Mark van der Zwan - The Evolution of Hedge Fund Investing

00:00:06 [Mark van der Zwan]
So if you think about one big secular shift in markets and the active management industry is the shift from generalist approach to specialist approach. And the platform model, just in terms of underlying risk takers, tend to take specialization to another granular level.
00:00:26 [Vincent Weber]
Hello everyone, I'm Vincent Weber and this is Resonanz Spotlight, the podcast where we explore investment strategies, learn the story behind them and meet the experts who create them. From fund to fund to platform over separately managed accounts, the way we invest in hedge funds has changed a lot in the last 20 years. Today, with the biggest multi-strategy platform stronger than ever, we might wonder, has the evolution of hedge fund investing come to an end? Have we solved all the problems or are we on the edge of a new shift in hedge fund investing? I'm your host, Vincent, and in today's episode, we are going to tackle these questions. Joining us is Mark van der Swan, a leading figure in the industry.
Mark is a chief investment officer and heads the hedge fund solution business at Morgan Stanley Investment Management. He and his team manage 25 billion US dollars across various strategies. With 25 years in the field, Mark has seen the change in the hedge fund investing firsthand, making him the perfect guest to discuss today's topic. Mark, it's good to have you here.
00:01:31 [Mark van der Zwan]
Thanks for having me, Vincent.
00:01:32 [Vincent Weber]
That's great. Mark, let's dive straight into our topic. Mark, you have a fascinating background. So could you share with us the story about how you came to lead Morgan Stanley hedge fund business?
00:01:46 [Mark van der Zwan]
Yeah, absolutely, Vincent. So first of all, it was somewhat of a circuitous journey for me. I'm born and raised in Ottawa, Ontario, Canada, and I did undergraduate studies in Canada, actually in chemistry and computer science. At that time, my intention was to continue in the sciences field. And ultimately, after university, I did end up working actually at a vaccine lab where I did computational modeling work. quantitative work and intellectually very very interesting but at the same time as i started earning a little bit of money i got interest in the markets and kind of think of combining both quant and markets really piqued my interest and so ultimately i did a pivot and i went to business school again remaining in canada and did an mba in finance but ultimately after business school moved to
san francisco bay area which You all imagine the late 90s, very exciting time to be there. That was sort of the peak of the dot-com boom. At that point, I worked for a boutique investment firm. Small was really cool for me because it enabled me to really have my hands in a whole range of different kind of investment topics. And I worked there for five years. And what I quickly realized was how little I actually knew about investing. And, you kind of go through those cycles of things where you realize how little and how much ramp up you need to get on terms of the learning curve from that. From there, however, I moved and I joined Morgan Stanley Investment Management's hedge fund business in 2004.
Those are very much sort of the go-go years of the hedge fund industry. But the group within Morgan Stanley was a pretty fascinating kind of boutique group. surmised at the time that they were very much in kind of the cutting edge of hedge fund investing and it really did appeal to kind of the intellectual aspect of investing that wasn't necessarily always the case in the hedge fund field at that time and of course today as well. So I was quite fortunate to end up landing within Morgan Stanley.
What was really worked out great for me within Morgan Stanley was that very much was a culture and is a culture of meritocracy and my particular group very much emphasized promotion from within so i ultimately assumed more and more responsibility and i took over broader chief investment officer responsibilities in 2016. at that time my broader vision was as i was thinking about expanding our activities was my broader vision was the platform model of investing really representing the most efficient delivery mechanism for skill-based returns. And I was fortunate that throughout all of this time at Morgan Stanley, they supported this culture of innovation. The firm supporting our expansion of our activities, whether it was in prior years and expansion of the secondaries or, and then more recently, the multi-PM platform business.
So circuitous, but exciting for me as a. a Canadian kid now living in the East Coast of the United States.
00:05:07 [Vincent Weber]
Before we continue on the platform, I'm just curious, when you started Morgan Stanley, were you applying some quant skill or was your job very much qualitative?
00:05:18 [Mark van der Zwan]
I think certainly when I first joined, my quant skills were seen as being a real asset for me. And I would argue more generally, just given my background prior to My prior firm, having a really robust both quantitative background and actually program experience, I think was a skill set that I was a little bit more advanced than others on that. And so it gave me a little bit of a leg up where I had less knowledge, particularly prior to my stint in San Francisco area was the investing side of it. And again, my point earlier about. having some naivety associated with how all this activity got conducted. I certainly ramped that knowledge up in San Francisco and then it really was a combination of more qualitative but using that quantitative skill as well.
