's really one of the hardest things in the world-to stay disciplined in terms of style, not panic when things go against you, etc; to not fall into group-think (whether "street consensus" or internally or amongst your friends at other funds).

One good example would be a value manager like Einhorn buying gold. At the end of the day, it's not area of expertise, it's not what his investors signed up for, and it's actually the kind of thing I can easily imagine Einhorn making fun of a value manager for doing earlier in his career (David, if you read this, call me!).

Another example is playing out right now in the distressed world. The default rate is extremely low and the number of distressed situations is small, and managers are sitting on lots of capital (due to investment gains and inflows after strong returns the last 3-4 years). If you're a typical distressed manager, you have four options: 1) Style drift into equities or performing credit etc 2) Buy distressed securities at relatively higher prices (less upside/more downside=smaller margin of safety) 3) Sit on cash 4) Return capital to investors

s 1 and 2 are forms of lack of discipline and lack of intellectual honesty. 3 is takes extreme discipline to do in any real size for an extended period of time-investors don't like it and it dilutes returns in the short run. 4 is extremely rare for obvious reasons.

On your #3: I think the industry overall is a bit stagnant but there's no reason to think that it represents a long-term downward trend. One thing that's interesting is the increasing concentration of AUM in larger ($5bn+) funds but that isn't really that surprising-institutional/pension AUM has increased (biased towards large funds for lots of reasons), fund of funds have decreased (were more willing to do diligence on smaller managers than a pension investment board), and LPs are more and more concerned with controls, compliance, etc that are characteristic of larger managers as opposed to "two guys and a Bloomberg" start-ups.

I guess I'm not sure what exactly you mean by "becoming long/short mutual funds" (which already exist by the way). If you mean fee pressure, there's some of that, but I think some people overestimate the difference between the fees charged by mutual funds and the fees charged by hedge funds.

I guesstimate the weighted-average base fee for the hedge fund industry is probably around 175 bps. 2 & 20 is the classic model, but it's never been set in stone and managers giving one form of discount or another has been going on forever. It can take a ton of forms-for example, "hedge fund seeding" firms give managers start-up capital (both operational and investing) in return for a share of the equity in the management co, which, while it doesn't change your headline management fees, is basically taking a discount on every $ of AUM you ever raise. Additionally, most manager will gladly charge 150 bps instead of 200 for a huge check from a big pension or for a longer lock-up period.

By comparison, many boutique/alternative-strategy mutual funds (and other retail products like REITs, BDCs, and MLPs) charge fees over 150 bps-for example one "hedge fund-like" mutual fund manager I can think of charges (depending on share class) 200-300 bps of total running fees for its flagship fund, plus sales loads and redemption fees etc.

Obviously mutual funds can't charge direct incentive fees (though they do have certain "shadow incentive fees" like redemption fees, and many other "retail" products DO charge incentive fees), but on the other hand they can tap a retail investor base that (generally) is not open to hedge funds which makes it much easier to reach critical mass via brokerage/wealth management distribution channels.