Price signaling is a marketing theory that suggests the quality of a product can be broadcast through the product’s pricing. The more expensive item must be better than its cheaper counterpart on the shelf, taste better on the pricier menu or last longer than the less costly competitor. Right? While I might wish to deny it, the degree to which I want to impress my dinner host dictates not the esoteric excellence of the wine I purchase (I am no aficionado), but the amount of money I pay for the bottle. In the absence of an expert’s knowledge and confidence, price is a subtle and powerful tool to communicate quality, real or perceived, in the consumer goods and services marketplace.
If only it were that easy for hedge fund managers. The reality for the aspiring emerging manager is that the priciest offering and the most incredible track record may communicate not quality but a flashing sign that reads “steer clear!” to sophisticated allocators. How an emerging manager chooses to publicize their performance history to prospective investors must begin with the truth and be followed by a proper contextualization from an institutional allocator’s vantage point.
In my experience, emerging managers derail interest not necessarily because their returns are not interesting, but because their inexperience with the seasoned allocator’s perspective causes them to inadvertently advertise their lack of institutional preparedness. In that light, here are five key “do nots” in emerging manager track record compiling.
1) Do not change your advertised historical returns.
Temptations to change your historical track record are around every corner. Perhaps a new system has been added to the strategy and you would like your past track record to accommodate an improved model. Possibly one account you have chosen as your public track record is not currently performing as well as another separately managed account with nuanced differences such as markets traded. The reality is many an emerging manager falls prey to these and other temptations. Once you have published, you cannot, nor should you, alter your track record. Nor should your track record differ if an investor sources your returns from a database or from your distributed materials. This will be found out and reflect on the quality and consistency of your approach. Instead of a seasoned investor asking clarifying questions, you will likely be dropped from consideration without feedback.
2) Do not show back-tested returns.
A dollar for every “pro forma” track record I have dismissed in my career could put a dent in our fiscal deficit. All pro forma’s share the same look, a near perfect 45 degree angle slanting from zero to “infinity and beyond.” The view that a pro forma can lengthen your track record and give perspective is an inaccurate one. Providing any pro forma history, even before you have an actual trading history, almost certainly will communicate not that you’re likely to make money 80% of all trades but that your lack of experience removes you from consideration.
If only this issue were limited to emerging managers. Too often, established managers introducing new models are tempted to show pro form histories as well. Evidence of pro forma histories in more established manager’s presentations does not validate the use of pro formas as an emerging manager. It does, however, offer further evidence that we can all fall prey to the pro forma’s allure. If a prospect wants a pro forma they will ask for it, otherwise leave it out.
3) Do not have trading gaps.
Trading gaps in track records signal a “red flag” for sophisticated allocators who will immediately ask questions. While a performance gap in your track record may be admirably defended, your defense may not be enough to overcome the red flag. Once you begin trading, unless you’re an unusually opportunistic manager who makes a handful of trades a year, make sure you continue to trade without a full calendar month’s pause. Running sophisticated investor money will not afford you the opportunity to simply stop for one reason or another. Without evidence that you can be consistent in your strategy implementation, you will not garner the confidence of your prospect that you suddenly will trade dependably. In short, it is difficult to overcome a gap in your track record. You will struggle to convince a sophisticated allocator that you are worthy of the fees you are requesting.
4) Do not have huge volatility swings.
More so than your absolute return, investors want to quickly ascertain what they can expect from a volatility and risk perspective when they give you money. This speaks not to how great your year was in 2008 or your terrific month in May 2012, but rather whether they can anticipate within a reasonable range the risk they will assume when they allocate money to your strategy. Upside volatility in the form of a tremendous month or quarter is unlikely to communicate that you could be up 50% next month as well. Instead, what upside volatility shows in your track record is that the other shoe will drop at some point. A sophisticated investor will read the outlier strong month or quarter in your track record as upside volatility that they missed concluding that there will be commensurate downside volatility in the future. Even a passionate and reasoned appeal to your conviction in the exclusive upside volatility of the strategy is not likely to sway an allocator.
5) Do not try to convince investors your trading history is longer than it actually is.
Above all, be honest. Only in very rare instances (and in these cases long term there is investor regret) will tremendous skill overrule whether you can be without question trusted as a money manager. The most sure-fire way to eliminate an investor’s confidence is in trying to broadcast returns that are not legitimate or are manipulated in any way. Returns must be earned through actual and audit available trading for a separately managed account or fund. Not only will your business run the risk of violating regulatory demands, which is fatal for your business, but your reputation will be, and fairly so, tarnished without a high likelihood of rebirth. Do not run this risk; do not publish returns that are in anyway controversial. If you are genuinely a terrific investment opportunity, you should not need to pull strings to show a track record that represents your skill.