After a widespread public battering due to poor absolute performance and the Madoff scandal in 2008, the hedge fund industry needs a champion. Kenneth J. Heinz — president of Hedge Fund Research Inc. — is exactly the right person to fill the role, say people who know him well.
Mr. Heinz appears on the TV business-show circuit at least once a week to talk about what he and his company know to be true about hedge funds. That is a lot of information. Chicago-based HFR, which has been tracking hedge funds for 20 years, maintains one of the industry's largest hedge fund databases. It distills information about performance, asset totals and net inflows for 6,500 hedge funds and funds of funds into monthly and quarterly reports. HFR runs a broad family of hedge fund indexes.
Having ready access to that much data might overwhelm someone less passionate about hedge funds than Mr. Heinz. He was an options trader before joining HFR Asset Management, the money management sibling of HFR Inc., in 2002. It was as manager of HFRAM's investment management division, which manages a family of hedge funds of funds, that Mr. Heinz moved from trader to hedge fund investor. He took over leadership of HFR in 2006.
The combination of trader/investment manager/statistician is a powerful one, said Odell Lambroza, a portfolio manager at hedge fund Advent Capital Management LLC, New York. “A lot of people in Ken's position are very theorectical,” Mr. Lambroza said But because he was an investor, he is practical and asks very insightful questions. I learn a lot from Ken. He gives me fact, not fiction.”
How did you land at a hedge fund research company after your early career as a trader? After I finished my MBA at University of Chicago in 2002, I met up with a gentleman who was working at HFR Asset Management. It was a very new, cutting edge concept back in 2002, this idea that there was a firm that was allocating to the hedge fund industry. The business model was intriguing to me.
(After joining HFR that year) I quickly developed a propensity for taking an investment strategy and decomposing it into its component parts. I wanted to know how the strategy worked, why it worked and when it didn't work.
There's probably not a day that goes by that what I learned as a trader — what drives asset pricing, what options are used to gain market exposures, what drives the pricing models, how volatility drives options pricing — doesn't condition my thinking about hedge fund strategies, especially about approaches like convertible arbitrage.
Do you miss managing hedge funds of funds now that you've moved over to research? I don't think of myself as having entirely transitioned away from money management, because we (HFRI) manage the HFRX indices, which are passively managed investible benchmarks. It's just a different kind of investment management. I'm not running that on a day-to-day basis, but I am very involved.
When we construct the indices, we take a high-level, top-down approach, essentially analyzing all the information we have from the database to construct an investible subset (of open hedge fund managers) which mirrors the performance of the broader (hedge fund) industry. It's not so much about picking the one manager that will stand out from the hundred in that strategy. It's more about verifying and validating the information the manager has given to us to make sure that the strategy designation for that fund is accurate. If the inputs are correct, then the analytical underpinnings of that manager's strategy should work to create that representative exposure within the investible index.
So managing the investible indexes is akin to investing from a distance, because if the investible hedge fund isn't constructed right, it won't meet its performance target? Yes, absolutely.
How important is it for you to meet hedge fund managers in person? The more fund managers you meet, the more chances you get to not only understand their investment strategy, but also to hear more about what they are thinking, about their own approach, about the markets.
Meeting managers also helps you to see what differentiates that fund's strategy from everyone else's with a very granular understanding. Finding differentiation is tough because there are thousands and thousands of funds out there. When you meet with a manager, you can ask the most critical questions you need to in order to decide whether to invest with the strategy. What is the best operating environment for this strategy? What's the worst-case scenario? Have you been through that kind of challenging environment? If you have, how did you do? If you haven't, what do you anticipate doing to survive?
How does HFR's client base break down? Most of the users are investors, but you can't neatly dissect the client because many fall into multiple categories.
Institutional investors and their consultants are really big users, accounting for about 40%. Hedge funds and hedge funds of funds make up about 30%, retail and high-net-worth investors, 25%, and other, 5%.
The growth for HFR has come from institutional investors, hedge funds and funds of funds over the past few years, which is indicative of the trend in the industry toward more institutionalization.
What were the most profound issues in the hedge fund industry in the past five years? I'll go from least to most significant.
The first was a recognition after 2007 that hedge fund performance is not heterogeneous. There was a five-year period from 2002 to 2007 when the hedge fund industry grew a lot, but the performance divergence between different funds was very limited because there wasn't a sharp increase in volatility or dispersion between asset prices that we've observed more recently. It's clear that hedge fund investors need to understand that every hedge fund investment strategy experiences market environments when it will do well or not.
The second important shift is the emphasis on structure, and this is certainly very salient post-(Bernard L.) Madoff (Investment) Securities. It has been a very difficult capital-raising environment recently for anything other than the top firms in the industry. That manifests itself in hedge funds competing with each other on the basis of some of their structural characteristics rather than on (investment) strategy differentiations. The largest funds have been able to offer robust infrastructure, compliance, custody and other essentials on their own for some time, but the rise in the industry of investment platforms gives even small and midsize hedge fund managers access to the same services.
The third change is transparency. The black-box mentality is almost gone from the hedge fund industry. The idea that you wouldn't know how much leverage someone was employing or even what strategy they were doing seems so abstract because this information is so available now.
It's important to remember that the increase in hedge fund transparency didn't start in 2008. It actually started evolving at the end of 1998. It's been a gradual process that coincided with the proliferation of electronic media. I remember that when I started in 2002, firms were still sending hard-copy presentations in to HFR every month. You'd get huge stacks of them every month and now, we hardly ever receive paper communications.
Most hedge funds report everything that we ask for to the HFR database these days.