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Panayiotis Lambropoulos, CFA, CAIA, FRM, is a Portfolio Manager at the Employees Retirement System of Texas – a $28 billion retirement plan – located in Austin, Texas. His responsibilities include sourcing, analyzing and evaluating potential third party managers deploying all types of alternative investment strategies. His focus is on the Trust’s Absolute Return Portfolio as well as Opportunistic Credit allocation. Lastly, he is responsible for the Trust’s Emerging Hedge Fund Manager program – ERS Launchpad - which he proposed and spearheaded.

Panayiotis started in the alternative investment industry as a Research Analyst at Grosvenor Capital Management in Chicago. He later joined MCP Alternative Asset Management, a multi-billion Tokyo-headquartered Investment Advisor (Fund of Funds) in Chicago. He was responsible for sourcing, analyzing and monitoring hedge fund investments, and contributing to portfolio allocation decisions. He worked alongside institutional clients and top investment decision makers for some of Japan’s best and largest blue chip financial institutions.

Panayiotis holds a B.S in Business Administration with a concentration in Finance and Marketing from Boston College, and an M.B.A in General Management from Northwestern University’s Kellogg School of Management. Panayiotis is a CFA Charterholder and has earned his Chartered Alternative Investment Analyst (CAIA) designation as well as his Financial Risk Manager (FRM) certification.

Franc?ois-Serge Lhabitant is a Professor of Finance at the Edhec Business School and a Visiting Professor of Finance at the Hong Kong University of Science and Technology. He has been researching hedge funds since 1994 and is considered a specialist in alternative investments, known globally for his work on hedge funds and emerging markets.

Since 2004, Franc?ois-Serge is with Kedge Capital, a European group where he directly oversees a multi-billion portfolio allocated primarily to hedge funds, private and public markets, and risk-controlled strategies. His portfolio has received several awards for its performance. He also is a member of several advisory boards for large hedge funds active in the areas of credit and distressed securities. He was formerly a Professor of Finance at HEC, Lausanne, Switzerland and at the Thunderbird School of Global Management.

Franc?ois-Serge is the author of several books and research papers on hedge funds, emerging markets and the modeling of interest rate contingent claims. He is a Member of the European Advisory Board of the International Association of Financial Engineers (IAFE) and a Member of the Alternative Investment Management Association (AIMA) Investor Steering Committee. He was a Member of the Scientific Committee of the Autorite? des Marche?s Financiers, the French financial markets regulatory body. He is also an acclaimed expert in Ukrainian cuisine.

Franc?ois-Serge Lhabitant obtained a Ph.D. in Finance (1998), a Master of Science in Banking and Finance (1994) and Bachelor of Science in Economics (1993) at HEC, Lausanne. He also holds a Computer Engineer Degree (1989) from the E?cole Polytechnique Fe?de?rale de Lausanne and an LL.M. in Tax law (2015) from the University of Geneva.

A candid conversation with Panayiotis Lambropoulos, CFA, CAIA, FRM and Franc?ois-Serge Lhabitant.

Matthias Knab: Investing in alternative investment managers is about Alpha.

However, faced with a challenging return environment, this Search of Alpha has become much more difficult for investors as a number of factors have been eroding Alpha. Let’s discuss some of these factors and also try to find out if those factors are still present or abating?

As I approach the question for Alpha erosion, I start with a parameter, or anchor point which I’ve kind of stuck at pre and post financial crisis. I kind of looked at the returns pre-financial crisis that were perhaps unrealistic versus post-return financial crisis that are perhaps more normalized in their expectations. In the early 90s and leading all the way up to the pre- financial crisis we saw a lot of funds that had first mover advantage, that we could argue had led to unrealistic results, and one could argue that most of those funds probably would not pass the institutional risk management or operational test today for many institutions like our own. Therefore they would be challenged to generate those same types of returns. For example, if George Soros came in our office and said, “I’m going all in, on one bet and the breakup of the ECM,” it would be pretty difficult to get Texas ERS to invest, purely from a risk management perspective although he generated great returns. So perhaps we should view the time period after the financial crisis as a more normal time period in terms of return expectations.

