On The Benefits of Niche Specialization for Analysts

This past Friday and Monday, two conference calls were held by Vedder Price and Chapman & Cutler, respectively, along with other associated parties pitching American Airlines' debt holders to use their services in the ongoing American Airlines bankruptcy. Both calls discussed the experiences of the firms involved in previous airline bankruptcies, including certain legal "victories" they garnered for their clients. Both firms did a fantastic job presenting their case and in my opinion, both firms will inevitably perform substantial work for funds and other AMR / AMR EETC debt holders over the next two years.

One of the most popular questions I receive from clients when I work with them as part of our resume and case study services is: "Is it more likely for funds to hire a generalist or an industry specialist?" To be completely frank, I think this will vary from what firm you are talking about and the specific management skills of the CIO / Founder / Portfolio Manager as well as size constraints (small firms can't afford more than a few analysts). Many funds and other buy side organizations have been wildly successfully with either formula.

With that said, in my opinion, I believe over the next couple years you will begin to see more and more funds focus on hiring talent with specific industry or product specializations. This will be driven by four fundamental factors that I will try to tackle individually:
  1. The recently history of the fund management business becoming increasingly specialized
  2. An increasingly "global" viewpoint of managers
  3. The consensus view that big funds will dominate asset gathering over near future
  4. The decline of "Expert Networks"
The recently history of the fund management business becoming increasingly specialized

Through the 90s, the hedge fund business was synonymous with a few high profile fund names: Tiger Management, Quantum, etc. The concept of a retail focused hedge fund, or one focused on financials really was driven by two factors: 1) Tiger Management shuttering its doors releasing analysts with immense industry specific knowledge (and performance related numbers) to capital allocators, specifically fund of funds and former Tiger Management clients ready to seed these firms en masse and 2) The Global Settlement and other actions by Elliot Spitzer that seperated the research staff compensation from investment banking fees. What this did was dramatically reduce the compensation of MANY Wall Street analysts. These people, with immense knowledge and contacts in their respective industries, again left en masse to the hedge fund industry which could leverage their talents to focus on specific strategies. Similar things are also occuring in the private equity business where former partners leave their current established shop to set up an industry focused fund.

I do not know if a study has ever been performed that tries to bifurcate performance of industry focused funds returns with more generally focused funds, but I will comment that in my opinion, at least for funds sub $2 billion dollars, the capital raising is much easier being a niche focused fund. I will talk about this a bit more further on in the post, but I believe after the financial route of 2002 and 2008, risk managers and risk management at large endowments and pensions are becoming more and more savvy in regards to overall portfolio composition. If I have ten long / short equity funds in my endowment, I can lay each and every one of them out to determine my overall industry exposure. Say each of those ten funds were massively overweight tech - this would be a serious cause for concern.

But if I go to an endowment with an insurance focused fund for instance, the CIO and risk managers of that endowment know exactly what they are buying into. Further, they can probably be more comfortable evaluating my prior stock selection skills versus an industry specific benchmark. One of the studies that private equity fund of funds perform before allocating to a specific manager is attribution of return per partner. If Partner A has generated all the return for the private equity shop relative to Partners B and C, that gives cause for concern. For an industry specific fund, attribution is much easier relative to a general fund that may have many analysts making many different decisions.

An increasingly "global" viewpoint of managers

Right or wrong, you can ask 8 out of 10 prognosticators on the stock market where returns will come from over the next 20 years, you will inevitably hear emerging markets. While I would never make such a bold statement, it is hard to argue that a long/shorts fund's investment options should be limited to U.S. base companies. First, most components of the S&P 500 generate substantial revenues and cash flow overseas and second, barriers to capital flowing in all sorts of direction are crumbling everyday. Despite political rallying around "protecting U.S. interests", we will most certainly see more foreign companies purchasing U.S. based companies over the next twenty years than we have in the past twenty years. Speaking of AMR, I would not be surprised if we saw the complete dismantling of the Federal Aviation Act which prohibits foreigners from owning more than 25 percent of an US airline.

If we operate under that assumption, then we must, as analysts know the major players in our respective industries not just domestically, but globally. This helps out in so many areas ranging from valuation (more comps!), gauging business trends, management reference checks, etc. I've always operated under the assumption that, all else being equal, the more people you know in an industry, the more value you will be to your portfolio manager. One thing I tell resume service clients to do is network with people in an industry they like to cover like nobody's business. If you cover the steel industry, and didn't attend Goldman Sachs' Steel Conference a few weeks back, and not walk away with 25+ business cards of management teams and fellow investors, you didn't do it right.

As buysiders, we are driven by one thing: Better returns for the appropriate amount of risk undertaken. And as fund management gets more and more competitive at the margins (as many articles have pointed out in recent weeks, alpha of the fund management business now is zero), more portfolio managers and founders will continue to broaden their scope internationally where competition is less fierce AND markets are more inefficient. We've seen Warren Buffett branch out internationally for the first time this past decade with comments from WEB that he wants to do more internationally. So will everyone else. And because of this, industry specialists, that can better survey their industries globally will be in high demand.

The consensus view that big funds will dominate asset gathering over near future

Whenever I hear the term "consensus view" I generally will run the other way as the consensus view is probably already priced. With that said, it's hard to argue what everyone has been saying for the past 18 months: That the majority of assets raised in the hedge fund industry will be allocated to the mega funds. While you may think this flies in the face of my point above on industry specialization, in my opinion industry specialization will be the path of least resistance for raising capital for new managers in the future. Say there are $100 dollars of incremental capital to allocate to hedge funds globally over the next ten years. If 70% of that money is going to the top 25 funds, the remaining $30 dollars is being scrapped over by 1000s of funds trying to differentiate themselves from the competition.

