By Miroslaw Izienicki, Fifth Capital Ltd.
Achieving transparency and governance-led marketing advantage through bounded rationality
Polarization within the hedge fund industry continues to increase. Institutional investors favor firms with greater levels of assets under management and longer track records. Indeed, Hedge Fund Research Inc. reported that by the end of 2007, 87% of allocations were invested with funds managing $1 billion or more - a much higher proportion than just a few years earlier.
While larger hedge funds operate on an industrialized scale, smaller funds find it increasingly difficult to contemplate long- term growth prospects as investors restrict themselves to dealing with funds they recognize by name or otherwise are comfortable with. Facing an unprecedented number of smaller funds, investors are unwilling to contemplate making allocations so discounting any performance advantages.
What Can Smaller Funds Do?
Transparency maximizes the number of docking opportunities between funds and investors. It also helps the alternatives industry to reach out to new investors. Opportunities exist for innovative platforms to bring institutional investors to funds that are constrained by scale or resources.
Transparency can only be achieved through complete accountability of the factors that drive both the search for investment opportunities and the resolution of investment decisions in the face of risk and uncertainty. Insofar as the risk universe comprises both quantitative and qualitative variables, hedge fund managers must be able to describe in a unified manner three key factors:
The element of the whole investment decision-making process that is supported by quantitative model output; its boundary conditions, i.e., the assumptions supporting model construction and the limitations of its output; and how or the means by which the residual uncertainty is resolved.
Stakeholder equilibrium is achieved through communicating the presence of uncertainty (aptly described by former U.S. Secretary of Defense Donald Rumsfeld as comprising "the known unknowns" and "the unknown unknowns") and being able to account for how it is dealt with.
Accounting for the Investment Decision
The traditional goal of decision making is to optimize, or to compute through the exercise of mathematics one solution to a problem that is superior to all other possible solutions. With complex non-linear, time-dependant problems such as the financial markets, the limitations of the fully rational approach become obvious - in the real world we are faced with uncertainty and with limited resources.