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- [00:05]
Bill Kelly
Welcome to Educational Alpha. I'm Bill Kelly, your host, bringing you on the ground conversations with business leaders, educators and industry colleagues from around the globe. Educational Alpha is sponsored by iCapital, the financial technology company with a mission to power the world's alternative investment marketplace. Part innovator, part educator, and part navigator of the alternatives industry, iCapital offers intuitive, scalable digital solutions that have transformed how private market and hedge fund investments are bought and sold. With iCapital, financial advisors, wealth managers and asset managers around the world now have access to everything they need to deliver the return and diversification potential of alternatives to high net worth investors. To learn more, visit icapital.com.
- [01:01]
Narrator
In this episode, Bill speaks with John Capless, founder, founder and CEO of Pivotal Path, to explore how his firm is redefining hedge fund transparency and trust for institutional investors. John walks through his career path from early hedge fund experience to founding Pivotal Path and the core challenges investors face when accessing reliable hedge fund data. They examine the systemic flaws in commercial databases, the necessity of strategy level insight, and the foundational importance of data integrity relationships and peer benchmarking. The discussion also touches on the evolving role of due diligence, the use of AI in fund evaluation, the relevance of Portable Alpha, and the lessons learned from attempts to democratize hedge fund investing through liquid alternatives.
- [01:45]
Bill Kelly
John Caplis, welcome to Educational Alpha.
- [01:48]
John Capless
Thank you Bill. Pleasure to be here.
- [01:50]
Bill Kelly
Looking forward to the discussion. We hatched this plan a while ago and I'm glad we're able to finally pull it off and little bit of a delay this week and getting this together and thanks for tolerating my grandfather duties. If I have any excuse, I guess that's as good as I'm going to get. So thank you.
- [02:05]
John Capless
That works.
- [02:07]
Bill Kelly
So it's an interesting topic, interesting space and broadly I think here I'm referring to hedge funds. I don't know if that is too trite of a way to sum up your business model, but we're going to talk a lot about Pivotal Path and the service that provides institutional investors. But before we get there, maybe some of your formative years, which I think has mostly been in the great city of Baltimore, but maybe a bit on your background and we'll take it from there.
- [02:31]
John Capless
Well again Bill, thank you for having me. So my background started off after graduating undergrad at Washington University in business school, cut my teeth in 2003 in an event driven hedge fund called Chesapeake Partners. Eventually they were about $2 billion at their peak. But merger arbitrage, distressed debt, value investors, really got a great education in what it takes to be a part of a successful hedge fund. I quickly pivoted over to interesting new opportunity where I actually had the chance to co found what became a CTA and ran it from 06 through 2010 through some obviously very difficult periods of time where we were able to make money every single year, which was pretty unique, especially in the CTA space of that 0809 period. And from there I joined Campbell & Co. Where I sat on their investment committee. I was co ran their risk management team which oversaw all the underlying strategies. And that's really where I started to see a lot of what was missing in the industry. The way that we looked at it then, which bill, it's probably not very different today where you have a number of databases on one side, databases trying to create transparency and somewhat opaque industry and organization. The issue has always been, which we can get more into detail, is that for the most part, a lot of hedge funds don't have much incentive to report or to give their data consistently. It's certainly not a regulatory requirement. So many times hedge funds choose not to. I can walk through some of that data, but that's one side of the coin. The other side are the consultants. And nothing wrong with their business model, but their model has always been much more focused on creating an approved list of managers that can fit across their entire client base. So we saw a couple of things. One, when I was at Campbell speaking to a lot of investors, I saw that there was an opportunity to create a critical mass of hedge fund information. A lot of the busy work maybe didn't need to have to be done the way it was both taking the time of the hedge funds themselves, but also the consultants that were doing it. But then also the ability for investors to be able to go into a database or a research platform and actually see the vast majority, if not all of their funds that they're currently invested in or interested in investing in are actually there. And those were things that were missing then and in fact arguably have gotten worse throughout the years where even the perceived benefits reporting to databases, it really hasn't been realized. And then the second part is databases, they sell to hedge funds, which is really the competitors in their business. If you know that the vast majority of people looking at your data are not investors, but hedge funds themselves, it minimizes that potential benefit. And then lastly, a lot of these organizations are also media companies, whether it's Bloomberg or With Intelligence or others. So hedge funds are very concerned about their narrative being taken away from them and having data published and stories written about them. So there's been a lot of issues with trust and integrity of data that really has created a chilling effect for hedge funds to provide their data, which means that anything built upon it, whether it's indices or benchmarks or peer groups, are quite flawed in practice. So that was really the genesis. That's the Baltimore background and hedge funds, and hopefully that gives you some insight, and I'm happy to share more.