And while size will affect performance, if you are an emerging long/short fund with a general approach, it is VERY difficult to garner those investment dollars versus a large fund like Maverick that has dedicated investment teams focused on specific industries. This seems counter-intuitive until you think about the concept of index hugging of the mutual fund industry and how it too affects capital allocators in the fund management space.

Why do so, so many mutual funds deviate so little from their benchmark? I think the CFA Institute calls it the concept of 'herding.' I call it the "comfort of the consensus." Mutual fund manager, just like most high paying professionals waking up tomorrow morning want to keep their seat. By not straying too far from the index their relative returns will never look terribly bad, but they also will probably never look terribly good either. Similarly, the CIO of an endowment of fund-of-funds, will never really take big heat from his stakeholders (Board of Directors, or fund of fund investor) if he loses money in a fund like Tiger Global. Similarly, risk managers and compliance officers at these same institutions feels many many more times comfortable recommending an established firm, with many other name brand investors already invested, along with proper reporting, compliance, and back-office protocols relative to a start-up managers that may not have these luxuries.

They say the fastest growing job on Wall Street right now are compliance managers or Chief Compliance Officers. While almost certainly not a line item for many smaller firms, nearly every major fund has an entire compliance team. More and more, this is becoming a requirement for major endowments and pensions to invest in a certain fund. Further, with the adoption of Dodd-Frank, regulation is getting heavier, and whenever their is new regulation, there is need for new bodies to make sure the firm is in compliance with those regulations.

The decline of "Expert Networks"

For full disclosure, I have used expert networks in the past and will continue to use expert networks in the future. I think they do indeed serve a very specific need for parties (asset managers, consultants, law firms) looking for insights into a particular industry. It is unfortunate that the actions of a few people have tainted the general populace's viewpoint of this service. Even more unfortunate is that more and more, you are hearing funds being asked by potential institutional investors if they use any expert networks in their research protocol. While I do not know if this places a big red X on whether the institution will invest or not, it cannot be good.

The problem with expert networks of course are the margins. That may sound silly, but the margins in the expert network are mind-blowing. This is at both the company providing the overall service but also the experts themselves High margins attract any and all sorts of new comers and this can and has brought in people to the business that were ethically challenged and conducted themselves deplorably. While I may sound a little feisty here, it is simply driven by my opinion that a few bad apples has seriously hurt the business of so many people with unquestionable integrity and my "Utopian" idea that investing is really a game of skill of the mind, where each and every one of us are on a level playing field until we are not. And when you upset that delicate balance, you are putting me, and the thousands of other professional investors and millions of individual investors in a weaker, tenuous, and downright upsetting position.

With the decline/shaming of expert networks, the need for analysts with their own set of industry contacts (under the watchful eye of a compliance officer) has become even more important for differentiating your portfolio returns from the rest of the competition. In addition, I do believe you will begin to see more and more traditional research providers focused on industry and niche verticals (think Meredith Whitney) be in demand from funds looking to strengthen their industry analytic depth without risking the issues that have enveloped the expert network industry over the past 18 months.


I've been meaning to write about this for the past couple months and the aforementioned conference calls from AMR brought the issue to front-center. I can only imagine how busy dedicated credit analysts from the sell-side have been in the wake of the AMR filing. Even I have received nearly 50 emails from investors discussing my AMR post from last week. Analysts and fund managers thirst for this type of specialized information in the hopes of getting a leg up on the competition.

If I had one recommendation for all those looking for a job at a fund (whether you be out of work currently, on the sell side, at another fund) in a tough environment: Learn an industry like the back of your hand. Be able to tell me the names of each and every CEO and CFO across the industry and what their Modus Operandi in terms of management and capital allocation are. Be able to contact many people in the supply chain to get a sense of what's going on on the ground for distributors, buyers, etc. Know the customers and how companies are differentiating themselves from one another whether on price, service, quality, etc. Know the Wall Street analysts to get an understanding of the consensus view and be able to tell me why and how they are wrong. Even better, know other buy side analysts and understand their views and why THEY are also wrong. Like Li Lu has said, evaluate and know the business like you inherited it. I think by doing this, you will make yourself much more valuable and marketable for the years to come.


Anonymous,  12/07/2011  

Interesting post but also seems very " wall street" focused. Your comment on having to all conferences, know the views of every other analyst seems likely to create herding thought process. Sounds like what a sell side analyst should be doing, not necessarily independent minded investor? Industry contacts important however. Suppose based on my view of absolute value regardless of what street thinks.

AIGswap,  12/07/2011  

Good Post. However, one could give merit to the opposite argument, that is being as far away from the Street as possible, which helps in independent thought. WEB claims that its a huge leg up to get away from the "noise". Berkowitz and Burry had the same attitudes.

I suppose the most important thing is to look where no one else is looking... IMO that's the easiest way to add value.

Anonymous,  12/07/2011  

huh? tons of mumbo-jumbo for what? i think this is more wishful thinking than what the reality is. Especially coming from a guy claiming to be a distressed analyst. C'mon, when was the last time any distressed focused shop hired an industry analyst..

Anonymous,  12/07/2011  

I agree that this is the way the industry is moving, but as someone who is looking to start a small fund (at which institutions will predictably thumb their noses) I think this is a wonderful development. The more the market is driven by these slow moving, index-hugging institutions the better bargains there will be for the little guy who isn't style boxed into a sector or country. Regarding Maverick and their supposed due-diligence, one would think that the Sino-Forest debacle has debunked the value of their "boots on the ground" supposedly rigorous due diligence (but I'm sure it hasn't).


hunter [at] distressed-debt-investing [dot] com

About Me

I have spent the majority of my career as a value investor. For the past 8 years, I have worked on the buy side as a distressed debt and high yield investor.