Book Review: Managing Hedge Fund Managers

Edward Stavetski’s Managing Hedge Fund Managers provides a thorough analysis of the factors to be considered when investing in hedge funds. The book is particularly relevant now, at a time when less capital (due to deleveraging and redemptions) is chasing more alpha (due to market dislocations), making the hedge fund space more attractive. It is all the more compelling in our post-Madoff environment, as due diligence gains new significance, and investors are forced to play detectives.

For any investment, Stavetski says, the first step is to write an investment policy statement identifying objectives and constraints: required rate of return, time horizon, liquidity, and the level of acceptable risk. After that, picking the right hedge fund to achieve those objectives is as much an art as it is a science. In his view, quantitative measures raise questions rather than provide answers. Qualitative judgments are paramount.

Performance is a key statistic when evaluating a hedge fund, though prior performance is not a guarantee of future results. Stavetski outlines best practices in analyzing performance, and reviews myriad statistics representing absolute, relative, and risk-adjusted performance. Some of his favorites include the Sortino ratio and the downside deviation used to calculate it, time-weighted and dollar-weighted returns, and peer group analyses.

His insistence on evaluating performance both on the long side and the short side is right on the money. Many managers fall into the trap of shorting a general market index to act as a hedge without searching for alpha on the short side. The short side should be an important alpha source, and Stavetski warns investors strongly against any firm that fails to take advantage of that.

Stavetski devotes an entire chapter to weighing the arguments and empirical evidence relating to small funds’ alleged ability to outperform large funds—a highly debatable subject. The core reasoning in favor of this thesis is that, in the process of deploying more capital, good ideas can be exhausted, since “alpha is finite.” The counter line of reasoning, which Stavetski does not fully cover, is that large funds realize economies of scale and yield benefits that positively impact their research and trading. Although his overview is not conclusive, it provides a glimpse of the fascinating trade-offs that occur as hedge funds accumulate assets.

His thorough examination of the different types of risk is particularly valuable. The adequacy (or lack thereof) of value at risk is explored in detail. Liquidity risk is explained along with its measurement, and its importance is stressed, for when liquidity dries up hedge funds can be forced into losses. Counterparty, model, and high-watermark risk are highlighted as well.

Stavetski sees intellectual talent and leadership as hedge funds’ most important assets. Portfolio managers’ biographies (and those of their teams) play a central role in firms’ marketing strategies. Pedigree and prior experience, however, should always be the starting point for further inquiry by investors. Has the portfolio manager been successful running money, or in a different capacity? Has she left behind a portfolio in questionable shape? Does he have serious social or legal violations, even nonfinancial violations, which suggest a tendency toward irresponsible behavior?

The talents of portfolio managers and analysts should make money for the investor; sound organization of the hedge fund should protect the investor from losing money. Prime brokers, administrators, auditors, and other third-party service providers, commonly listed on a fund’s marketing materials, should serve as leads to more questions. To drive home this point, Stavetski relates the story of a fund whose auditor was run by its CFO. This should have been an immediate warning sign, and, indeed, eventually the fund closed down amidst losses. Obtaining the names and contacts of service providers is where due diligence starts—not where it ends.

But all the caution in the world is no guarantee of a good hedge fund investment. Stavetski makes a compelling point of how several of the legendary blowups occurred despite stellar manager biographies or periods of superior performance. In each case, he recounts what the red flags were and how investors could have spotted them.

Stavetski’s scrutiny may be sharp and his perspective skeptical, but he emphasizes that, despite heightened media coverage of hedge fund demises, fewer hedge funds have imploded to date than the number of corporations that shut down annually, and strategically chosen hedge funds can provide superior risk-adjusted performance. Managing Hedge Fund Managers is a comprehensive guide to the process of selecting hedge fund managers, and it flings open doors into a traditionally secretive world.

–Boriana Handjiyska, CFA, is an associate at Morgan Stanley, where she provides portfolio analytics services to hedge fund clients.

This article was originally published in the Spring 2009 issue of the Investment Professional.