- [05:47]
Bill Kelly
Yeah, that's great. And before I transition to some of the topics you brought up, John, this was not your first rodeo when you left Campbell, and I'm sure you could have been satisfied from a career standpoint if you retired from Campbell. And Katie Kaminsky, who I know well, has been a big contributor to the kayak curriculum. I know a bit about the firm, and I would put it in the world class category. But you had an itch to scratch. It's sometimes not easy being an entrepreneur as one myself, when seven of us left a big, comfortable organization to start a firm called Boston Partners with not even a paperclip to our name. And you just hope that the prospective clients have as much passion and belief in your mission as you do, because without them and without cash flow, you have a great idea that eventually fizzles out and disappears. So you had some conviction, and you talked about some of the founding principles of Pivotal Path and why you did in the first place. How were you convinced that the clients would come once you built it?
- [06:43]
John Capless
So I sat on some investment committees locally and local charities and saw the same issue where consultants were saying to them, there's three hedge funds. You want to invest in healthcare. Here's three funds that we like, and you can pick one of them. And there was that constant question, actually would turn to me on this investment committee and say, well, there's gotta be more than three healthcare funds. And how did they get to these healthcare funds? And we're not really satisfied with why these are the three best for everybody. Then they would do the flip side where they would say, well, let's see, let's go on databases and see what's available. And they would do that same thing where they notice that, okay, we have a portfolio of 20 hedge funds and 18 of them aren't on this database. If they're not on this database, then how can I be sure that these other funds that are supposedly health care funds are really viable options for me? So I saw that not only at the charity that I was on the investment committee for, but I started talking to foundations, started Talking to multifamily offices and single family offices and seeing this was an issue, that they were frustrated with it. But there was no other solution to getting just that, transparency in the industry and having a complete picture of who the funds were and what performance actually is. Two very basic principles of being able to invest in any, not asset class necessarily, but hedge funds as a set of strategies. So that was clearly lacking. And the more people I talked to, I saw how consistent their response was. So there was certainly frustration there. And that's what gave me the confidence, along with initial partners and investors who were willing to seed our idea and turn it into a reality. But I can't say by any means it was easy. We've been doing this for now. It'll actually be our 12 year anniversary in July. And I can say that the first five years was very much building not just credibility and trust with the allocator clients, but really showing hedge funds that what we were doing was completely unique in the space. It wasn't about building a portal that was a better portal and a better mousetrap so hedge funds would put their data there. It was about building trust and relationships with hedge funds and having them know who your underlying clients are, why they're using you, making sure that they understood not just why it benefited them to share their data, but also what we could give back to them in ways that wouldn't violate the trust with our allocator clients or the trust of the other hedge funds. And that was something that even today, again, is still pretty unique in the industry. I can't say we knew exactly how to do it day one, but over the course of our first five to six years, and we learn every day, but that was the basic principles that we knew we had to build. It was just trust, credibility and relationships, protecting the data, only working and representing institutional investors. We knew that as those institutional investors, as clients grew, that it would just continue to reinforce where we sit in the ecosystem.
