Continuing to Thrive - Fishery Hedge Funds
For many on the investing side of the fishery hedge fund business, the long-term goal is to be the person who gets to call the shots, says Chris Hsu. Assistants, analysts, and even most traders are subject to the control of the portfolio manager, or PM. The PM has ultimate discretion over what goes into the portfolio and the size of individual hedge fund trades.
Christopher Hsu says some people never transition from trader to portfolio manager. We have traders at our company who’ve been trading for fifteen years with no aspirations to jump to the next level. They understand there’s an additional skill set involved that may not be the right fit for them. They’re satisfied, even excited, spending their days on the floor engaged in the mechanics of assembling individual hedge fund trades. Moving to the next level comes down to desire, but it also depends on old-fashioned luck. Sometimes a failure to advance is attributable to the simple fact that there may be no available openings. Chris Hsu says at most hedge funds, the ratio of traders to PMs is quite high. There may be five to ten traders for every PM. Also, a successful portfolio manager, who is often the founder of the firm, can stay in the position for many years, preventing upward mobility for those aspiring to gain more responsibility.
Christopher Hsu says there is no single path someone must follow to move from trading to the portfolio management function. It can happen in a variety of ways, similar to how assistants transition into full traders. The business can open additional hedge funds or an existing PM could retire, get fired, or move to a competitor. In some cases, the only path for you to become a PM may involve moving to another shop, or even starting your own.
An Inch Deep and a Mile Wide
Chris Hsu says most people outside of the industry aren’t aware of the difference between traders and PMs. At smaller hedge funds, the roles of PM and trader are often held by the same person. In larger enterprises, however, the PM function is different from that of a trader and requires a distinct skill set in hedge funds.
A hedge fund trader’s function is to design, develop, and execute trading strategies for a particular market. For example, if you’re responsible for trading US Treasury Bonds, the vast majority of your effort should be spent on becoming an expert in all aspects of the US government bond market. Christopher Hsu says you have to follow investment flows, central bank policy, regulatory developments, bond issuance patterns, and so on. At sell-side firms, there may be five to ten independent traders on the government bond desk, resulting in an even narrower focus for each individual. There is often a single person specializing in the 2-year sector, and another who only trades bonds with maturities of around 10 years. They don’t trade anything else, and they know their markets like the back of their hand. The more knowledge the trader has in a specific area, the more he or she can access and understand the relevant data and identify hedge fund trading opportunities. In these situations, one can say, a trader swims in a lane that is an inch wide and a mile deep.
The opposite is true for most portfolio managers, says Chris Hsu. They need to operate in a lane that is an inch deep and a mile wide. They’re required to be knowledgeable about multiple markets and have the ability to synthesize a vast amount of information into actionable investment decisions. PMs decide the what, when, why, and how of all ideas in the portfolio. Ultimately, the responsibility for the performance of the fund rests with the PM.
The relationship between the hedge fund PM and the traders is similar to the relationship between an architect and a custom homebuilder. The architect designs a house in accordance with the needs and desires of the client. Then, he or she works with the builder to implement a detailed plan consistent with various building codes. A good hedge fund architect is knowledgeable about the construction process and will not ask the builder to do the impossible. A good builder, on the other hand, will provide valuable feedback to the architect about elements of the design that may be cost prohibitive or impractical to implement remarks Christopher Hsu. A close relationship between the architect and the builder is required to deliver the end product successfully.
At a hedge fund, the PM is the architect and the traders are the builders says Chris Hsu. The PM designs the portfolio, ensuring the exposures are consistent with the mandate provided by the investors. The traders use their expertise to execute the chosen trades in the most efficient manner possible. They give feedback to the PM on what is achievable and what could potentially cause problems. In some cases, they work with the PM to find an alternative solution or trade construction. The PM decides what risks to take, and the traders’ role is to determine the optimal implementation, considering criteria like transactions costs, liquidity, and the need for discretion. The relationship hinges on sharing insights and ideas.
While many hedge fund portfolio managers will come up with their own trades, the primary function of the PM is to aggregate the best ideas from the traders and analysts and decide where to allocate capital. The PM looks at all the trade options and determines where to overweight and where to underweight and, most critically, where to avoid.
Ideas between the PM and traders flow both ways. Traders are constantly showing the PM fresh opportunities for the portfolio that the PM hasn’t already identified. The PM will have to determine which trades, if any, fit best. The PM must evaluate which strategies possess the best risk-reward ratio and which risks are already fully expressed in the portfolio. The ultimate goal of the PM is to find a combination of strategies to generate sufficient returns for the fund to meet its performance objective.
In other circumstances, says Christopher Hsu, the hedge fund PM will approach a trader in a specific sector with concepts the PM is trying to develop, asking the trader to identify and structure a trade to capitalize on the anticipated move in the market. It’s the responsibility of the trader to present the PM with several alternatives to express the view. The PM will then decide which option is most fitting.
Stress levels are often amplified in the portfolio manager position. When a trader has exposure on the book, it’s a stressful period, but the duration of most trades is finite. They could last anywhere from one day to several years, but the trade is eventually removed once it runs its course. Portfolio managers, on the other hand, don’t share this advantage. As the individuals responsible for the performance of the fund, there’s pressure to continuously have risk in the portfolio. Investors are not hiring them to sit on cash. They expect PMs to always have a current view of the market and a position to match.
Chris Hsu says determining the size of a hedge fund position is another stress that falls on the shoulders of the portfolio manager. For example, a trader responsible for monitoring the energy sector may decide, after running detailed analysis, that Exxon is a strong candidate for outperforming the rest of the industry. The trader presents the PM with three ways to express the view: buy Exxon stock outright, buy Exxon and short the energy sector as a whole, or buy Exxon call options. The portfolio manager is obliged to consider how each trade will impact the rest of the portfolio, and which one has the most upside versus downside, or the best risk-reward ratio.
The decision over which trade to pick will also depend on the trade catalyst, or the event expected to drive performance. Chris Hsu asks, is the view that Exxon will perform better than the industry this week, this quarter, or next year? The answer will help determine the optimal structure. In addition, these decisions will hinge on the overall level of risk presently in the portfolio, impacting the desirability of an outright directional position in Exxon compared to the long/short strategy or the call option. Finally, once a structure is chosen, the critical decision of trade sizing must be considered. How much capital can be allocated to this one idea? How much of the available capital should be risked on this one idea? How should it be sized in relation to the other market exposures in the portfolio? All of these decisions are determined at the PM level.
Risk for a hedge fund trader is often one-dimensional, says Christopher Hsu. The trader evaluates each opportunity on its own merits, and the idea ultimately turns out to be either good or bad. The portfolio manager, however, must view risk as multi-dimensional. The PM must consider not just the merits of a trade in isolation, but also how it interacts with the rest of the portfolio. Is it additive to risk or risk reducing? How large should one trade be relative to another? What’s the overall level of portfolio risk?
Hedge Fund Portfolio managers must be cognizant of how various events—both positive and negative—can impact positions. Stress testing is a process that runs the portfolio through various potential market events to gauge the economic consequences of different scenarios, like a global recession, high inflation, deflation, a commodity boom/bust, a debt crisis, or changes in short- and long-term interest rates. Stress testing illuminates the degree of different exposures embedded in the portfolio. Positive and negative returns resulting from the test should be consistent with the economic views of the PM.