What is the secret sauce? Feel like I don't know anything

I look at the SM HFs that consistently generate returns year after year. A lot of these hire PE guys.

What is the secret sauce? How do they do it? I am in a large cap PE firm right now and there is no secret sauce to what I am doing. It is just classic over-complex models and neurotically detailed diligence.

This leads me to believe that the secret sauce lies in idea generation. When you look at some of the top investors (e.g., Elliott or Abdiel - these are just two that come to mind), you see backgrounds in Law, Philosophy, History, and other Liberal Arts studies.

This leads me to believe that the key to the success of being a hyper-successful public markets investor is first principles logic and an ability to develop a coherent thesis about the world around you and that that is the context in which "good" idea generation is grounded.

What I think is interesting is that PE doesn't train these skills at all for the most part. You model what CIMs you have available, and there is nothing proprietary anymore (for the most part) in the large-cap space.

For this reason, I draw parallels between HF and venture in terms of the critical thought required (taking extraneous factors out of the question, such as crummy VC firms that can't get deal flow to where they have the luxury of critical thought, to begin with).

Maybe I am not thinking about this correctly though (the above thoughts are a bit meandering). Please let me know what you think, and please be nice, I am just trying to think through this subject out loud with the help of this forum.

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Comments (72)

  • Associate 3 in HF - EquityHedge
Mar 11, 2021 - 1:17pm

What's really going to get your goat is, if you really applied first principles logic, you'd have to ask yourself whether Abdiel is the template you should model yourself on, or if they happened to be lucky from factor exposure...

I don't know enough about them either way, but that's a line of thinking you might want to examine more closely.

I like these sorts of discussions (that often go nowhere btw). Think it comes down to deciding how you want to define success. If you align yourself with the right factors that do well over the next decade and outperform, will you consider yourself successful? Is picking the right factors to align with part of the skill in this game? Etc.

Mar 16, 2021 - 7:11pm

Associate 3 in HF - EquityHedge

What's really going to get your goat is, if you really applied first principles logic, you'd have to ask yourself whether Abdiel is the template you should model yourself on, or if they happened to be lucky from factor exposure...

I don't know enough about them either way, but that's a line of thinking you might want to examine more closely.

I like these sorts of discussions (that often go nowhere btw). Think it comes down to deciding how you want to define success. If you align yourself with the right factors that do well over the next decade and outperform, will you consider yourself successful? Is picking the right factors to align with part of the skill in this game? Etc.

One of the best replies that I have ever read in a place like this.

SafariJoe, wins again!
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  • Analyst 3+ in HF - EquityHedge
Mar 11, 2021 - 7:32pm

Being a good business analyst does not equate to being a successful investor. While it is an input, monetizing ideas (or understanding when a business is under/over appreciated) is a different skill set. 

Mar 11, 2021 - 8:15pm

Really being able to understand a business and it's respective industry allows someone to understand the growth drivers, the upside optionality that may not be priced in etc. 

  • Analyst 2 in AM - Equities
Mar 12, 2021 - 6:42pm

Agreed 100%. A stock picker and a business analyst are two very different things. The real sign of a great investor is being able to switch between the two... 

Mar 11, 2021 - 7:34pm
  • Idea generation, sure, but you'd be surprised how unoriginal or crowded hedge fund ideas are, a lot of PMs talk to each other everyday. 
  • Abdiel and Elliott are probably similar in the depth of diligence on single name as they are very concentrated. It's about clear understanding of key business drivers and either have a variant view on the duration or magnitude of outperformance of these drivers in relation to what's priced in (ie. consensus pricing in sustainable 10% growth, they see 20% sustainable because they developed strong conviction on one optionality that's not played out yet)
  • Finally, it's about sizing correctly - win big when you are right and lose small when you are wrong, both on a single-name (ie. more than 3-to-1 upside/down ratio) and on a portfolio basis (ie. winners got sized big and losers got sized small based on conviction level)

A lot of people can do the work, outperformance comes from superior thinking and conviction-weighted betting. 

Instagram: @dickthesellsider | Clubhouse: @dicktoad | Substack: dicktoad.substack.com

  • 9
  • Analyst 2 in Consulting
Mar 15, 2021 - 7:46pm

Totally agree on the depth of research, but Elliott isn't a concentrated fund. They might have 1 or 2 positions that make up 5% of the portfolio, but that's about it. 

