Adam Blitz on the hedge fund outlook and Evanston Capital’s approach to manager selection

Key Takeaways

• The hedge fund outlook is bright for highly skilled long/short equity managers.
• Combining diversified sources of alpha can limit overall volatility.
• Selecting managers is a forward-looking exercise that emphasizes portfolio construction and the ​“soft side.” 

The hedge fund outlook today is strong for those managers with the skill to outperform their fees. ​“I’m really excited about long/short equity — we have been for a few years,” said Evanston Capital CEO and Co-CIO Adam Blitz on the Insightful Investor podcast with host Alex Shahidi.

“I actually have a little bit of a contrarian view,” Blitz explains. “[Now is] one of the least competitive times for certain strategies in 15 years, especially in some of the more equity-oriented strategies — because you have so much money in passive investing. …[T]he competition in true fundamental stock picking strategies is less than it’s been in some time, which should create what we think are much better return opportunities for the very small number of managers who really have an edge.”

Hedge fund outlook

“If someone has demonstrated good performance over a long period of time and they’re still very passionate about what they’re doing and they have the right team dynamics, I think the setup going forward is especially good,” Blitz said.

The current environment of index-oriented securities trading can actually create opportunities for managers who are experts in a particular equity sector. ​“The bulk of the volume every day is due to people who are really insensitive to prices [of] individual stocks,” said Blitz. ​“I think of it as having more price inefficiency — probably more volatility on the way to having that inefficiency reverse, [so] much more opportunity for long-term stock pickers. I really think of it as a white space right now.”

While noting the positive environment, Blitz emphasized that the average hedge fund adds no value net of fees. ​“We said this right from day one and continue to think it today. In active management in general, whether it’s long-only or hedge funds, most managers are smart. Most of them might have a small edge, but in most cases, it’s not enough to overcome the fees they charge.”

“The reason we exist” 

“Our whole job, the reason we exist, [in] picking managers is to project how a hedge fund is going to do in the future,” said Blitz.

There’s no substitute for really digging into a track record. Blitz listed several foundational questions in the evaluation process:

• Was it truly alpha or was there some beta tailwind that happened to arrive during that period?
• Did they take a swing for the fences and get lucky?
• What’s the real edge here?
• Can we articulate it?
• Do we understand it?
• Is it replicable in the future?

Sector specialist managers

In the equity long/short space, managers with a definable, demonstrable edge may have some combination of:

• Specific expertise, such as deep sector awareness thanks to spending careers in a space
• Relatively small team
• Small enough AUM to size positions in meaningful ways — for example, in shorting a midcap stock

While selecting for these characteristics is by no means a rule — Blitz noted that ​“our only rule is we don’t invest in things we don’t understand” — they are well aligned with the current opportunity set.

When evaluating managers on these and other criteria, Blitz emphasized the importance of looking forward: strong performance over the past three to five years is not, on its own, reason to assume a winning streak will continue. ​“I think that basic logic is backward,” said Blitz. ​“Assuming everything else is set up … the person is fully motivated, the team is strong, the morale is good, the investors aren’t leaving; let’s say all that checks out. Then you’re probably buying into a manager who you think is very good, and their portfolio has probably underperformed and is therefore probably attractively valued.”

The ​“hard stuff” and the ​“soft side” 

“People in our industry spend a ton of time — probably too much time — on ​‘give me your best stock idea,’” said Blitz, “…and not nearly enough time on portfolio construction.”

He listed a number of questions Evanston Capital asks prospective managers: How do you size things? When do you get in? When do you get out? How much illiquidity are you willing to withstand? How would you be able to get out of the position? How do you imagine your portfolio evolving as your assets evolve over time?

“Those are the questions that actually matter to performance, much more than a one-off example of an individual stock that the manager might be excited about, [and] that’s what I’d call the hard stuff. We also pay a ton of attention to the soft side. Why is the lead person doing this? What’s their motivation? Do they have a genuine passion and love for the industry? Are they doing it solely as a means to make a lot of money? We’ve found that true staying power comes from a real passion for the industry, a real competitiveness to want to continue to do well.”

Blitz emphasized there’s no substitute for judgment and experience: ​“No one’s ever going to get everything exactly right on [motivation], but you can see movies play out. We’ve seen how firms and people evolve, and we can make judgments on the ones we think will continue to perform well, and we can make judgments where we say, yeah, someone’s performed great in the past. That’s wonderful. But the firm today looks so different from the way it looked three years ago when those returns were generated that it’s almost irrelevant in terms of trying to project how they’re going to do in the in the future.”

The same goes for presentation skills: Evanston Capital is not evaluating them on how they might present at a cocktail hour, Blitz said, but on how ​“we think they’ll do in managing the portfolio, managing the firm, and really being passionate about what they’re doing.”

Diversified alpha vs. cheap beta

As an allocator, Blitz explained, Evanston Capital looks past a manager’s headline return to evaluate its components: how much of the return actually reflects the manager’s skill (alpha) and how much can be replicated elsewhere (beta).

“There are rare occasions where a manager might be so skilled that you accept some level of beta in their strategy,” said Blitz. ​“But in general, you want to be focused on what is the manager’s true skill — and am I getting access to that skill and paying fees to get that skill as opposed to some beta that I could get elsewhere for cheaper.”

Blitz also explained the ideal of finding ​“as many different sources of alpha as we possibly can,” noting again how equity long/short managers with different sector focuses avoids substantial overlap in their positions — or sources of alpha.

“Manager A’s skill is probably different from manager B’s skill and manager C’s and so on,” said Blitz. ​“If you combine seven or eight or 10 of them and they’re all doing different things, even if they’re all individually running at fairly high levels of volatility, combining them together reduces volatility. …But you retain a high level of expected return because each individual manager is taking a reasonably high level of risk.”

Liquidity and leverage

Blitz discussed why Evanston Capital is wary of leverage, using the experience of convertible arbitrage managers in 2008 as an example. At that time, he explained, the strategy appeared attractively uncorrelated to other markets and offered a high Sharpe ratio. ​“But what actually happened,” Blitz explained, ​“is so many convertible arbitrage managers were doing very similar things with high levels of leverage. They all used the same counterparties, [and] all of a sudden, with all that leverage, you had people selling relatively illiquid securities at the same time. The strategy you think would be the most protective in a time of stress ended up being the worst-performing — and no quantitative model would have predicted that.”

In addition to mark-to-market risk, Blitz explained, investors must consider risk in terms of permanent loss of capital. ​“Leverage and liquidity can exacerbate that permanent loss of capital. If you get a tap on your shoulder about a margin call, and five other managers are getting a similar tap on the shoulder and they use high levels of leverage or the underlying positions are not very liquid, a real risk event unfolds very, very quickly.”

Therefore, Evanston Capital’s risk mitigation approach includes limiting exposure to high levels of leverage and to strategies where investors may be able to redeem faster than is warranted by the underlying securities.

For much more on the evaluation process and the hedge-fund outlook, listen to Blitz on the Insightful Investor podcast (Ep. 90 – Adam Blitz: The Hedge Fund Playbook).