But since then, the investing composition has changed, and I believe we have an 80-20 problem here. We have seen the growth of institutionality – we had roughly around 2700 hedge funds in the early 2000s, and now we have around 8,000 hedge funds, whatever the number is. We had $200 billion in the hedge fund industry in the early 2000s and $4 trillion today. So the number of managers and their assets have grown, the industry has changed, and a lot of that capital is going to a small number of managers and thus concentrating in a certain part of the industry, and hence manager selection matters when it comes to Alpha selection.

Let’s take a look now at the institutionality that I alluded to. A lot of institutional capital entered the industry like pension plans or insurance companies, and they brought their own demands and expectations alongside with them. There is the criticism that the institutional capital tends to ask for a Ferrari but they want to pay the price of a Pinto. They have high demands and want everything to be perfect in terms of managers generating their returns but they don’t want to pay for that.

Franc?ois-Serge Lhabitant: I would completely agree with you, I think a lot of what I would call “old Alpha” has been reclassified as systematic Beta or risk premium, so that’s probably one thing, but I think there is another element that is quite important which is the fact that Alpha is a limited supply element and the only place to get it is by extracting it from another market participant or another group of market participants which have negative Alpha.

I also completely agree with your comments on the effects of the institutionalization of the hedge fund industry. When I started looking at this industry, people were targeting high teens in terms of return with risk that was probably in the high teens as well. But if today you have a hedge fund with a volatility of more than six percent, a lot of people consider it as risky. The problem is supply versus demand - if hedge funds want to attract institutional investors, they basically need to deliver very low risk and as a result of that investors also get relatively limited returns. I would completely agree with you on that

Matthias Knab: Given these developments, what would you say is the role of hedge funds in an investor’s portfolio today? Do you see them becoming more relevant for investors or less?

Remember what I said before about Alpha being limited? It’s a little bit like having a party where the cake keeps shrinking the more people you invite until the bite size becomes extremely tiny. As a result you end up biting this cake but also another cake and another cake and then the last cake may not be very good. Similarly, my worry or my expectation, more than my worry, is that a lot of people are going to come to hedge funds or come back to hedge funds probably not with the right approach, probably not very happy to go back and ultimately they’ll be disappointed. So, unfortunately, allocating to hedge funds and hedge funds Alpha is a cyclical story, and the more hedge funds you have, the less Alpha they will probably generate.

Matthias Knab: Francois, this brings up of course the question how investors can find the funds that make them happy? What is the right way to research and to invest in hedge funds?

A good starting point is always trying to figure out what you really want. When we started 20 years ago, I remember my boss at the time did a little exercise with the team, asking each one from the team to create our 15 hedge fund portfolio, write it on a piece of paper and then we’ll compare notes. So we sat down around the table and everybody took a pen and a paper and wrote his sort of ideal 15 hedge fund portfolio. And when we compared notes, it turned out that 10 of the names were common across everybody around the table. You still want to examine the reasons from everyone why they picked those funds, but that was an interesting starting point.

The next thing is then to monitor those 10 to 15 names, make sure they are still hungry. You need to have a clear picture where each of the managers is and how they will develop from there, because if a manager is really successful, they will grow, and you grow either by performance or by taking more assets. But growing and having more assets to manage can become a challenge – I’m not saying is a challenge but it can become a challenge – and so investors need to be cautious.

The two questions that I always ask before adding a manager in my portfolio are the following: Is it different, or is it better? So, to get in my portfolio, you need to be someone that is different – and then the answer obviously is generally diversification; and “better” means return enhancement. Sometimes, we find the ideal which is a manager who is both different and better, but it is unusual I have to say, because after 20 years of doing it, we already have pretty good funds in the portfolio. But you need to fulfill one of the two to be selected in our case.

But it’s not just returns that we are looking at, of course, the quality of the operations, the quality of the infrastructure is crucial. Since day one 20 years ago we have an operational due diligence team. My view is that I’m not here to invest in operational risk, I’m here to take investment risk through our managers. I’m happy to take that risk, I expect some return against. If you a hedge funds has a poor setup, we walk away. In some cases we may engage and try to improve or change it, but if it doesn’t work, basically we walk away.