Mar 11, 2021 - 7:44pm

right now, you are a worker bee...the head of these firms is doing a completely different job...

just google it...you're welcome
Controversial
Mar 11, 2021 - 8:46pm

Been doing this for almost 10 years. Hate to break it to you but there is no secret sauce on this side of the fence either. Elliott's returns over the past 10 years are shockingly bad. I also have Abdiel's returns since inception and you have to give them credit for finding religion in SaaS early on, but their returns are no different than any SaaS-based fund or index. 

*/

  • Associate 2 in RE - Comm
Mar 14, 2021 - 1:59pm

Not doubting what you say at all, but curious why investors are throwing cash at Elliott if their returns are so bad? Think their AUM is approaching 50B

Mar 18, 2021 - 12:16am

Their returns are not much different from some funds, but they still beat out the vast majority (like, all of them, from a whalewisdom article I saw). In an industry like this, every small edge matters. 

If you don't mind, could you clarify if you meant that there exists no secret sauce at all (thus implying all of the returns can be attributed to luck)? Sure there may not exist a golden key to alpha land, but there must be tidbits of intention-driven success here and there. 

  • Intern in PE - LBOs
Mar 11, 2021 - 10:08pm

OP here. Another question for the thread that is a little bit less philosophical. But how do you develop conviction around whether something is or is not already priced in by the market?

  • Research Analyst in HF - Other
Mar 12, 2021 - 12:02am

survivorship bias. plenty of funds that follow the same process as e.g. elliott or abdiel but got blown out over the years. 

this industry is mostly luck, don't let anyone convince you otherwise.

Mar 24, 2021 - 5:35am

Idk how well this answers your question, but I remember reading a study (albeit it wasn't recent) that said that when taking into account all funds (not just those that are still going), the return rate was about the same of the S&P 500. 
 

I personally don't think there's any luck involved, but there's def survivorship bias

Most Helpful
Mar 12, 2021 - 1:33am

I'll throw my 2c in. By no means do I have this figured out, I'm just another dude that would like to figure it out.

1. Organizational habit - Your investment process has to be set up to maximize return on time spent, while balanced with mitigating risk of overlooking downside drivers that can really blow up your thesis (I.e. not talking about tax rates or 50 bps margin decline). From top-down, everyone has to buy into a culture of focusing on and questioning the top 3-5 drivers that make or break the thesis. The less wheels you spin, the more time you have to ID high-conviction ideas and build a higher quality thesis. You will naturally have more at-bats if you can do this efficiently and can get to the incremental opportunity or kill the dud idea quicker than your competition. Often, if you have classic IBD types driving the investment culture, this is very difficult to achieve as too many in this business have been ingrained to believe "work = output".

2. Radical weighing of facts - 90% of your time should be spent thinking deeply about the top 20% of facts that will drive 80% of the outcome. This is the issue I have with private market investing in general - people do a lot of diligence just to wash themselves with the satisfying feeling of false security and intelligence. Many folks in the middle are even incentivized to actually create distracting work in a misguided attempt to "add value". Most of these useless slides, analyses, calls, not only add no value but actually detracts away from sound investing by triggering analysis paralysis. I hope people don't take this the wrong way, but the over-emphasis on "attention to detail" in this industry is overdone. Legends like Buffett and Malone have been known to say something along the lines of, if they can't figure out whether a deal is a good one based on napkin math, they don't do it. Yes, you must be detailed enough that you won't miss a critical driver in your thesis. But most of the money is made on  how much more thoughtful and fact-based your assumption is around getting the top 3 numbers right that will drive value. Figuring out which are the top 3 signals that matter is the tricky/rewarding part, which I think comes with experience, intuition, and relentlessly thinking critically about "is this the right driver for me to be spending time on". I have never seen an investor that is your typical "turn every stone, check every box" mid-level PE archetype actually have big ideas and be right about them. Not all facts and assumptions are made equal, and most facts are noise that must be ignored altogether for intellectual hygiene.

3. Don't discount feelings - whether it is selling a new smartphone, a vacation idea, a house, a car, or a company/stock, no transaction that creates enormous value and wealth for its seller is built on rationality alone. Every buyer has a brain of which half or more is dedicated to rationalizing their emotions - over which most have little control. You have to acknowledge and respect how something makes people feel. In the markets, this expresses itself in valuation multiples and trading momentum. No amount of statistical cheapness can help you if you buy into an industry that elicits terrible feelings by the next buyer (I.e. value traps). An astute investor is just one step ahead in ID'ing what will become interesting to the future buyer. You still have to pick good businesses and can't be just buying concept stocks - cash flow statements and bankruptcy courts don't care about feelings. But ultimately earnings quality and feelings (I.e. multiples) are linked at the arms and create virtuous cycles. If you are buying a melting ice cube that throws off a shit ton of cash flow, that is fine but as long as you're not delusional about where the value comes from - the cash flow, not feelings - so you must set it up accordingly so that you have control over that cash flow (I.e. take it private or go activist). 

