Benchmarks and Universes Part 1: Presenting the Product
I spent about a week laying out the key words needed to seduce an investor into handing his money over to a money manager. One important part of the pitch was missing: the product. I can’t show you the product because investing is a completely invisible exercise. There’s nothing to show you, except a bunch of numbers. You can rest assured, if I’ve lured you to a country club for a presentation or managed to get an hour of your time in your office, that my numbers are going to be very appealing. No money manager in his right mind is going to show up with an ugly set of numbers, known as a “track record”. All of our sweet words about proprietary processes and customized solutions won’t count for anything if our track record isn’t eye-catching.
|Napkin in Exile (2000)|
How do you know that my track record is attractive? We will demonstrate our superiority by contrasting our track record to a benchmark and a universe. Before we dig into the details of benchmarks and universes in parts 2 and 3 of these posts (I’ll try to make it interesting), you need to understand the purpose of this exercise. Most of us underperform benchmarks (like the S&P 500) and universes (a group of comparable managers). However, when we place our track record in front of you, it will appear that we are among the elite, known in the industry as “top quartile managers.” Think of a bodybuilding contest in which almost all the competitors have serious muscular deficiencies. When we strike a pose, we’re careful to hide our defects and highlight our strengths. If you, the judges, aren’t discerning when we present our track record, we will fool you time and again.
Instead of muscles, I now want you to imagine a series of charts in which my performance is almost always better than some comparison. The bars representing my performance are going to be higher than the other bars in my graphs. The message I am conveying to you is that I always win, which is odd because after you give me the money, you’re not going to win nearly as often as my pretty charts suggest. My performance will be compared to a universe or a benchmark over various historic time periods, for example, one year, three years, and five years. I can assure you that I’ve spent many hours looking sifting through universes, benchmarks, and timeframes until I’ve gotten the perfect set of charts. I’ll drop copious footnotes in a microscopic font at the back of the presentation so that my manipulations are thoroughly documented. However, as you stare at my graphs and listen to my words you will have no doubt that I am a top quartile manager worthy of your confidence whether we’re talking about stocks, bonds, real estate, private equity, commodities, or hedge funds.
We’ll look at benchmarks in the next post (unless something more interesting crops up in the next day or so), but for now I am going to spend a few moments explaining that our product offerings are much simpler than we make them out to be. All investment products are one of two things, despite all the asset classes and jargon. You are either going to invest in equity or debt or some combination of the two. If we’re talking about equity, you might be investing in a company, real estate or a commodity, but in all cases you own a small piece of something. It’s merely a question of what kinds of stuff you want to own. Your goal is to own a wide range of stuff as cheaply as possible.
If you invest in debt, you are going to be a creditor to a company, government, or other entity. They will be indebted to you and owe you principal and interest. The question here is to whom do you want to lend your money. Again the idea is to lend your hard earned money to a wide array of entities, so you’re not too reliant on any one debtor.
The form of your investment is either going to be liquid or illiquid. Money market funds and mutual funds are examples of liquid investments; you should be able to get your money back when you want it. Private equity and privately held real estate are examples of illiquid investments. So is your house. Since private equity invests in non-public companies, the manager cannot quickly convert the investment into cash via a sale in a market. Your investment is going to be tied up for 5 or 10 years.
Where does a hedge fund fit into this discussion? You should think of hedge funds as lightly regulated mutual funds for so-called “sophisticated investors.” They invest in equity and debt just like all other forms of investments. The difference is that investors give hedge fund managers greater discretion (sometimes too much discretion) in choosing the types of equity and debt they can invest in and let the hedge fund managers employ more esoteric strategies. At the end of the day, however, it is still all about investing in equity and debt.