- [09:37]
Bill Kelly
I imagine those first maybe three to five years was a little bit of the chicken and the egg because you had to get the hedge fund managers into the database, build that trust, and then you reach a tipping point where you've got enough inventory there to make it interesting to the allocators.
- [09:53]
John Capless
Yeah, in some sense, like you're saying it's building that market, you have to build one side of it to get the other side, and vice versa. Our goal had been in the beginning to help allocators. We knew that that was where the major problem was, at least at that Point in time. So the hypothesis was if we can start working with a couple of really well thought of allocators that again, trust us and are working alongside with us to reach out the hedge funds, tell them why we want to speak to them, why we're collecting their information. We started strategy by strategy with our allocator clients. The goal was to, if you can, convince allocators that they should pay for something like this, that's a pretty rare thing because again, most of the other databases, platforms, if you will, they've made their money by selling to the gps, selling to the hedge funds. Again, there's nothing easy about that, but it's certainly a lot easier than convincing allocators who tend to get a lot of things for free and expect a lot, that they should pay for something. So we went the hard route and we knew that if we went the hard route, it might take a little bit longer. But once we created that trust with the allocators and then it filled back through the ecosystem with not only the hedge funds, but the prime brokers as well, really understanding who are all the trusted parts of the this hedge fund ecosystem. And if you can build trust with each one of those trusted components, it'll all start to reinforce itself. And so that was really the genesis. In the beginning we knew it was going to take a long time to build that critical mass. And we knew if we could just keep adding respected and thoughtful investors, that's what would be the hook to get the hedge funds to obviously trust us and see the benefit of working with us.
- [11:31]
Bill Kelly
So obviously you have competitors in the space and without necessarily naming them, although if you want, you can, but there must be something about pivotal paths, platform that exudes trust more than others. And maybe this is one of your founding principles. What was missing in that trust quotient for hedge funds? And obviously they're secretive by nature, and I understand that. But what was their hesitation to reporting into databases? Because on the flip side, more exposure, especially if your numbers are good and if you have a quarter or poor run, you want to stop reporting. But was there one or two missing elements that the trust was just not present enough?
- [12:07]
John Capless
At the most basic level, there was no relationship. A hedge fund database would go out and say, if you put your data here, clients will come. So in the beginning, a lot of hedge funds thought that makes sense, right? I mean, to your point around visibility, as time went on, they saw that didn't really happen. They didn't really get new investors that were sourcing them because they were part of these databases, the first part of it really was what they were promised didn't come to fruition. And that's something that didn't happen day one or day 30. But over the course of over decades, it started to question, is there really much value in putting my data there? Number one, the second part was hedge funds are smart. They're only going to share information and data if they think it benefits them. So if that benefit isn't there, but also there's a risk, and the risk was real, is that your data can get into the wrong hands. So I mentioned earlier that some of these databases have media arms. They write stories about hedge funds that are in big drawdowns. Most of the databases, if you look at their client base, it's predominantly hedge fund competitors. So they'll sell to anybody with a credit card, and that's fine. There is an element of creating transparency around that, but it was creating transparency for the wrong constituents. So if there's a lack of a relationship and then you see that the benefits that were promised to you don't come to fruition, you see that there are downsides to putting your data out there and seeing that you can actually lose control of the narrative where maybe your data's published before it's communicated to all of your clients. And you see that it gets around, and you get negative media stories around it that over the years started to put a dent in the willingness of hedge funds to share that data. We wanted to approach that exact opposite side of that. It wasn't about having a portal to put data on. It was about building that trust, just like a consultant would, just like an end investor would, where we have that direct relationship. We're speaking to every single hedge fund that's on our platform. We're meeting with them, we're seeing them at conferences. We have a whole research team dedicated to speaking to them and evaluating them on behalf of our clients. And that's really what we saw that was missing. So you have to protect that data. We don't resell it to other hedge funds. We don't resell it to anybody who's not an institutional investor. And then also our clients have seen that we add a lot of value. Again, it's not just taking data from point A and giving it to clients over in point B. It's about how we set peer groups up, how we build benchmarks, how we create tools that enable our clients to do really two things that databases don't really help with. Number one is, does a manager