Ugh the FBI still quotes the Dow... -Matt Levine
  • 42
Mar 12, 2021 - 9:33am

I take this the right way because it's so well-said. 

Instagram: @dickthesellsider | Clubhouse: @dicktoad | Substack: dicktoad.substack.com

  • 1
Mar 12, 2021 - 12:38pm

A core thesis, a time horizon, and pricing are the big 3 you have to nail IMO.

Simple example is when Trump first came into office and lowered the tax rates, if a hedge fund couldn't see that this would drive up SPY after the first earnings call thereafter, they're blind (multiple historical examples that substantiate that thesis). So there's a thesis. The time horizon plays into when to enter and exit the trade, which will be affected by also considering what your opportunity cost of the trade is. And the pricing is all about what you think that delta will be. That delta also has a relationship with a degree of certainty. If you are very certain but small delta, hammer that trade. If you are less certain but big delta, smaller volume and gamble for the high IRR

I also think that what we consider "top" investors or hedge fund guys often made most of their returns in a handful of big trades (eg. Soros v Bank of England, Einhorn v Lehman, Ackman has a few examples, activist guys like Singer buying debt from S America, Icahn, Loeb, etc.). So the "idea generation" talk honestly isn't a case of HF's knocking it out of the park consistently, its more about RBI singles and doubles. We just remember the home runs. 

Mar 12, 2021 - 1:11pm

In my view, the most important thing is the ability to remove emotions from the investment process. I've said this before, but to make money you have to have a view that is both correct and different from what is priced, and you need to have confidence that your correct view will become priced over a time horizon that allows you to earn excess returns (the longer it takes your view to become priced, the lower your annualized returns, and the more subject you are to both thesis drift and exogenous factors). That is easier said than done. We are constantly overloaded with irrelevant information daily (maybe even hourly) that elicits emotional responses that want to dominate rationality. Half this game is focusing on what actually matters as other have noted, and making decisions independently and objectively based on facts rather than feelings or the opinions of others. But you also have to try and assess what feelings and opinions of others are driving prices at any given time, because it is the breakdowns in the rationality of others that create opportunity for disciplined investors.

You also have to have the discipline to commit to your strategy even when it is out of favor, which again, is an emotional trait. Investing is cyclical, especially now with so many factor-based strategies and etfs out there. There is no single strategy that works at all times unless you are straight up arbing market internals on some structural basis. Even the best funds have poor stretches. You have to be willing to just eat that reality, and it can be quite painful when things aren't working for seemingly non-fundamental reasons. All too often funds get sucked into what is working in the moment, and end up drifting away from their actual mandate. What I have seen as a common trait with most funds that have success is that what they don't do is just as important as what they do. Everyone chases performance, it is incredibly hard to fight FOMO, but the funds that just stick to their process and beliefs generate the strongest long-term performance. There are a lot of different ways to make money in the markets, but you have to find your philosophy and actually believe in it enough to stick with it through the hard times.

One of the academic arguments for market efficiency is that because there are so many smart investors out there and so few actually outperform, that it must mean that the markets are efficient. That is a horribly rationalized argument IMO. I think the correct take from that is that it is just very difficult to beat the market rather than it cannot be done. Why is it so difficult for all these intelligent and well-credentialed people? It is because they are still human at the end of the day. You can be incredibly smart and also emotional or biased, they are not mutually exclusive. Thus, I believe that is the secret sauce that you are asking about. It is the ability to be aware of bias and emotional drift, and separate it from the investment process. Again, I'm saying this based on my experience and my observations regarding funds that outperform consistently and/or over long time horizons. There is also academic work seemingly supporting that view. Low turnover and higher concentration strategies seem to be optimal, and you could make an argument that if your turnover is low, you are successfully able to ignore the shorter-term noise that generally elicits emotional responses in others, and that if your concentration is high, you are expressing views that you believe strongly in and are committed to.

As others have noted, a lot of the big name SM managers out there have hit homeruns on aggressive calls and have had their inflated annualized numbers carry them as they go on to underperform. The guys with true longevity have a repeatable process that works and that they stick to from what I have seen, and they generally just compound their capital consistently over time rather than having a blowout period of several years.  

  • Associate 2 in PE - Other
Mar 13, 2021 - 3:10pm

You'd be surprised how much success can come from absolutely nothing investment analysis related. Issues with fund structure, LPs, other things going on in the portfolio, messy IC situations, unorganized back office / operational overhead etc. can all have an underappreciated impact on investment performance. 