00:06:15 [Vincent Weber]
Okay, thanks. And I mean, if comparing your early days in 2004, the early days of hedge fund investing, so how have investors attitude towards hedge fund shift over these two decades?
00:06:29 [Mark van der Zwan]
It's been a massive sea shift, Vincent. at the time, the fund-to-funds approach was generally the model adopted by large institutional allocators. predominantly those fund-to-funds invested in hedge funds via LP-type investments, and where I think one of the broader themes I think that I see in the hedge fund industry is you can't paint the hedge fund industry as a homogenous brush, but I would argue the key aspect that was Predominantly there as it related to the fund of funds was sort of gaining access to difficult to access hedge funds. And flows into hedge funds and fund of funds continued to 2008, at which point we all know the global financial crisis impacted markets and very much impacted the hedge fund industry.
I would argue the fund of funds industry kind of had a double whammy crisis of confidence. Not only do the hedge funds in aggregate not deliver in what people hope them to get out of in terms of diversifier, but the fund of funds community also in many cases erred in their ways in terms of their allocation to those hedge funds. Madoff was very much kind of impactful in terms of that crisis of confidence. And there was a dramatic shift amongst hedge fund investors really to several things. One was some shift away entirely from the hedge fund industry. Those that remained within the hedge fund industry shifted often to more highly liquid structures, in many cases done via separate managed accounts.
And then there was also a disremediation of the hedge fund, the fund of funds industry, where large institutional allocators sought to go direct, sometimes via separate managed accounts, sometimes via. limited partnership investment the fund of funds industry massively consolidated as a consequence of that i would argue successful ones adapted to a more flexible model and still remain a very relevant component of the industry what's interesting however is as the institutional allocators effectively went direct their experience in going direct was often inconsistent They often allocated to single risk taker hedge funds, leaving them with exposures that often were quite candidly insufficiently diversified. And ultimately, the experience was not as clear cut or clean than many of these allocators wanted to experience. Hence then the rise of the platform model, where the platforms represented.
a path for investors to achieve a direct investment, but at the same time gaining a much more diversified exposures, enabling allocators to partner with a narrower set of underlying hedge funds, but at the same time kind of experience a more broadly diversified exposure to the hedge fund industry.
00:09:48 [Vincent Weber]
So now platform, have seen really a tremendous growth of assets, and some of the large platforms are really dominating the market. So do you think like hedge fund investing at rich is Zenit or there are room for more innovation?
00:10:06 [Mark van der Zwan]
There's absolutely room for innovation. I would argue, the success of the platform model has been pretty simple, Vincent. ultimately. From investors' perspective, they've generated a return profile that generally investors want to a greater extent of their hedge fund portfolio, namely low beta, muted volatility, but at the same time, an economically viable return. One kind of simple way of describing the platform model is kind of 0-5-10 strategy, zero beta, five vol, 10% return. The degree to which one can achieve a profile like that Generally, institutional investors would be somewhat pleased with that. And so, unsurprisingly, perhaps, allocators shifted towards the profile that generally people wanted to a greater extent. It gave real diversification that allow allocators to go direct while maintaining a relatively narrow set of rosters of direct investments, and they're able to access.
these underlying platforms and scale as well. But underneath the hood, however, there's a heck of a lot of things going on, as you can probably appreciate, Vincent, that led the category to deliver to a greater extent than others. And to your point, there's continual areas of improvement on those factors, I think, to be had as one looks to further extend one's capabilities in the platform space.
00:11:43 [Vincent Weber]
Maybe taking a step back, I often find it's pretty easy to get lost in the difference between platform, SMA, or even fun of fun. Sometimes the line gets very blurred. So maybe can you describe to us the difference between your platform, SMA, with your key strengths and drawbacks?
00:12:04 [Mark van der Zwan]
Yeah, absolutely. So I think maybe a good way of thinking about SMAs and platforms and the like is, If you think about hedge fund investing in kind of different iterations, so you think of a hedge fund in version 1.0. That represented an implementation path where generally institutional allocators gained access to hedge funds via an LP investment. So assemble a whole bunch of these together that had benefits of being able to access a broad range of talent, but there were some shortcomings. The SMA model represented kind of an advancement, hedge fund 2.0, where it addressed some of the shortcomings of a traditional LP investing. So, for example, it allowed the investor to tailor the risk exposures. They gain greater transparency.
