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A great place to look for the smartest managers: Interactive Brokers (NASDAQ: IBKR ) has long been the trading venue of choice for sophisticated high net worth investors. Chairman and CEO Thomas Peterffy once explained the reason for this: “We believe that the better the prices we get for our customers, the better their performance will be and the more business they will bring to us. On the other hand, our competitors believe that most customers cannot tell the difference between good and bad executions. I think we’re both right. As a result, they end up with the customers who cannot tell the difference, and we end up with those who can. I like the side we are on. ” The point he is making applies equally to new hedge fund managers; the smartest, most client-oriented managers will find their way to the trading platform with the lowest-cost and best execution. Interactive Brokers leads by a mile in this respect due to its highly automated processes. It can be extremely difficult to find smart new hedge fund managers due to marketing restrictions that regulators impose. For that reason I was very excited to learn of the new Hedge Fund Marketplace that Interactive Brokers recently launched. This allows clients who are high net worth/accredited investors to request information on those funds which use Interactive Brokers for trade execution. If investors like what they see, they can invest directly in the funds through the platform. Given that the smartest new managers are likely to migrate to the IBKR platform for its low costs, the Marketplace should represent an excellent source of prospective hedge fund investments. With this in mind I looked up the top 3 new funds in the Marketplace based on 2015 returns. Since performance is generally higher for new hedge funds , I restricted my analysis to those that were founded from 2014 onwards. 1. Summit Premium Plus Fund Limited Partnership Fund manager contact: Malcolm Clissold Investment approach: Mr. Clissold runs a registered investment advisor known as SCC Capital Group . Mr. Clissold’s investment approach is to use technical analysis and a quant-oriented approach to position the fund’s investment portfolio. The technical indicators used to time investments include advance/decline measures, new highs/lows, interest rate measures, price/volume measures, price/volume trends and relative strength indicators. Discussion: From the detail given on technical measures used, these appear to be fairly well-known techniques so the magic of this fund is probably in its quant model. It can be difficult to assess quantitative strategies without knowing the inner workings of the “black box”, which of course managers are hesitant to publish. Prospective investors in this fund should request that detail in a discussion with the manager. Since speaking with the manager is outside the scope of this analysis, I’ll move on to other funds where it’s possible to figure out the source of superior returns from the available written material. 2. Shannonside Capital Fund Fund manager contact : Brian Flynn Investment approach: Shannonside follows a long-term, fundamental value approach in its long/short stock-picking strategy . The manager conducts extensive research calls to industry experts in addition to reading all the company filings, news archives and conference call transcripts to build up a mosaic on prospective investments. They look to invest in situations where the picture that they’ve meticulously assembled on a company is different from what the market (mis)perceives . This is the kind of second-level thinking that Howard Marks describes as critical to generating superior returns and is a solid reason for believing that an investment could be a bargain. It is also a very difficult approach to copy due to its time-intensive nature. The fund holds a concentrated portfolio with large positions taken in its top ideas. Discussion: Shannonside can go the extra mile with its research because it first filters the investment universe down to a smaller pool of interesting stocks using proprietary screens. These guys are willing to hold a concentrated portfolio in their best ideas. Hence they can focus their research on a small number of promising opportunities. Other managers that can’t handle volatility must be much more diversified (the norm is to hold over 200 stocks). Diversified managers can’t focus on their top ideas because they have to spread research efforts among many more stocks. Diversification (deworsification?) is the norm in the fund management industry because most managers are afraid of losing their jobs if they under-perform in the short run. My point is that Shannonside’s process is difficult for other managers to copy. As such it may generate superior returns for many years to come. Negatives: As a European-domiciled fund, Shannonside Capital Fund is not currently available to U.S. investors. It is a concentrated fund with big positions in its top ideas so it is only suitable for investors that can ride out temporary volatility along the way to building long-term wealth. For those who can, Shannonside may present the opportunity for excellent returns of the kind the fund earned in 2015. 3. Phoenix Capital Fund, LP (Note – I’m only analyzing new funds here so some older funds that had higher returns than Phoenix in 2015 are not discussed) Fund manager contacts : Erik Trofatter, Jordan Causer Investment approach : Short option premium selling. Phoenix’s managers sell short high probability, out-of-the-money option premium on liquid and efficient underlying securities. Furthermore, the fund times its trades in an attempt to sell short option premium on underlying securities that are trading at the high range of their implied volatility. Discussion: Out-of-the money call options with strike prices far above the current market security price are like lottery tickets – there is a low probability that they pay off big if the security moves up by a lot but most people who buy these will lose the amount they paid for their “ticket”. By going short a portfolio of out-of-the-money call options, Phoenix is like a lottery operator – selling overpriced “tickets” to all the punters who dream of hitting it big. On the other side of the spectrum, nervous investors are also willing to pay a steep price for insurance against extreme downside events. By going short a portfolio of out-of-the money put options, Phoenix is like an insurance company that sells insurance for 100-year storms to buyers whose area only gets hit by a storm once in a thousand years. By timing trades, Phoenix is like an insurer that tries to only sell insurance when insurance premiums are expensive. In other words, it seeks to sell when volatility is high with the hope that vol will revert to the lower norms of the past. In selling lottery tickets and tail-risk insurance, the fund appears to be designed to take advantage of the human tendency to pay too much for these products. Peoples’ willingness to pay above the odds is a result of a bias to overweight low-probability events. This ingrained tendency was studied by Daniel Kahneman (author of “Thinking Fast and Slow”) and Amos Tversky when they developed prospect theory . The result of this bias is that positive long-term rewards are possible for firms that sell lottery tickets and insurance to the “suckers” that pay too much. If this is what Phoenix is doing, they could certainly generate excess returns for years to come. Negatives: The main downside to this type of strategy is that it could be like picking up pennies in front of a steamroller. The fund could appear to be consistently profitable by earning premiums from selling out-of-the-money options, and then a flash crash or 1987-style rout hits and suddenly all the out-of-the money put options jump to become in-the-money. In such a market, losses from selling puts could result in a big hit to the portfolio. I think the best way to get comfortable with this risk is to appropriately size any prospective investment in the fund. Conclusions: Hedge fund managers generally have their best years when they are young, hungry and driven but due to marketing restrictions this is also when they are hardest to find. Interactive Brokers Hedge Fund Marketplace is an exciting new place to discover managers at this early stage. This service should accelerate IBKR’s growth because it will attract new hedge fund clients to its brokerage platform. It is great for clients because they can find rising hedge fund stars and it is great for the funds because new clients can invest through the platform. As discussed above, I think I’ve found funds that could generate superior returns for investors for years to come. I’m excited to look further because I’ve only scratched the surface of what is available. Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in SHANNONSIDE OR PHOENIX over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Scalper1 News
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