Mar 15, 2021 - 10:30pm

Is no one gonna say that these firms have information edge? They know M&A deals before they happen, FDA drug approval before they happen, investigations, etc, etc. Are they no so well connected that they hear the whispers of these events and such? Additionally some of them are activists, so they can take positions announce on TV they're pushing for management change, etc, etc and the stock is up 20-30%

Mar 16, 2021 - 2:01am

You know nothing because there is nothing to know. The hedge fund industry is a scam. Its participants are nothing more than chiselers, purporting to have insights and techniques that generate superior returns when they patently cannot. They make their money by taxing the assets of gullible idiots who are dumb enough to hand them their assets. They disguise themselves in their fancy alumns, suits and ties while they're nothing more than glorified insurance salesman. 

Apr 2, 2021 - 1:41am

The secret sauce is to 1.) be different 2.) design a process that plays to your strengths/advantages 3.) match your capital base conducive to your process - the process which uses your strengths/advantages to maximize your differentness/variance
 

Where are you most likely to be different?

You know a niche set of names in a particular sector (MM sector guys)

You know a niche "type" of investment and can apply it across many sectors (growth investors, special sits/turnarounds)

You have the largest fund and can leverage expensive data, mgmt access, sell side research, etc. (MMs)

You are really good at cold calling people in industries and asking great questions to understand their suppliers/competitors etc (some tigers)

You go really deep and have a really high hit rate but have a very low idea velocity (ultra concentrated SM guys value or some Tiger)

You're very good at predicting what other people will predict about things (Some MMs, some Tiger)  

You're a great judge of people management (LT concentrated guys mostly)

You're a good storyteller and influencer (activist shorts)

You're good at activist geopolitics (Soros)

You're really good at ignoring the downside case and managed to collect a free on factor-driven secular multiple expansion through an extended cycle (too many funds - ARKK, muh LTV/CAC 2030 TAM bro's, some VCs, most real estate investors)

There's a million secret sauces. Know where you're different and secure a capital base that allows you to maximize your time and resources exploiting that difference. Or be lucky. 

Apr 3, 2021 - 11:54pm

The secret sauce is knowing buyers. Understanding trends. Knowing what's hot that hasn't caught fire yet.

Intuition, and generalized intelligence/ability to recognize patterns, read people is FARR more valuable than any hbs case you learned or math skill.

The best investments I've made are ebay, netflix, amazon, apple, bitcoin, chipotle, and a few others. I was a user of these products and understood that they were great and that where there's demand, and a biz that's hard to replicate (or wouldn't be successful as a duplicate), there's a winner.

Chase Coleman and Tepper are guys I'd look at.

But if you're investing in non high-growth stuff, it's harder. Elliott is good at knowing the details cold and playing hard ball. They'd also have way higher returns if they didn't fully hedge every position with a corresponding short on another company; they are very conservative and true to hedging.

I think people get way too bogged down in numbers and don't spend enough time thinking about the quality and demand for the product and where that's trending. Where there's demand, there's profits (unless there's liability in input costs).

Apr 4, 2021 - 7:32pm

Pattern recognition and intuiting yes - but not necessarily knowing what's HOT. And also - higher returns are not better returns - if you put a short on the other side you are ISOLATING your bet on company specific factors / alpha. This is what LPs want their hedge funds to do - deliver high quality risk adjusted returns - they'd rather have 10% alpha than 9% alpha +20% points beta.

Risk adjusted returns. Risk adjusted. To say that necessarily hedging an idea lowers your return is very indicative of the market right now - you deploy RISK to earn RETURN. Your value add and skill is driven by RETURN per unit of RISK. LPs don't want maximum nominal returns - they want the alpha piece of it and they can take that and lever it in their end as needed without paying you the fee - if you could offer 1% a month, every month, you'd steal AUM from ever fund on earth - and WSO would say you didn't even beat the market. AAA bonds don't beat the market, why would anyone ever buy a AAA bond if nominal return was all that mattered?

We'll never run out of posts of people saying "butttttt hedge funds don't even beat the bull market." Well than why is there so much demand for Millennium they're in installing a 5 year lockup? If Elliot is just way 2 boomer-hedged why are they turning down money. Hell why would anyone buy a treasury bond ever - it's never beaten the market! Risk adjusted returns come in many shapes and sizes and time horizons and strategies and concentration and turnover and team size etc. some strategies it's hard to tell how much risk is there and some it's very easy but alpha can be generated in many many ways - you just have to be different. The smartest-looking person at the top of the cycle is often the most levered and crowd-following sheep (hi Cathie).