do what they Say they do the first question in due diligence that often our clients are thinking about. So you have to know what they say, how do you get what they say? You have materials directly from them, you have bilateral conversations with them where they tell you this is what we do, then what they actually do is their performance. So performance shouldn't lie, it should be exactly what it is. And if you know how to evaluate that performance, you can see if they say this is our edge, you can see from the data whether they're actually affecting that edge, whether they're actually investing in the spaces that they say that they're really good at. So you can see if there's consistency in both of those things. And then as you build out that complete data set of all of their peers. And again, as an investor, the first question is the manager doing what they say? But then it really is about are they doing it better than all of my options as an investor? And better is obviously going to have different meanings to different investors. So there isn't again, this one size, there's not an approved list, there's not a rating that says this is a buy. There is a set of tools and information so our clients can very quickly in scale evaluate based on the metrics they care about, is this manager better than all of the other peers or consistently above the median in this robust peer group? That's ways that clients can then very quickly figure out not where to invest, but where to spend their time because they're going to make the decisions. And so using our data and tools and raw intelligence that can inform them and help them make those better decisions. And that again is all reinforcing, maybe.
- [16:04]
Bill Kelly
Just a follow up and then both initial and then ongoing due diligence. An observation from my side. During the post GFC decade where the risk on trade was alive and well and perpetuated by some of these media companies and certainly the FT to some degree. I think the expectation for hedge funds was S and P, like returns with half the volatility. If you could find that, you could go to the beach and maybe it does exist somewhere and there's a talent. But hedge funds have become a very complex industry. You cannot just put it all into one asset class. And your expectation should be that style of managing money is going to be out of favor in certain cycles and you should expect that and understand that, not fire them as a result of that because they failed to keep pace with the market. So much of your business, John, is initial due diligence of managers versus ongoing when managers hit these rough patch, you want them to continue to do what they do because if all of a sudden they tack in a different direction to try to put up more absolute return, nine and a half times out of ten, it is a noose around the neck.
- [17:09]
John Capless
It's such a great point. What I'd say is in the way that we work with our clients is let's take a step back from the manager. Manager selection, obviously important, very important. But before that, there's strategy selection. So as you mentioned, the hedge fund is not an asset class. They trade all asset classes. In fact, we break down the hedge funding Universe into 40 unique strategies across the globe. So I think that's the most important thing is these are a set of strategies that have a lot of degrees of freedom, meaning they can go long, they can go short, they can be nimble. But to your point, every one of these managers needs to be classified into a cohort. It's not just so you can do peer group analysis and see if this manager is good, but it's really about do I understanding the characteristics of the underlying strategy. And so I mentioned we create benchmarks. Benchmarks and let's call them indices. So if you have indices, it means that once you have a peer group, let's take something like multi strats. Number one. The biggest bias in the industry is that funds don't report. It's called a reporting bias. I mentioned all the reasons why for databases, but it turns out that the funds that don't report are not just a random selection of funds that say, oh, this is not for me. Turns out those are the better performers. These are the key contributors to our indices. And in fact, this is something that the University of North Carolina recently published a paper where they looked at all commercial databases and they compared it to pivotal path to really understand is there a difference in the quality of the underlying data? The answer is a clear cut yes. And I'll give you a couple of interesting points to start with and then we'll get back to the strategies. The first part, just our data set in general, we cover about 3,000 hedge funds. It represents about $3 trillion in hedge fund capital. That is over half a trillion dollars more than all commercial databases combined. That means that significant number of funds, it's actually close to 300 funds do not report to any database. They certainly trust us with their data. And those funds actually have almost double the performance of the funds that on average report to databases. So our entire data set has performance that's about 250 basis points better per annum than all commercial database data combined. And there's a lot of reasons for that. We can get into that. And the main one is performers. The big multi strats is a good example. They don't contribute to the data. What does that mean? It means that if you create an index out of it, and I will use a name here not to point them out, but I think it's important because it's a well known index. HFR last year came out with their POD Shop index and they said it was the first of its kind. Their POD Shop index was up 