Panayiotis Lambropoulos: I agree, I think the problems that could come with a manager’s asset growth also ties back to the 80-20 problem I mentioned before. Part of the problem that we have in the industry where 80% of the industry assets are managed by 20% or even fewer of all managers is that we see larger funds get larger, also because larger in the mind of some investors may imply safety. We know that is not necessarily true, we saw that with Lehman Brothers, for example – a very large organization which wasn’t that safe after all. I would concur that there is something like asset gathering risk as portfolio managers and funds simply seek to make money off management fees versus active risk taking and thus deviating from that active risk-taking ethos that was present at launch.

Again, perhaps that part of the problem is the institutionality of the industry. So, one thing that we do keep an eye on is that philosophical match regarding the asset liability. We want to make sure that as assets come in or assets are present that the managers stay true to their investment objective and they’re not managing to one or two big investors in their firm.

Capacity constrained strategies at some point do exceed their maximum utility function, there is a diminishing return to scale the bigger that you get. Having said all that, what it comes back to in any portfolio is purpose and expectation. What is your investment objective? And as you add different investment conduits like hedge funds – and I say that purposely because we don’t view hedge funds as an asset class, they are in my mind investment conduits that simply give you a different way of gaining exposure to pretty much the same main asset classes around the world, equity, rates, credit, and whatnot – once you define your purpose and expectation, you act accordingly as to what type of strategy, what type of manager you want, and you stay true to that.

Lastly, the other way that we think of smaller managers is thinking ahead, thinking of them as potential solution based investments. What I mean by that is that if you are fortunate enough and are able – whether through a managed account or through a strategic partnership – to really get access and insight into underlying portfolios, then what you are really getting an insight in is the capabilities of how those returns are generated. Therefore, you are in a better position to isolate what a manager can do well, what a manager does poorly, and therefore down the road you can perhaps approach the manager whether you have a problem in your portfolio or a problem you feel you can solve for the market, and use the capabilities of that process, of that engine if you will, to create a product that can be accepted in the market.

The best analogy I’ve used is that essentially you’re looking for a Tesla. You’re looking for a company that is at its core a battery company but can be utilized in different ways, whether it’s cars, trucks, rail, or elsewhere, but what you’re really looking at is that battery, is that process, and how it can be adjusted for other usages and greater utility.

Matthias Knab: Could I ask you to quickly clarify what is an emerging manager for you? What size or what track record would a manager have to bring to the table in order to be considered for your emerging manager program at the ERS?

Panayiotis Lambropoulos: When we revamped the program, I wanted to keep it simple so we purely define our parameters with a focus on assets under management and tenure or track record. We have several buckets, for example, for our true seed or day one investments, assets under management could be in theory non-existent and the track record, including past audited verifiable returns could range anywhere between zero to three years. For our acceleration part of our program assets under management could range anywhere between $300m to $500m, and the track record could be up to five years. Here we are looking for managers that may need that extra push in their capital raise or business growth.

Matthias Knab: Franc?ois, what is the role of smaller and emerging managers on your side? How do you research them, and what are your parameters for inclusion in a portfolio?

Franc?ois-Serge Lhabitant: Like Panayiotis, we also have the idea that if you do an allocation in the portfolio it needs to move the needle, so our minimum target allocation is $50 million which is a relatively large number. We want minimum operational quality from the funds we invest in, and our expectation is that a fund with less than $500 million would not be able to match our operational requirements. Consequently, we typically invest in funds with at least $500 million AUM. Now, there have been exceptions historically, although we are not seeking those exceptions, just to be clear.

The first type of exception is we know the manager from a previous fund where either we monitored or we were invested. The manager spins off, it is highly likely to reach those 500 million dollars, then we may get involved on an early stage. So that is what we consider as an emerging manager but it’s an emerging experienced manager.

Then, regarding size or AUM of a fund, we believe there are two strategies where. One is specific distressed situations – let’s, for example, say a Spanish Bank wants to sell a 500 million dollar credit portfolio which is distressed and doesn’t want to have an auction, they want to sell it quickly. If you’re large and you’ll get the call, you can move the funds. You can team up with two or three peers and basically get the deal done very quickly. That can be attractive, and we have seen a number of these situations where one, two, three large hedge funds basically got the deal because they were large but also because they can work efficiently and are able to move quickly.

