How to launch a hedge fund — Three Body Capital

Launching a hedge fund is a bold undertaking. Some nail it. Some crash and burn. And some end up somewhere in between, plugging away in a fiercely competitive and structurally problematic market.

Having spent a year preparing to launch our own fund, we have a deep appreciation and respect for the efforts of others who have trodden this path. We know how tough it is, and we know how rewarding it can be, too. This blog post isn’t us passing judgement or positioning as experts – it’s simply an attempt to explain how we’re approaching our business, and why we’re doing what we’re doing.

Beware the riptide.

It should be easier than ever to launch a fund, with proliferating service providers, outsourced regulatory cover, falling transaction costs, ample liquidity searching for yield and bags of demoralised sell-side talent looking for a home. There’s even books that tell you how to do it.

And yet, it’s an incredibly tough time to be going out on your own as an active manager to gather AUM. And the reason is structural. We all know that flows are coming out of active management, but the extent of the move is not to be underestimated. We did a deep dive into this topic in last week’s blog post on The Unintended Consequences Of The Shift to Passive Investing, but it’s worth reiterating.

Earlier this year, Institutional Investor declared that “half of US stock investors are now betting that they can’t beat the market”, with assets in passive US equities funds sitting at $4.3 trillion after twelve years of relentless outflows from active funds. And Bloomberg announced, “It’s official: index funds and ETFs have finally eclipsed old-fashioned stock pickers.” It described parity between passive and active management as:

“The official end of money managers’ position as the guiding force in the American stock market [...]. If, as expected, the shift keeps gathering momentum, the implications will be enormous for the industry pros, financial markets and ordinary investors everywhere.”

Obviously America is not everywhere, but we are seeing the same trend play out in EM. The below chart from Morningstar shows 5-year cumulative flows to US-listed active and passive emerging market equities. It’s the sort of thing that gives EM hedge fund managers nightmares – or stops them sleeping all together:

Over the last five years, passive strategies have attracted 2.5 times more capital flows than active strategies into US-domiciled EM funds. Globally, AUM deployed to active managers still leads passive, but a huge reversal has been in progress for years now, and it’s impossible to ignore the fact that inflows into index-based products are responsible for nearly all outflows from active strategies. This may or may not continue as the business cycle plays out, but what we can say is that for the time being at least, a great divergence is underway:

Active approaches have dominated asset management since the birth of the industry. In recent years, they’ve been slammed by commentators who have (quite rightly) drawn investors’ attention to lacklustre performance and exorbitant fees.

Passive has benefited by stepping in and providing cheap, liquid (at least for the time being) products but more importantly, it seems to have won the intellectual argument. Certainly, the direction of the market has helped. So too has shifting demographics and the rise of the millennial investor, who wants to “set it and forget it” with automated investment strategies. At the same time, baby boomers are retiring and redeeming investments in active funds in order to fund their retirements and pass on their wealth to their loved ones. Momentum is only going one way, and the result is that passive now accounts for practically 100% of inflow in the US equity market on a net basis.

Across, not against.

New active managers seeking to get a foothold in the market are swimming against the tide. If even the biggest active fund managers with the most high profile management teams, biggest marketing machines and slickest operational infrastructure are struggling to attract inflows, what hope does a lowly startup have?

There is always the promise of newness, the hot new hedge fund exiting stealth-mode and making its presence felt in the market. But as in all serious disciplines, being new is a profound disadvantage – it means less track record, less operational maturity and a host of other risk-factors for allocators.

New funds need a differentiator, a secret sauce, but the truth is that many people in the asset management industry, talented as they are, just aren’t that innovative or original – they come from established shops with franchise value and try to replicate the same strategies without the same institutional-grade structure behind them.

Even the strongest swimmer can’t fight the riptide forever. If you’ve ever surfed (or like us, pretended to surf whilst falling off a large piece of foam again and again until you give up and return to the car park to eat ice cream), you will know that the only way to escape a riptide is to resist the temptation to battle against it and rather, swim across it. This is how we like to think of our approach here at Three Body Capital.