6.8% as reported by them in 2024. Our multistrat index, which has about 80 constituents, about $400 billion, literally the entire set of multi strats, it was up 11% last year. We're talking of a difference of over 400 basis points. And that's just with one strategy that's in vogue. What's interesting is if you are an asset allocator, you're a pension fund, you're not only trying to figure out which hedge fund manager to invest in, you're starting off with how many assets or how much dollars do we want to allocate maybe to hedge funds in general. And there's different ways of doing it, but it's going to be based on these strategies and how they perform and their expected returns and their expected correlations and alpha. And they're using indices as inputs into these optimization models. So when you use something that has 400 basis points or even 200 basis points less than absolute return, and by the way, that's almost all in the form of alpha, at least relative to traditional asset classes like the S and P or equities. It means that it could be the difference between your model saying you should have zero allocation to hedge funds or 25 or 40% allocation to hedge funds. So this is very meaningful. And the way that our clients work with us is starting off with again the set of indices. I want to learn about managed futures, not about individual fund yet, but let's see, when does managed futures as a representative index, when does that perform well? When does that benefit my portfolio? Then from there what they're doing is saying, okay, if I believe that we should have a certain allocation to managed futures, who are the managers within managed futures that best and most consistently affect that strategy? So to your point, if you're picking a manager that has great performance, they were a trend follower and then they changed into more carry, they kept evolving. Nothing wrong with that. If they performed well. But it means that what you might have originally hired them for, originally evaluated them as a trend follower, all of a sudden 08 happens or all of a sudden 2022 happens and they're not performing because they didn't catch that trend. That's going to be a really difficult thing for you to explain to your clients or your board and to yourselves. So that's really the way that our clients see the importance of these benchmarks to really understand characteristics. And then that's that next step of who represents that. Whether it's one fund or multiple funds, we want to invest in that strategy.
- [21:59]
Bill Kelly
Self serving side point and then a follow up. So the self serving side point you mentioned, this UNC study, was Greg Brown involved in that? Is this Foo Flagler?
- [22:09]
John Capless
So he and Kristin Lundblood were co authors and they had a third as well. And there's a lot of really unique points that they've put together. Maybe I'll just give you a couple of other things just to give you the why let's accept that pivotal path has data that the other funds don't. I talked about the trust but there's even more than that. The way that databases and this is actually some quotes from them. It says commercial databases are riddled with negative performance bias. These flaws have perpetuated inferior asset allocation strategies and worse investment performance. As a result. The fact that these they're scraping data from whether it's regulatory filings, FOIA requests, even LP clients. And so what happens is there's a lot of overcounting. You mentioned earlier. The fact is there 4 trillion in the hedge fund industry. We don't actually think so. It's not a number that we report based on all of the funds we cover. And we have a very good idea of the very small number of funds that we don't have. We believe the number is closer to a little less than $3.5 trillion. That's number one number. But the second part is even the number of funds, how many funds are out there? Prequent will tell you 30,000 funds. We can tell you there's absolutely not 30,000 funds. We know how we get to that. They get to that because an IPC did this, the Institute for Private Capital with Greg Brown. They looked at all of the data in the regulatory filings and yes, there's a lot of firms and funds that will check off that box as hedge fund. But think about what this includes. It includes a lot of funds. It says the raw counts of funds available in commercial databases can be misleading as there are includes funds of one managed accounts, redundant share classes, feeder funds, private asset drawdown vehicles. So these entities are either significantly smaller in scale or inactive and they distort the perceptions of database comprehensiveness. That's a quote from the paper. But the point is there's a lot of noise even with what is available. I'll give you two examples. I won't name the funds because I want to keep their individual names out of it, but some of the larger two funds that you would think of, the databases count them as having 78 different unique strategies. We cover them, we speak to them, we know they have three. And so how do you get from three to 78? Well, one is you count all sorts of things that I just mentioned that aren't hedge funds. You count share classes and you end up doing all these things and it creates just a mess. So that even the data that does exist, it's not just that it's missing key contributors, it's also adding lots of things that aren't relevant and certainly aren't of interest to any of our clients. They would not be a peer at all. And so those are some of the things that are happening that is creating just a lot of distortion and a lot of confusion and noise in the industry. And that's what we've been clearing up for over a decade.