The other area where we believe that size can be an advantage is the quant space. There you can see firms that can hire hundreds of researchers, have computing power, data storage, can buy alternative data, can execute in a better way, have better research, etc. In my opinion, the quant sphere is really an area where you need to reinvent yourself on a continuous basis. I think if you’re a very small firm, you might have a better model when you start, but then the erosion of your model can happen far too rapidly that you can cope with it. So these are two strategies where we typically prefer, in general, larger funds.

Panayiotis Lambropoulos: I’ll probably add activist funds in there as well.

Franc?ois-Serge Lhabitant: Yes you’re right, however I would also add that in each of those strategies there is an “although”. With activism, if you’re too large, you’re forced to do large deals. Same thing with quant – if you have too much money to run and your marginal model is not as good, you are kind of forced to put it in action in the portfolio, even though you don’t like it. And with credit it’s the same thing. So while a large size can be an advantage, it’s really about the mindset of the managers that should remain focused on generating returns pocketing performance fees rather than management fees.

Matthias Knab: What advice would you as investors have for managers that are trying to raise capital? How can they stand out from the noise, so to speak?

Franc?ois-Serge Lhabitant: I think it was Groucho Marx who used to say he would never become a member of a club that would accept him as a member, so I’m almost tempted to say that a manager who is trying to raise capital is not a very good sign. Now, the reality is that fortunately or unfortunately there are a lot of new managers trying to raise assets that it becomes complicated. For me, I think the key point – and it’s not an easy one – is that they need to have a good strategy that generates Alpha that is ideally differentiated. It can be skill based, it can be position based or flow based, it can be quant, it can be qualitative, fundamental, macro, etc., but you need to clearly have an Alpha value proposition and you need to stick to it. That is absolutely crucial.

Secondly, you need to have a clear view on the AUM that you can run in in this strategy. Sure, things can evolve because the markets are changing, but have in mind that there are few things more frustrating from an allocator’s perspective when a manager tells you, either at launch or later, that they will close the fund at $500 million, and a year later they have 750 million, two years later one billion, they are launching a sub fund, etc., and you see the returns gradually eroding. Therefore, for me it’s really about running a fund, running a strategy, managing the capacity, having quality investors in the fund – people that are like- minded, understand the drawdowns, the expected returns, the risk parameters.

While it’s difficult, if you can, be picky with your investors. Try to get investors that spend the time that is needed – not someone that wants to allocate to hedge funds and therefore give you a 20 million dollar check because they need to increase their hedge fund allocation from four percent to five percent. Rather, focus and cooperate with investors that do their work, that do their due diligence, that try to get a strong knowledge of the fund they invest into, and try to become long-term partners. These are the investors that you should try to find in my opinion.

As I mentioned before, I view hedge funds as a business and managers should view that as a business, not a trading desk, and you should be true to yourself. A good analyst often isn’t a good PM, and good a PM doesn’t necessarily make a good business owner, and investors can tell the difference. I would say, avoid shotgun weddings and/or marriages of convenience – if you’re going into a business with someone that you haven’t worked with before the odds are against you succeeding.

Plan ahead early and often. Seek honest feedback and advice from existing clients, investors, and colleagues. Build an adequate runway to manage your business and plan the right amount of capital to run that business, understanding the difference between your fixed and variable costs.

You need to focus on infrastructure these days and key hires, like investor relations and compliance, but don’t overdo it, because not all bells and whistles add value to the process or your business. Think of your service providers as your allies, they can give you great advice and expertise about best practices in the industry.

At the same time, if you think of outsourcing any of your services, especially as you’re building your business, just remember that you’re outsourcing your name and your reputation, and you probably require more due diligence on that aspect of your business as well. Have a great marketing plan in place – marketing is not fundraising! Have a clear plan of who you are targeting, why and how, and how often you interact with them. Keep in mind that capital raising is a long-term adventure, it requires patience and building relationships; I think that rule of “seven touches” still applies in some way.

And, at the end of the day, timing is everything. Especially if you’re launching a fund, think of any beta tailwinds that you may have for your strategy and your product, and whether or not it’s going to be in demand in the market.

Matthias Knab: Panayiotis, let’s zoom in a bit on your ERS launchpad right which is your Trust’s emerging hedge fund manager program. This program has been designed and headed by you, and has been running for a while now. Can you inform us about the overall set up and also the returns you are expecting from it? And, what has been your experience with the program and when do you expect it to be fully implemented?