I know there will always be a new flock younguns on this board comparing gross returns and realizing hey these hedge funds are a scam!!! I just don't see how you can look at the eagerness of such a broad and massive base of LPs who clearly disagree

Apr 4, 2021 - 8:23pm

Anchor

Pattern recognition and intuiting yes - but not necessarily knowing what's HOT. And also - higher returns are not better returns - if you put a short on the other side you are ISOLATING your bet on company specific factors / alpha. This is what LPs want their hedge funds to do - deliver high quality risk adjusted returns - they'd rather have 10% alpha than 9% alpha +20% points beta.

Risk adjusted returns. Risk adjusted. To say that necessarily hedging an idea lowers your return is very indicative of the market right now - you deploy RISK to earn RETURN. Your value add and skill is driven by RETURN per unit of RISK. LPs don't want maximum nominal returns - they want the alpha piece of it and they can take that and lever it in their end as needed without paying you the fee - if you could offer 1% a month, every month, you'd steal AUM from ever fund on earth - and WSO would say you didn't even beat the market. AAA bonds don't beat the market, why would anyone ever buy a AAA bond if nominal return was all that mattered?

We'll never run out of posts of people saying "butttttt hedge funds don't even beat the bull market." Well than why is there so much demand for Millennium they're in installing a 5 year lockup? If Elliot is just way 2 boomer-hedged why are they turning down money. Hell why would anyone buy a treasury bond ever - it's never beaten the market! Risk adjusted returns come in many shapes and sizes and time horizons and strategies and concentration and turnover and team size etc. some strategies it's hard to tell how much risk is there and some it's very easy but alpha can be generated in many many ways - you just have to be different. The smartest-looking person at the top of the cycle is often the most levered and crowd-following sheep (hi Cathie).

I know there will always be a new flock younguns on this board comparing gross returns and realizing hey these hedge funds are a scam!!! I just don't see how you can look at the eagerness of such a broad and massive base of LPs who clearly disagree

You have some good talking points but overall that's not it.

1) If you hedge out the position, yes you are isolating company specific factors, but maybe you have a strong opinion on the factors of that entire sector being undervalued. When you hedge it out, you are betting one company will outperform another within that sector. The smart funds bought cruiseline bonds, or stock, many cruiselines, not just one, and not hedging against another one. The smart thing to do was buy everything. It was all cheap.

2. Beta is a poorly defined metric. Google stock beta is incredibly high, but mostly it just goes up a lot, but the farther the returns from the index, the more "risky" it is. Yet you could have a company that loses 2% a year, and has a much lower beta.

3. HF's are highly subscribed because consultants and FoF employees who are paid millions to advise pensions and wealthy individuals make compelling arguments to why they should be invested in HF's. But tell me, why did the largest pension fund, CALPERs pull all their HF investments? Umm, because HF returns suck... any way you slice it. They aren't gross winners, they aren't risk-adjusted winners, they are just fee gobblers.

Millennium also had a huge year last year and has generally had market beating returns. But there's a damn good reason HF commitments are down and index fund commitments are through the roof. HF's are bad investments. Sure there's a few here and there that will smooth out your returns and beat the market or come close, but that's very rare, and if you want a smoothed-out return profile, you could just create a stock and bond mix that will do that for you without giving up almost HALF your gains to hedge funds. Yes, hedge funds collect half of all returns. 2% is a bitch, and when they are grossing 6% and taking another 1.5% of that, well, they leave with 3.5% of your assets and you left with a 2.5% gain. At least private equity has a hurdle.

  • Managing Director in S&T - Other
Apr 5, 2021 - 10:34pm

This thread has really come off the rails. Not even sure what people debating in the above anymore.

OP, the thing I think you are missing is that no one is hiring a "a kid out of PE, or law school or etc..." giving them X amount of capital tomorrow and saying this is your hurdle rate have at it. The #1 skill the upside analyzes as you said is "critical thinking" that is all we want to know "how do you get from point A to point B". That said the skillset you are creating is niche (yes maybe not niche on WSO or the uber PE to HF path people speak on here) but not the general population of finance professionals. 

I would say look at the AMAs recently by the HF guy even the sr PE guys to show their skillset and "how to think like an investor".

  • Investment Analyst in HF - RelVal
Apr 7, 2021 - 3:04pm

Well, to put it in simple terms, some pod monkey in the thread above is having trouble understanding the concept of the sharpe ratio, and as a result, is trying to make the argument that all hedge funds are shitty since they don't even beat the S&P.

  • Managing Director in S&T - Other
Apr 7, 2021 - 4:26pm
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