The Blueprint to an Alpha-Generating Fund

There are so many public and private equity firms out there. How do you choose the best one to work for as a young and inexperienced analyst? The decision is easy if you’re going to make that decision purely based on monetary compensation. But the odds are, if you're planning on staying around long-term, the most significant determinant of your long-term compensation and fulfillment will be fund performance. Sure, there’s a lot of chance that factors into performance. However, some structural factors that are arguably more important than the talent of the analysts working for the fund also go into it. Let’s imagine you’re setting up your fund and are trying to maximize your chances of outperforming. How should you do it?

Decision-making: Single-person decision-making will always yield optimal results when it comes to fund management. Not only does it allow one person to take responsibility for the success or failure of a decision, but it also facilitates far quicker decisions. In cases where funds are managed by groups/committees, Jeff Bezos has developed a solution allowing for more single-person decisions. It’s called the ‘disagree and commit’ strategy. Not everyone needs to agree that a holding in a portfolio is mispriced. In meetings, the most senior analysts should always give opinions last. This is to avoid authority misinfluence on younger team members. 

Aligning incentives: Most funds charge a fee based on AUM (assets under management). This structure is often misaligned with the client. Yet, the fund needs to offer some stable income to retain analysts. Still, there are ways to optimize incentives here. Firstly, charging a performance fee and/or pooling revenues and paying out compensation based on individual analyst performance can help. Furthermore, a clawback policy threatening to return fees to clients in the case of subsequent underperformance should be introduced to prevent excessive risk-taking.

Failure to ride technological waves: As with any business, public and private funds are subject to disruptions due to technological advancements. Many fund managers live in psychological denial about these disruptions. However, some savvy managers can wisely ride the waves of disruption. Two notable waves of disruption in the public markets are low-cost index funds and the Internet. For instance, most fund managers should want to hold an index fund instead of cash to maximize long-term returns. Managers who historically conducted primary research "on the ground" may opt to use YouTube and Tegus to gather and process more information at a faster speed than competitors to maintain an edge. 

Aligned capital: Choosing a fund that can lock up client capital for long periods or is highly selective about what client capital it takes in is crucial. Inflows tend to be largest when attractive investments are scarce, and outflows are largest when attractive investments are abundant. You've hit the jackpot if you can find a fund where the opposite occurs. Lowering fees for long-time fund clients can increase loyalty. 

Fishing where everyone else is fishing: Arguably the most significant determinant of performance for public and private funds. The more crowded a market is, the less likely that the companies within that market will be mispriced to the downside. Generally, smaller companies tend to be mispriced more frequently than larger companies. However, there are also special situations and companies where Wall Street forms a wrong consensus view. On the private side, it is helpful to have a sourcing advantage in which there is an urgency to sell for the client or some other attractor for the seller to underprice their business.