- [24:51]
Bill Kelly
Excellent. So I opened the side door because Greg is on the CHI association board of Directors and very smart, talented and thoughtful. I would consider him a pracademic as opposed to full on academic, but puts out some very good research and I'll tag that when I post this episode. You talked about these 40 different strategies on your platform, John. You mentioned the Pod Shop Index as an example and the fact that the bias to not reporting was a lot of the large well performing managers. So if I come to you and you create an index for me and I say okay, this looks like a space I should be in, it fits the risk profile of my overall total portfolio approach. And off to the races is the reality though that the index you've created has some of these best performing managers that are either in a soft or a hard close. And while those numbers are mathematically very very accurate, I can't be a buyer because they're not accepting allocations.
- [25:47]
John Capless
That's very much possible. But I'll tell you, the vast majority of managers, even when they are hard closed as they report to be, they're still replacing redemptions. Maybe not every single one of them, but there are still feeder funds There are still ways into them for the right investor and probably anyone willing to write a substantial check. Maybe not too large, but there are ways in. First and foremost, we throw around terms like hard close and soft close. These are not very well defined terms. They can mean different things to different people. So that's number one. The second part is that just because you have a few really good firms that may be hard closed, doesn't mean that there aren't other funds that are doing just as well as them. They may be lesser known, they may be smaller, but the point is, when our set of indices, our composite has over 1200 hedge funds that represent well over $2 trillion in hedge fund capital that's capturing the vast majority of the universe. There are plenty of funds to choose from within. So to your point, let me give you an example. So what can happen is there can be survivorship bias as well. So I mentioned all of the things about missing key contributors, but if you're not careful and you don't know how to read the data. Also, survivorship bias can create performance that looks great, but it's really because it's only capturing the funds that have done well and then you're looking back in time and that's often what has also happened in the index world. So we want to be very transparent. Our indices began in 2015. We started collecting data in 2013. Anything we show you prior to 2013, we do have data going back to 1998, but it is ripe with survivorship bias. It has to be because we weren't around, we didn't have the funds that came and went. Anything after that has completely zero survivorship bias because we have methodology and rules about when funds become part of an index. We set those constituents once per year. Only a fund can drop out if it shuts down throughout the year. And that way when you do that and you can have transparency. When did a fund become part of our information set? If a fund that has a 30 year track record all of a sudden gave us said, okay, now we trust pivotal path. We just got introduced to them. They're not going to be part of our 2025 index if it's a multi strat, they will be part of our 2026 index if they still meet our criteria of minimum assets and minimum track record. But it won't be backfilled and it's not going to change anything about the history. It's that transparency which gives clients comfort and confidence. They can see exactly who the constituents are at any given year and they can make the judgment as to whether, yes, a few of them may legitimately be hard closed for a certain period of time. They may reopen very soon. So I think you still have to evaluate them. Unless they are truly, we'll take a medallion. It's not going to be open to the public. So should that be part of an index? No. But anything else that kind of opens and closes and has other rules around who they let in, I think they need to be part at least of the benchmark that you're using.
