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The Circle of Hedge Fund Life

Date: Thursday, February 8, 2007
Author: Jacob Bunge, Financial Correspondent, Hedgeworld.com

SINGAPORE (HedgeWorld.com)—Quantifying an idea that has long been discussed by hedge fund managers and investors alike, Shoham Cohen has authored a paper on his theory of the life cycle for emerging hedge funds, identifying four stages: introduction, growth, maturity and decline.

According to Mr. Cohen, co-founder and director of Singapore-based ESC Financial Services Pte Ltd., too often hedge fund investors (particularly the more conservative institutions and family offices) turn away from funds with track records of less than five years, or assets under management of less than $300 million, and end up investing in funds that are established but far past their prime. What Mr. Cohen advocates is setting aside a portion of an existing portfolio for emerging fund managers to take advantage of young funds' most fruitful years of performance.

"Emerging funds should be thought of as the first step towards rejuvenating an investment portfolio," Mr. Cohen wrote in his paper, "Funds Life Cycle: Timing Your Investments." Emerging funds, he wrote, can provide better returns, better capital protection, a longer-term investment prospect, and up-to-date investment strategies.

"I, for one, seriously worry when a fund becomes too famous/popular, because it's more likely to be renowned due to intense marketing activities (based on historical performances and brand building) that may result with high exposure and inflow of investments," Mr. Cohen wrote. "Historically, high-profile funds—in most cases—will add less value."

Having served as a director for several hedge funds, Mr. Cohen established ESC in May 2005 with Eylon Cohen, his brother, to develop their funds life cycle theory and help emerging fund managers make their assets grow and expand their distribution networks via the partners' relationships with investors in Hong Kong, Japan, Taiwan and Singapore.

To determine a fund's position in the fund life cycle, Mr. Cohen examines its risk and return statistics, assets under management, track record, number of investors, geographical operations and exposure in the media. Other factors include the number of employees, what sorts of departments the firm operates, and the attitude of the fund manager, who should be "hungry to succeed, and financially driven," Mr. Cohen said in an email interview.

Fund managers in the "introduction" phase will usually have up to $25 million under management and a one- to two-year track record, and operate in only a few countries on one continent, according to Mr. Cohen's theory. At this point, performance ought to outpace benchmarks, and downside risk should be favorable.

The "growth" phase is entered when a fund becomes more well-known and builds a good distribution network; AUM will be on the rise—along with global recognition—and institutional investors may come calling. New hires will be made, business operations will develop, and, most important, the fund will continue to deliver strong performance and capital protection.

On average, a few years will pass before a fund enters "maturity," marked by a high AUM total, hordes of investors, and slackening performance compared to past years—perhaps no longer beating the benchmark. Mr. Cohen recommended at this point that managers review trading techniques and strategies, and consider at least a soft close if not an outright close of the fund. Increasing the minimum investment is another idea, but this generally won't improve performance, Mr. Cohen said—only delay it from deteriorating further. By the time funds reach this period, Mr. Cohen said, AUM may have grown too big to handle, and it also can be a time when managers may find themselves engaged in philanthropy, sponsorships and various other activities. "These are all great; however, [they] may not benefit directly investors," he said.

And then, decline. Managers and key personnel are rich now, and may lack the fire that once drove them to outperform. The worst part, Mr. Cohen said, is that all too often managers are aware of this, yet they continue to operate the fund, coasting on its size, reputation, and brand name.

Warning signs that a fund has peaked or is approaching its peak can be found in its marketing and public relations efforts, Mr. Cohen said—ads, public placements, sponsorships and a high profile on marketing newswires. "The only reason a fund manager is targeting such exposure is to get more consumers," he said. "This type of exposure is targeted in a justified way by brand names like Coca-Cola, Microsoft, eBay, etc. Hedge funds are not brands, fashion accessories… [they] are a source of wealth creation."

Any fund managing more than $400 million that uses leverage and is still open to new investment should be looked at very carefully, Mr. Cohen said, as they may have size and liquidity issues. It's best to enter a fund when it manages 1% to 10% of its estimated maximum capacity, a view he likened to venture capital—identifying new stars when they are still small.

Some funds, particularly those focused on commodities, tend to have a shorter life cycle due to limited size and liquidity, said Mr. Cohen, while foreign exchange and equity funds can last longer. In addition to closing the fund or raising minimum investment levels, he added that it was possible to stave off the decline of a fund by operating fewer share classes to better manage assets, or using more prime brokers to reduce the risk of slippage. Geographical and sector diversification also help, and Mr. Cohen added that he approved of recent efforts by SAC Capital Advisors' Stephen A. Coen and Caxton Associates LLC's Bruce Kovner, who have returned assets to investors to reduce overall AUM.

"Having said that, the most effective way for fund managers to attempt elimination of the decline phase is to close the funds to new investors," Mr. Cohen said.

While the life cycle of a particular fund can't be prolonged indefinitely, Mr. Cohen's theory can prolong the life cycle of a portfolio if regular re-weighting and reallocation is maintained. When an emerging fund reaches maturity, investors should consider replacing it with a different fund, and a portfolio should be constructed with funds in all three pre-decline phases—introduction, growth and maturity—with exposure growing as the funds evolve from one phase to another. "The timing to shift a fund out of the emerging allocation would be once an investor may feel that the performances are being slowly compromised, and once an investor has a new fund to integrate and introduce to the portfolio," he said.

The idea is to strike the right balance between emerging managers and more mature funds. In Asia, Mr. Cohen wrote in his paper that most portfolios are balanced with 50% of assets in traditional investments and 50% in alternatives; he said he believes that up to 20% of a portfolio ought to be allocated to emerging managers.

Even institutional investors will begin to come around, Mr. Cohen said. "I am aware that investors, especially the more conservative ones, tend to appreciate more funds with over five years of track record, and over $500 million in AUM," he said. "They believe that it is a source of confidence…. I believe that this will change, and more sophisticated investors will allow up to 30% for emerging managers in their portfolios."

Mr. Cohen said he's received much positive feedback for the "Fund Life Cycle Theory," with investors, managers, and others telling him that they were vaguely aware of the idea but hadn't seen it spelled out. "More and more professionals are accepting this idea, and slowly are opening their portfolios to [it]," he said.