Where has all the Talent Gone ?

I started in the hedge fund industry in the early 90's, I was, and still am a supporter of the industry, so what I am about to write is not something that puts a smile on my face. However investors need to know the reality in order for the industry to survive.  We have a quality problem in the next generation of hedge fund managers. Why this is, and how it happened I will explain. Starting my career as a hedge fund manager in the early 90s we were a fringe industry, controlling enough AUM (assets under management) that could make you wealthy by performance but not by earning a management fee. This meant that only the most dedicated of individuals would work in the industry. Our backgrounds were extremely varied, some from investment banks, some from prop trading companies, some from trading their own monies. We enjoyed running portfolios were we had freedom to execute strategies not governed by the long only asset management industry. We were secretly wealthy, never quoted in the press, never mentioned on the the front page of a newspaper. The markets were dominated by large tradition asset management firms that were governed by benchmarks. Investment banks conducted prop trading but due to their capital rules they were not a dominate force in the markets, mostly concentrated on market-making. However life changed as institutional investors started allocating funds to hedge funds, regulators relaxed rules on investment banks. Suddenly the traditional managers with their long-term investment styles became ordinary clients, hedge funds volumes exploded, investment banks became warehouses of risk. This led to a change in the hedge fund model. Management fee became the biggest driver of hedge funds income. At an average of 2% management fee of assets many of us were now becoming insanely rich just by surviving, suddenly performance fee was no longer the driver of our income. Institutional investors had a twofold effect: not only did their money mean due to our larger status we had to change our style but they were less demanding of absolute performance, more interested in returns compared to volatility. We as passionate managers of the 80s and 90s, were smart enough at first to balance the increased assets with still above average performance. We became even richer, our size of position meant now market commentary included our actions.  This extra publicity was not confined to market commentary as we started to find ourselves on Rich Lists, society pages and being investment minded individuals we even managed to gain publicity as we started to invest in other alternative assets like art. Suddenly everyone wanted to work for us. First we employed the senior traders from investment banks. What this meant was the relatively inexperienced traders left were promoted. Suddenly investment banks had lost their intellectual property and experience in proprietary trading. They did not care as other  business areas expanded in importance like product development, sales trading, market making, prime brokerage that directly benefitted from hedge fund volumes. This was the main factor in the demise of the schooling of traders at investment banks. They were no wise heads left to direct the young, raw arrogant talent. This was never really appreciated in a bull market as even the youngsters could produce profit.  However from 2007 -2012 it has became blatantly transparent, and explains why the investment banks are more than happy to quickly close down their prop trading in all asset classes.  So if the investment banks were not cultivating the trading talent then you think surely the hedge funds were but this was not the case. The main hedge fund managers now owning their own firms were talented traders and investors.  We had started working as hedge fund managers because we were passionate about trading. This passion translated to dedication to our work which did not make us the best teachers. This dedication to be the best was also lacking in our new employees. They really wanted to work for us just for the money.  They are smart, academically brillant but lacked the market savvy to deal with a changing market environment. This can clearly be seen when you look at hedge fund returns at the end of 2012. Firms where the experienced hedge fund managers who dominates risk taking at heir firms have outperformed. Take Dan Loeb at Third Point. Here is a manager that is a perfect example to show the passion of the old school hedge fund manager. Even though many criticize his style, he is a hands on leader, so when you invest in Third Point, you pay your management fee for one of the best researchers and portfolio managers around. However be aware not all old school managers are like that. Some firms really show the weaknesses where the founder has stepped aside to let others run their business. Izzy Englander's Millennium are a prime example of this. Izzy set up Millennium to be a quasi fund of hedge funds. Thankfully he does not charge a management fee but makes money from volume rebates and performance. Izzy was great at spotting trading talent and then putting a sensible risk structure around this talent. However Izzy is not hands on any more and his senior staff who run business lack the talent, knowledge and hubris to spot talent. If fact if ever there was example of how arrogance hides incompetency, the Millennium senior staff are that. This is an international problem: both New York and London have the same attributes (in fact in my analysis I think the London office is worse, where the head of finding new trading talent is so inept I think the only place he could survive is Millennium which thankfully still has a common sense risk management infrastructure that Izzy originally developed).  However if a Millennium, whose business is spotting new talent, cannot even staff itself with quality at a senior level, then this obviously reflects on the talent in the whole industry. Another key factor in finding the next generation of hedge fund manager is background. Unfortunately there seems to be belief that Physics or Mathematics from a top university means that an individual will be a great trader because of new technology of electronic execution. In fact the investment banks are partially to blame, but maybe this was there only choice given the lack of senior trading experience. While these individuals are extremely smart they unfortunately tend to have similar academic foundations. This is why the Flash Crash of 2010 and the quant problem driven by Goldman's hedge fund products of August 2007 exist, basically the models trade the same. One of my most successful trading hires in the last few years was a gentleman that was educated at the best university, did not get the highest mark, but the was someone through university traded his own account to make some money. He was passionate about the markets and became a great employee and trader. However as he often said to me, he would have never been considered as a trader in an investment bank or as trader with another hedge fund. If he ever has a desire to set up his own hedge fund I would back him. Of course I have not told him that but he does have that passion for trading, he is not just trading to earn lots of money, he enjoys it and he is dedicated. So there is hope. Unfortunately though finding him is like finding a needle in a haystack.