- [28:42]
Bill Kelly
Maybe not a goal of this podcast, John, but I feel a little bit vindicated and I'll tell you why in a quick story. I was at a conference. I won't name the conference or who's on the platform, but I was not moderating. I was in the audience and it was a bunch of consultants. It was a 40 minute panel for 35 minutes. Private credit, private credit, private credit. So they finished and if I'm nothing else, I'm the most curious person in the room. I put my hand up, they call on me. I said, you know, for 35 minutes it's all been private credit. What is everybody in this room worried about? Volatility and drawdown risk. What about hedge funds? The answer I got, and everybody nodded, is all the good ones are closed. So I feel vindicated listening to your answer to that last question. So we'll just park that one. So I want to cover a couple things and we don't have a lot of time left, but I want to talk about the evolution of due diligence both when you started pivotal path 11 years ago or maybe close to 12 now, and where it was then, where it is now, how much it's changed and evolved. I think a common denominator is still very, very important, I would argue. And how, if at all, you're using any kind of generative AI as you think about the current phase and future phases of due diligence, I'll go pre.
- [29:51]
John Capless
AI to just give some background. And I think what's really important is the fundamentals need to be right before you start using AI. So AI is only as good as the data you have to work on. You mentioned this a little bit earlier. Used to be that hedge fund was viewed as successful if it had half the volatility of the S and P but outperformed. So we know depending on the strategy, but certainly equity strategies, many of them long bias to think that it's not going to be down when the S and P is down significantly, it's Just not understanding what the strategy does. One of the things that's happened over the years, there's two main trends, but it's led to a lot more sophistication. It's led to expectations being set in the right ways, both for the investor and the met manager and the investors constituents. That's aligned the incentives a lot better because investors know what they're getting into and hedge funds know what they're expected to deliver. And that was not the case. There was so much misunderstanding of what hedge funds should do pre financial crisis. Part of that was just the investor base itself was less sophisticated. There was more fund to funds, more individuals. Today you look at pension funds, endowments and foundations make up a significant majority. Private banks, firms with significant due diligence efforts that are investing in these hedge funds. And that's replacing a lot of the less sophisticated investors, which means that number one, they require more. So hedge funds have adopted and have adapted, have become more transparent with what they're willing to provide, maybe not to everybody, but certainly to their underlying investors. And the investors have also gotten in general smarter or at least more deliberate in terms of exactly what they want from funds. Even five years ago, for the most part, it was should I invest in the commingled fund or not? It was this binary choice. And maybe there were elements of a given fund that you liked, but other elements that you didn't. You wanted to separate the alpha from the beta. Today that's something that we're seeing. Hedge funds and investors sit on the same side of the table. They're becoming much more solution providers. The allocators are saying here's what we want, and hedge funds are saying, here's how we can help deliver that. And whether a lot of this is through the proliferation of separately managed accounts and separately managed account platforms that no longer have the negative connotations around it. So a lot of funds, almost all funds, are participating in that or will be very shortly. So that means that not just the largest pension funds, but many, almost all institutional investors can actually have that. Conversations with hedge funds can have transparency into the strategy, can agree upon benchmarks, can create portable alpha strategies that were very popular pre global financial crisis, blew up around the financial crisis. Again, probably more to do with the lack of understanding of what they were and were not doing, as opposed to they just didn't work. We're seeing that become much more popular. So the due diligence has gotten more sophisticated, which means that the need for data and quantitative tools has also gotten more sophisticated. So now Fast forward to today. If you have all of the data and you have actually not just return data from some funds, but you have a rich set of information, both qualitative and quantitative and struct, structured and unstructured, that's where you can start to use AI in ways to do more sophisticated searches, queries, maybe I'm looking for a manager who the PM is a minority or went to a certain set of schools or whatever it may be, given that you have all of this rich information. Yes, smart AI can search through that very quickly in ways that would have taken hours and hours manually even if you had the information and now spit that out. So those are things that we are working on with our clients. We have different risk factor models that represent hedge fund strategies that incorporate some AI. We incorporate AI throughout our process just to collect data in a smarter way and classify things. But I'd say that the industry itself is still pretty early stages. You have to get the blocking and tackling right, you have to get the fundamentals right. And if you just throw a lot of data that is scraped publicly and not curated, you're going to end up with a lot of outputs that may look fancy, but they're not all that meaningful or valuable. And so we give a caution to that to get the fundamentals right. And then you can start applying all sorts of fancy algorithms to do better searches and more efficient due diligence. But we're not fully there yet.