The empire strikes back.

We believe that the prevailing hedge fund business model is broken and as such, fails to provide a compelling alternative to passive management. In order to compete with index-based approaches, active managers need to make their offering more compelling and relevant. We’re doing this by aligning interests with investors, zeroing management fees and charging a 30% performance fee only.

Taking management fees out of the equation changes the math of investing. It’s not just good for clients – it’s good for us, too. We no longer start every year 200bps behind. We’re not obliged to keep cash invested if we don’t like the market. And by aligning interests with investors, we’re able to create a new audience for our hedge fund.

“No-win no-fee” is our way of fighting back against the passive industry. But it makes running a hedge fund very challenging. Bills to pay, mouths to feed and talent to retain are tricky to handle when you’re not getting paid a sweet 2% management fee on assets. Of course, relying on personal savings and a flawless track record might actually work if you have the correct mixture of expertise and luck, but it’s not a sustainable business model or credible proposition to investors and business partners – not to mention families who rely on you to put food on the table. So how does one square the circle?

Re-engineering the hedge fund.

Abolishing management fees means re-engineering the hedge fund by devising sustainable income streams that can supplement the right kind of fund management over the long term – one that’s mutually beneficial and sustainable.

That’s why we’re building a business with a cash generative core at Three Body Capital. By creating multiple revenue lines – including a deal platform for professional investors in private markets and a prop trading platform – we fuel our hedge fund with operating capital, enabling us to remain strategic with how we manage investors’ money, and of course our own.

Our model has been designed to be self-reinforcing, enabling us to monetise distribution channels built up over many years investing in emerging markets. Not only do the 3 parts of our business (three bodies, if you will, at least for now!) support and sustain each other creating a flywheel effect – they offer our clients opportunities to generate alpha beyond the traditional fund management model. By optimising around access, opportunity and network, we seek to provide clients with a comprehensive toolkit for navigating public and private markets across business cycles.

Whatever you think, think the opposite.

Such were the immortal words of the late Saatchi & Saatchi advertising guru Paul Arden, gracing the front cover of his book of the same name, published in 2006. As it was then, so it is true now. And as he would have wanted, the principles of thinking differently apply as much within the advertising sphere as they do outside it – especially in an industry such as ours where creativity, especially in the business model, is often subjugated by the desire to “play it safe”.

Who knows what’s next for markets? They have a habit of surprising, delighting and infuriating us, which is why as active managers we love to study and pit ourselves against them. All we really know is that in order to survive over the long term, we have to make money for our clients. And to do that, we have to remain open-minded. Sure, long-short EM equities are in our blood. But as we’ve said before, we’re not ideological about how we make money.

Digital assets are becoming an important source of alpha, one that we believe is being overlooked by too many investors – both managers and their clients. There are huge opportunities for those who can apply skills honed in traditional markets to the crypto arena. Again, this is an area that we intend to explore as our business evolves in the coming year. For this reason, the Three Body Fund will be a multi-asset hedge fund with the capacity to take risk across industry sectors, market geographies and asset classes.

Who knows, perhaps active managers will rise again, if (and when) the cycle turns and the passive bubble pops? In the meantime, we have to get on with our lives. We have to confront the fact that passive management is a big part of the market, plays an important role in many investors’ portfolios (even very smart ones) and presents huge commercial challenges for stock pickers who believe in alpha and the utility of absolute returns.

This is another area where we believe it’s important to think different. There are still opportunities for active managers in emerging markets, mainly because they are simply not as liquid as US equities and other developed jurisdictions. But to survive in a landscape dominated by passive flows, active managers in emerging markets need to construct investment processes that are robust, replicable and cognisant of the structural parameters driving flows into and out of different markets. And they need to offer clients more than just absolute returns – they need to offer them holistic solutions for generating alpha in public and private markets, traditional and digital assets.

We thank you for your patience, good humour and support this year, and we wish you a peaceful and nachas-filled start to 2020!