And at the margin, if you were a large allocator, you could use your scale to your advantage to reduce costs in terms of financing or execution and the like. So, for example, one challenge people have faced in the hedge fund industry is that some hedge funds carry too much beta. And you can well imagine a separate managed account, you could more explicitly control that beta exposure via guidelines. Another challenge facing investors is the underlying hedge fund may be targeting a volatility level that's inappropriate, often too low.
for an institutional allocator and so a separately managed account allows one to target volatility to be much more tailored to the asset owner's desired level of volatility platforms represent i would argue kind of hedge fund 3.0 and where they're addressing shortcomings in maybe even more granular and sophisticated way so if you think about one big secular shift in markets and the active management industry is the shift from generalist approach to specialist approach. And the platform model, just in terms of underlying risk takers, tend to take specialization to another granular level. So, for example, in equities, a platform would typically have PMs operating in different sectors and often sometimes in subsectors as well.
That obviously could be achieved by a separately managed account as well, but you start running into real proliferation of number of separately managed accounts. The other aspect I would argue really are around three variables that I think the platform model kind of further improves upon Hedge Fund 2.0. One is control, right? Platforms tend to, the guidelines associated with these underlying portfolio managers tend to be even more granular yet still. And so the control in terms of engineering your outcome can be far more granular. The second aspect is you tend to operate in terms of best practices with what we call T plus zero visibility, meaning we see the books on a real time basis, as opposed to a typical SMA route where one has end of day visibility where you can evaluate on that.
You also have even greater ability from a control perspective to target volatility in a more kind of aggregated type way. One interesting aspect of the platform model is that the underlying portfolio managers, they're not the ones deciding what target volatility to run. They tend to are given buying power and that buying power, what capital is associated with that buying power can be controlled at that total portfolio level. The second aspect is this enforcement side, as I was alluding to earlier. A platform tends to have kind of additional control and enforcement functions, such as a dedicated central risk function. Obviously, those guidelines could be enforced intraday, since you have that visibility. But there's also generally a presence of a central trading layer hedge book.
which acts in essence as a second layer of risk control, where potentially risks are contained at the individual PM level, but individually they might aggregate up to more significant risks, and that central trading layer can conduct hedging above and beyond what's being conducted at the underlying portfolio manager level.
00:16:37 [Vincent Weber]
You just talk about specialization. So if I understand you correctly, that means Warren Buffett, they wouldn't be able to get a job at a platform.
00:16:49 [Mark van der Zwan]
You're actually right. I think from multiple perspectives, and this is not taking away whatsoever to Warren Buffett's skill set, but that is not the type of portfolio manager that would be employed at a large platform or any platform for that matter. Number one, because you tend to, within a platform, seek to tackle the active management challenge. through hiring specialists, of course, and generalists. And also, what you also tend to do is you tend to require, through guidelines, the portfolio manager to drive highly idiosyncratic or alpha-driven returns and where factor exposure is limited by guidelines. So very different model, clearly. I would say, by the way, Vincent, as well, the one other efficiency point The kind of expansion of sophistication point platforms very much take advantage of here is on the efficiency side as well.
Generally, a platform is what we call an omnibus structure. So it's one vehicle. That one vehicle ends up being one much larger balance sheet, often very well matched balance sheet, which makes it a very attractive for. to appeal to the financing counterparties. You also generally can kind of take treasury optimization to a greater level within a platform because you tend to have multiple prime brokers, whereas with a separately managed account, though you also could, it's often done in single prime form. And so the efficiency piece you can kind of take from a treasury perspective, I think yet to a yet another level. Now, of course, all of this comes with complexity and cost associated with it, which is clearly the largest drawback associated with that path.
00:18:48 [Vincent Weber]
So these are the key drawbacks, or are there other weaknesses to the platform? I remember if you go back in time to the days of the Amaranth implosions, there were a lot of question marks around the platform model, which apparently disappeared over the last subsequent years.