Panayiotis Lambropoulos: After having worked Employees Retirement System of Texas for a couple years and looking how we had worked so far, I thought that we had internally built a lot of intellectual equity, if you will, and know-how of how to conduct due diligence. We had team members that were experienced in sourcing and finding managers, so I thought we were ready to expand our search as I alluded earlier to a different source of return.

When I approached this project, the objective was to create some type of customized venture that aligned our internal goals with external resources through a true partnership. I wanted ERS to benefit from a global network of external resources, so in a way synthetically, if you will, extend our internal staff’s bandwidth. Just to put that in perspective, there are only five of us on the team, in the middle of Texas, and this is a global industry. Most importantly, ERS wanted to retain control on the investment due diligence and investment decisions and as I explained, we wanted to retain and create a different source of Alpha, a synthetic Alpha if you will.

We just got approval to upsize our program given the opportunity set in the early success of the program and so we are targeting another one to three investments in the next two or three years. That would bring us hopefully to four or five investments by year five or so of the program.

Matthias Knab: Another issue that is currently discussed and examined is the situation of minority and women-owned fund managers. Are you giving female and/or minority owned investment management firms special consideration?

Panayiotis Lambropoulos: Yes, we absolutely support and consider minority or women owned funds. Earlier I laid out the parameters of the four buckets of our program, it goes without saying that we do consider minority women owned funds within those buckets as well. We’re active and have many conversations, also with groups that purely focus on minority, women owned funds. So, this is a given and it’s stated that within those four brackets we look at all types of backgrounds when putting together our program.

Franc?ois-Serge Lhabitant: Maybe I am surprising some people by saying I just don’t care about the gender or the racial background of a manager. I am investing in hedge funds, and if a hedge fund is run by a woman, or a man, a minority owned or majority owner, whatever – for me, those are not an investment criteria. When we look at a hedge fund, the gender of the owners, the gender of the portfolio manager, the gender of the senior people is not a criteria to favor the fund or reject the fund. We judge a fund basically on some investment criteria first and foremost. We do have of course some policies that we like to follow, for example, there are some areas where we don’t want to be involved or we don’t want to be associated with, but we don’t have any particular policy to support a fund or a firm based on gender or identity. Of course, in our portfolio we have funds that are owned by women and funds that are run by and owned by minorities, and if they perform great or if they don’t perform, they will be treated as any other fund in our process. Now, just to be clear, I’m not running a public plan, and that may make a difference.

Matthias Knab: As we are about to end this conversation which we called “How Creative Investors Address Alpha Erosion”, how would you sum up your recommendations for allocators that want to be a bit ahead of the curve?

For example, if you have come from the management consulting world, I think you can pretty much apply a lot of principles in the investment world or when you think about strategic relationships. You can use a cross-section of ideas and mix and match, that’s how I came up with the idea of Launchpad because I tried to find a hybrid of good and bad that I saw in the private equity world and the hedge fund world and try putting some things together that were different and stood out from the pack.

And again, when we’re talking about things like due diligence or portfolio allocation, it all begins by setting your expectations with the appropriate purpose, and expectation within an investment portfolio.

Don’t chase returns or names. Seek a purpose when you are looking for these allocations, and obviously, at a higher level, I would say never stop being intellectually curious. Given the type of world we live in today, always remember that we are part of a very small yet great ecosystem, so be kind to each other because everybody remembers how you treated them.

Franc?ois-Serge Lhabitant: Also, remember that hedge funds are a label, so there are a lot of different animals behind the label. Before venturing into hedge funds, allocators should ask why do we want to invest in that, what are we looking for? So, rule number one for me is set your expectations and really almost write them down so that in one, two, or five years you can revisit and see if you’ve achieved them.

The second thing is, ask yourself what could go wrong and how much would I lose, focusing on the downside. Now, don’t misquote me on that –if you can’t afford to lose say more than two, three, four percent of your portfolio, then hedge funds won’t be the solution. For me, focusing on the downside also means: If there is a disaster out there for the fund, how much can we lose, what’s the real Armageddon scenario? And, can you live with it at the portfolio level? I would summarize as understanding the risks that you are taking. Sometimes those risks might be large, but you might be able to take a large risk if you understand them and you know they are here.