Bucking the family tradition of a career in heavy construction led David C. Saunders to build an institutional hedge fund-of-funds company.
Like the rest of the male members of his family, Mr. Saunders, co-founder of K2 Advisors LLC, Stamford, Conn., was destined for a career as a civil engineer, intent on raising steel bridges and huge public works projects. Mr. Saunders worked on job sites during the summers for five years until, at age 19, he realized that managing stocks would be both easier and more rewarding than managing a construction crew of 110 people for 14 hours a day in the summer heat.
Mr. Saunders began to trade equities after college, migrating to hedge funds and eventually landing the head trader spot at Tiger Management Corp. in 1991. Describing his two-year tenure at the legendary hedge fund powerhouse as akin to “earning a Ph.D. in investing in hedge funds,” Mr. Saunders still has the bearing of a Tiger cub, characterized by high energy and a deeply intellectual investment approach.
Like many Tiger alumni, Mr. Saunders left the firm with personal wealth to be managed and, given his background, he invested in hedge funds. K2 Advisors was born out of his family office in 1994 after co-founder William Douglass approached Mr. Saunders about creating a fund-of-funds management company. The pair named the firm K2 after attending a fundraiser to benefit a Himalayan climbing team. The picture they'd seen that night of K2, the second-tallest mountain on the planet, instantly appealed to Messrs. Douglass and Saunders.
“The connotations (of climbing) apply to investing. You have to take risk. In order to be a successful mountain climber, you have to take risk, but as in investing, in truth, you're really a risk manager,” Mr. Saunders said.
What was it like to be an equity trader in the 1980s? When you're a facilitation trader at an investment bank, you are handling the transactions for the major institutions. In that role, you know what they bought and what they sold, you know when they come and when they go, you know who made money and who lost money. You got to see their footprints, and hedge funds were right a whole lot more than they were wrong. And that wasn't something I could say about mutual funds or other investors. (Hedge funds) always seemed to be one step ahead of the pack in terms of the types of trades and the investments they were making, picking up on trends much earlier than other (managers). And they were armed with the ability to go both long and short.
Did you jump at the chance to work with Julian Robertson at Tiger? I felt like I was moving up a division because Tiger had such a wonderful reputation and was considered such a powerhouse. It was a wonderful place to work. You had so many smart people that you were surrounded by, all of whom possessed tremendous energy levels, who were literally chasing around the globe looking for opportunities to make money.
Was there a common investment strategy within that global alpha search? I think one of the things that contributed to Julian's success is his ability to identify the next money-making opportunity. He has morphed many times into new investment strategies. ... He just has always had a knack for finding the right investment, but always steeped in fundamentals. Fundamentals always were at the core of the investment decision. I think that permeated everyone and everything we did at Tiger at that time.
How did you develop K2's investment strategies? The framework we started out with was really around risk, because that was something I'd seen firsthand for all of my career.
The three core market risks we were focused on at the time were leverage levels; concentration risk in any single investment; and liquidity.
Correlations also concerned us. One of the things that a macromanager necessarily has to think about and do is to take a top-down view of the world and then think about the correlations of the knock-on effect of price movement. If you've got a collapse or a flattening in the yield curve, it can have far-reaching market ramifications. Looking back at our hedge fund portfolio even in those early days — back then, it was constructed around a pool of Lotus notes, pre-introduction of Excel spreadsheets. From the start, we were trying to understand the relationships between the managers and trying to build a better risk-adjusted portfolio.
Did hedge fund investors manage their expectations well enough last year? The hedge fund industry largely ignored the market risks, the exposures that live inside hedge funds. I think the investment community by and large really misunderstood those exposures in their (hedge fund) portfolios. Certainly the weakness in portable alpha (strategies) showed itself.
How could investor expectations be so far off? They were basing their understanding on poor data.
Hedge fund (investors) have mostly focused on historical performance, which is very misleading, and made assumptions about the risk levels or correlations that those historical return streams have given off. Unfortunately, last year really highlighted the weakness of that process. We think (that process) is weak for multiple reasons.
The first point is that you're really only getting between 12 and 52 data points from each manager per year. You're getting their monthly NAVs (net asset values) or their weekly NAVs. And to try to infer from that data some correlation levels is a very dangerous game to play.
What that can mask is high levels of leverage, potentially concentration risk and certainly, liquidity. When a market is shocked like it was last year, those problems can manifest themselves in your portfolio. But that was the standard by which everybody measured all investments.
Think about the traditional measurement methodologies out there. If they had daily data for hedge fund managers, it probably would have yielded more accurate results. But they didn't.
At K2, we have historically avoided any strategy that uses excessive leverage. We started looking a long time ago at what hedge funds owned and then did risk analysis on those holdings.
How often do you get position-level data? Monthly.
Is that sufficient? It is for those managers who don't change their portfolios with high frequency. It will not work on strategies that turn their portfolios very frequently.
So do you ask for more frequent data for rapid-trading portfolios? Historically, we haven't used many of those managers. The way to better understand those strategies would be to take in data daily. However, for certain funds, such as our currency funds, we do that and look at those exposures on a daily basis.
How did K2 weather 2008? This is an incredibly difficult environment for (investment) managers. I don't care if you're a long-only manager or a hedge fund manager, 2008 was a very difficult year with the exception of a few bond managers. But we finished (last) year virtually flat when it came to assets. We had inflows, drawdowns in performance across various funds. Some managers made money, many didn't. And we had typical redemption levels for the year, 3% or 4%, which has been our norm for years.