00:19:10 [Mark van der Zwan]
I think the platform model, I think the power of it lies in one's ability to risk manage at multiple levels, both at the individual portfolio managerial and the aggregate level. And so one is able to kind of contain drawdown to a greater extent via that multi-level component of things. I think the strategy is particularly well executed in very liquid. where risks can be very, very well hedged. I think where challenges start creeping up to a greater extent is platforms extending that activity into less liquid activities, activities that are more difficult to properly understand the risks associated with it. Illiquidity may be not there to the same extent. And so those risks are risks, I think, that are creeping in. to certain extent amongst some of these platforms.
I think another risk, Vincent, within this lies in kind of the success of the platform sowing the seeds of future challenges as more and more dollars get deployed within the platform approach and where the platform approach is executed somewhat differently by different groups. There's often kind of a central approach that's in common with one another. I think it introduces a risk what we call internally a sort of platform beta or this risk of deleveraging impacting the broader industry. I think that is a risk I think that's very pertinent and probably even more influential risk today than it was when the platform model was a much larger footprint than it is today.
00:21:04 [Vincent Weber]
And you talk a lot about operating efficiency. So, and I know your platform like to talk about, the bot of scale, technology, infrastructure. So, where's the hype? Where's the reality behind this buzzwords? is it, are we talking there about like proprietary ingredients or is it something, I want to get to know, technology infrastructure that any new market entrails?
00:21:32 [Mark van der Zwan]
could quickly gain yeah i mean firstly infrastructure resources are absolutely critical in the platform model it's kind of a it's a it's a machine seeking to deliver skill-based returns and and real key advantages lies in that in in the efficiency of that machine and certainly that benefits larger scale players as these costs can be absorbed over a larger asset base And of a critical importance for a startup hedge fund, a platform hedge fund is how much of those costs are being passed through. And if it's a relatively smaller asset base, those numbers can be quite large in percentage terms. I think it benefits the nascent players that have existing infrastructure to take advantage of so that it's not such a large lift to gain access to that infrastructure.
But I do think it's interesting, Vincent, that the platform model has moved in some ways in kind of this proprietary versus vendorized path, as you were kind of alluding to. I would argue that historically, the very large incumbent platforms kind of benefited from competitive moats by virtue of having proprietary infrastructure that was not available in vendorized form. Today, however, some of the most important tools that a platform acquires, such as a portfolio management treasury system, risk systems, order management systems, amongst the most sophisticated solutions to that are often vendorized solutions today. And those vendorized solutions have real appeal because they're supported by a very large support in terms of programming and data engineering, et cetera, et cetera, leaving the so-called proprietary infrastructure as somewhat being much more of a legacy infrastructure.
And so we've seen competing platforms shift towards these vendorized solutions. That doesn't make it any less expensive to access these, but those that can overcome those competitive moats through having sufficient amount of scale are in a much better position today to kind of get 2024 platform technology in place versus, say, 10 years ago when much of that would have had to have been built in-house. Right.
00:24:03 [Vincent Weber]
So today, when considering an investment in a platform, what key factors should investors think about to determine if it's a good fit for them or not?
00:24:13 [Mark van der Zwan]
Yeah, I mean, I think in terms of looking at individual platforms and kind of disentangling one versus the other and thinking whether it's a good fit the first part i think one needs to ask oneself is where does this platform sit in terms of economies of scale and diseconomies of scale in the platform business there's clear economies of scale alluded to earlier critical infrastructure and resources one needs sufficient amount of scale to be able to get to a place where the costs are not too unduly large One needs to be sufficiently scaled in order to compete for talent, diversify sufficiently, and take maximal advantages of some of the efficiency points I alluded to earlier. But there's diseconomies of scale as well.
Diseconomies of scale come in the form of having to put too much capital to work at underlying portfolio managers, which may hamper their ability to deploy that in a nimble, more successful type way. regions and certain sectors, it's much more difficult to deploy larger portfolios where one is not occupying a duly large amount of percentage of average daily trading volume, for example. And so thinking about this economies of scale and diseconomies of scale point, I think it's an interesting kind of dimension to consider. And this includes then what strategies they include. do those strategies, can they be successfully executed at the scale in which that platform's at? I think there's other ways, Vincent.
I think the helpful ways in our minds to kind of think of the platforms and how they might differ and where one might have the greatest amount of comfort, I think it's really around these sort of four big categories. First is playbook. Second is talent acquisition strategy. Third is the machine that we talked about earlier. And then fourthly are terms, right? So on the playbook side, platforms differ in terms of what strategies are included and why. How hedged are the portfolio managers expected to be? To me, best practices in the platform model and kind of what makes platforms tick is the ability to engineer return profiles, the underlying PM level, such that you can drive low correlations amongst those PMs. Platforms differ, I think, on how important they see that component of things.
