Smaller is better

Jeffrey Tarrant and Theodore Seides started out in different worlds but came together to focus on smaller hedge fund managers

Mr. Tarrant, the elder of the co-chief investment officers and Protégé's CEO, managed money for prominent families and went on to build the hedge fund database Altvest, now owned by Morningstar Inc. While building Altvest and starting Protégé, Mr. Tarrant also served from 1998 to 2002 on the board of directors of The Investment Fund for Foundations and advised TIFF on building its first hedge fund of funds.

Although Mr. Seides' childhood dream was to manage the New York Yankees baseball team, his career started in the endowment world when he joined the investment staff of Yale University after finishing undergraduate studies there. He stayed for five years, eventually becoming senior associate overseeing public equity managers and managing internal fixed-income portfolios for the university's now $19.3 billion endowment. After receiving his MBA in 1999 and following a two-year stint managing private equity and hedge fund seed investments, Mr. Seides teamed up with Mr. Tarrant to start Protégé Partners in 2001. Mr. Seides is president of the company.

Protégé now manages $2.1 billion in hedge funds of funds and customized portfolios that combine investments in small, established hedge fund managers with seed investments in new firms.

A lot is riding on Messrs. Tarrant and Seides' conviction that returns of small hedge funds will top those of the stock market. None other than Warren Buffett, chairman and CEO of Berkshire Hathaway Inc., bet the Protégé pair that their hedge fund portfolio couldn't outperform the returns of the Standard & Poor's 500 index for the 10 years ending Dec. 31, 2017. The winner will donate $1 million to charity.

Jeff, how did you get into money management? After I got my MBA at Harvard in the mid-1980s, it was the time when Harry Markowitz's theories were being adopted and I became fascinated about how to use a hedge fund approach to do this.

So I got into the hedge fund business — which back then was pretty nascent — by joining Berkeley Asset Management Inc. We were running two small (hedge) managed-account funds of funds and back in those days, the managers we had money with were Paul Tudor Jones and Louis Bacon, larger managers.

Most of the hedge fund investors back then were large European family offices. I worked for a large German family office then and it was kind of a club: All the investors knew each other and we all knew all of the managers. There was a roster of only about 180 hedge funds in the "80s to invest in.

How did you and Ted meet in order to form Protégé? There were a number of triangulations that brought us together. One was because I was on the board of TIFF. David Salem ran TIFF then and he introduced me to Ted. And Ted's former boss, Dave Swensnalso was on the TIFF board at that time.

How is Protégé's flagship portfolio constructed, Ted? We're strong believers in the concept that smaller managers provide an opportunity to deliver outstanding results. With that belief, what we chose not to do was to make particular strategy bets. If we can find great, talented small managers that we think have a good chance of outperforming, we don't allow a strategy allocation to drive portfolio construction. Effectively, we've created a multistrategy hedge fund.

That said, we have tried to make the portfolio look roughly like what we were seeing in market with about half of assets invested in long/short equity and ¼ each in relative value and event-driven strategies.

Ted, as with other multistrategy hedge funds, are you dynamically allocating assets between managers? Not much. That could be disruptive to a hedge fund depending on its size. We're just not big believers that you can pick strategies that effectively.

How large is the hedge fund seeding subportfolio, Ted? The target for the seeding component is about 40% of the portfolio, but it could rise up to 50% or drop to zero. We view seeding as a way to reduce, if not eliminate, fees charged by the underlying manager. Many new hedge fund managers starting their businesses in this environment are capital-starved. That means they may be more open to a seed deal. They often will not charge 2% (management fee) and 20% (performance fee) because they are desperate for inflows. The weighted average fee level charged by our managers is 1.4% and 17%.

How does seeding improve returns, Ted? We get returns from the established hedge funds we've invested in, but there's an economic stake we get from the emerging hedge funds we've seeded that results in profits — cash flows — as they've grown. That money is returned to the initial investors in the fund. For example, last year those initial investors received an additional 65 basis points of return from the cash flow resulting from the seeding deals. After we've done the calculation the total fee investors pay, including our fee, is about 1.75% management fee and 20% performance fee.

How popular are you with new hedge fund managers? Is Protégé their first call, Ted? We like to be popular. We aspire to be one of the most desired first calls. That doesn't mean we want every single one of the 6,000 small hedge funds out there to give us a call. Many of our introductions to new managers come through more established hedge funds.

Do you sense that some institutional investors might be picking your brains so they can replicate your approach? Jeff? Yes, to some extent. Unlike the early days when our clients were predominantly endowments and foundations and content with a single pooled strategy, today most of our new inflows are coming from pension funds and what they are really want is customization. They don't want their investment to look like the flagship fund. They might want to take more risk, they might want a more concentrated number of managers or more hedge funds from Asia. I think of customization like this: We've built the pizza and customization gives an investor just one slice.

Jeff, you and Ted have talked a lot about Protégé mimicking an endowment model. How then do customized portfolios fit into your business model? For the first 10 years, we did offer a single pooled strategy for investors, which is very typical of an endowment. The evolution to more customized, specialized portfolios took some engineering on our part. We have a huge technology infrastructure, which makes it easier to provide the investor with just a “slice” of the overall pool.

Where we've had to make some adjustments is with our investment staff, adding more client-facing responsibilities to some of the investment staff's work load, having them work more closely with the investor relations team to act as a liaison between the client and the investment teams. Some of our younger partners are anxious to become more closely involved with clients and customization will be a good way to facilitate this.