I think relevance of this concept of platform beta I alluded to earlier and the platform sort of attunedness to that would be of key consideration in my mind as well. One final point on the playbook side, I would say, is platforms very much differ in terms of their capital allocation strategy. So how much do they add to individual portfolio managers versus the others? There's very much differences in approaches there. Some approach a much more feed your winner approach, which has implications. Others tend to be much more broadly diversified. From a talent acquisition strategy perspective, I think one needs to get comfort that that platform Acquisition strategy is a sensible one, meaning it's able not only to attract high-quality talent, but retain them as well.
And how is that set up and what are the mechanisms for that to achieve? On the machine side, clearly one wants to see that a platform has sufficient amount of infrastructure and resources to effectively handle that risk. And not all risk is as easily understood. If a platform is expanded, for example, then more complex strategies, less liquid strategies, more difficult to risk model strategies, the machine needs to appropriately reflect that. And then the one final point, and this is a point that very much you see differences amongst the platforms, are the terms in which these platforms provide to end investors, which kind of the most critical one is the fee level. how the fee structure works.
Generally, platforms approach kind of are in a spectrum of the full pass-through model all the way over to kind of a fixed fee structure model. Ultimately, I think investors need to feel comfortable that the fee level that's being charged and the pass-through component therein enables them still to generate an economically viable return in spite of those feed loads. I think an important metric that investors are becoming more attuned to when evaluating this is what we call the net to gross ratio. So the net to gross ratio would be the net return to a limited partner in that platform on the numerator, and then the gross return to gross of not only the pass-through component at the central level, but the PM payouts, et cetera.
And in our view, that net to gross ratio needs to be at an economically viable level, particularly when you're thinking about how much dollars have gone into the platform model. And obviously that introduces more competition within that. Where that ratio needs to be, I would argue it needs to be north of 60%. The platform model. in many cases is implemented at numbers far lower than that but obviously that's my bias. I do think that puts platform investors in a more kind of solid footing as markets as these as greater amount of dollars flow into this approach.
00:30:11 [Vincent Weber]
That's a very interesting way to to analyze platform. Again, taking a step back, so do you have any advice for those really new to hedge fund investing?
00:30:24 [Mark van der Zwan]
Yeah, I think what's interesting for me is hedge fund investing, firstly, I think requires a very balanced skill set in some ways. I would argue that it's become increasingly quantitative, even in fundamental equities, for example, where kind of the old era of just more qualitative stock picking. has been supplanted by stock selection where portfolio construction is much more sophisticated and i would argue more generally that's one of the largest advancements going on in the platform space but the hedge fund industry more generally and so what that ultimately i think in terms of advice for newcomers is looking to have a balanced skill set for those that may have a more quantitative skill set kind of developing more of that qualitative skillset is very valuable.
At the same time, those that may have more of a qualitative skillset, accessing greater quantitative skillset and programming skillset we see as being important. Virtually every investment person on the multi-game platform team have some level of programming experience. We're in a world of much larger data sets, kind of breaking through really what the limitations of excel and the like is and i think that's a relevant kind of skill set to have even in kind of a para programming type way interestingly though i as i alluded to earlier a big thing i think newcomers need to be aware of in the hedge fund industry is there's a secular shift away from generalist investing to specialist investing right and the platform model reflecting that and so there is opportunity i think to find one's niche as well
in much more granular areas and where specialization leads you potentially to have greater edge in those markets. And that edge might be in all sorts of different ways. I do think though, as new investors, I think there's a lot of misconceptions about the industry as well. Often the industry is painted in kind of this homogenous brush, right? The reality is this, is that Some hedge funds are very well hedged. Some are not. Some are overly aggressive in their approach. Some are unduly conservative. Some charge exorbitant fees. Others are designed with much more well-aligned fee structures. And the reality is hedge funds are not an asset class, but they're a delivery mechanism for skill-based returns.
And in some ways, if you can think about it in that light and look to optimize that delivery mechanism i think it's going to lead to much better outcomes for all those involved in this industry mark thank you for sharing your insight and thank you for being with us today and to our listener thank you for tuning in to resonance spotlight and for making it this far through this episode thank you