- [34:14]
Bill Kelly
Reminder, I actually get her on this platform, but Manell Amman from Digital Vault. I think I saw their logo on your website right before I signed on. So what is your relationship with preferred partners? Like that. How does that work?
- [34:27]
John Capless
There's nothing economic behind it. We happened to meet each other years ago, had very similar philosophies and how we were trying to improve the industry, similar clients. And the idea is really just think of us as approved vendors, meaning that we know what they do on behalf of their clients. We are comfortable and confident. Saying to a fund, if they say, hey, we're looking for something like this, we're not endorsing them, but we're saying we know them, might be a good opportunity for you to at least learn more. Same thing with them on their side, where they know that a lot of their clients are hedge fund investors. So to see our indices and be pointed towards our indices and just say, look, these are what the industry views as the most complete and comprehensive and accurate indices benefits their clients. So it's a loose relationship, but it's a mutual respect and something that we both think that we're adding a lot.
- [35:15]
Bill Kelly
Of value to the industry quality organization. So thanks for that point. So two things I want to cover before I let you go, John then one is this portable alpha you just mentioned a moment ago and I'm not a student of this, you are, but it doesn't work so well. The beta exposure and where I'm looking for the alpha have a correlation of one. Now I've got a little bit of a mess on my hands and maybe that's why it didn't work so much in the gfc. But I think I've seen you quoted, there have been some articles about maybe this is the day in the sun for portable alpha. It's not a layup. You have to be very careful about how you structure it in the first place. What's your current view on the benefits or lack thereof of portable alpha?
- [35:54]
John Capless
What's really interesting now is it used to be that only the biggest pension funds, the allocators, could create portable alphas on their end. Let's say that they have some equity bucket, let's take some of that, let's say was in active equity managers and they thought, well they're not really giving as much alpha as we would like, but we think the hedge funds can do that. So let's take some of that that we would have in long only managers and let's put it in futures contracts, keep that exposure. But now let's take that excess cash that we don't need and let's invest in hedge funds. Now exactly to your point is if you invest in hedge funds that also have a 0.7 beta to the S and P, then if the S and P is down, not only you're going to lose money in your passive investment, you're going to lose significant money even if they're adding alpha. Maybe you lose a little bit less, but you're not actually tacking on returns above that. So you have to make sure and historically that they needed to be the ones that actually had a hedging strategy on and needed to offset changing portfolios. And obviously just because a Fund has a 0.7 beta today, over what time frame are you measuring that and how often are you rebalancing? How often are you hedging that? Those are things that really limited to only a sophisticated small group that could do that effectively. Unfortunately, you had some other groups that may have gotten involved that did get hurt, double hurt. In the global financial crisis today, there's two trends that are emerging. One is the Investor base has gotten more sophisticated. But I think even more importantly than that, the managers themselves are now offering portable alpha strategies. Meaning that you can actually as an investor say to them, here's our benchmark. It could be the S&P 500, it could be Barclays high yield, it could be a currency, whatever it may be. You can give them that benchmark and they can then manage a portfolio that's going to have neutral exposure to that benchmark and anything that they generate is going to come on top of that benchmark. So now you have the managers that understand that and that is really what's democratizing it for lots of investors that may not have been able to participate in that. And it's Man Group and Brevin Howard and lots of big names that are doing this. That's one thing that's really changing the industry in portable alpha. The second part is I mentioned that the managed account platforms are also allowing investors that aren't necessarily very large and sophisticated that built their own platforms to piggyback off of technology. So they can also put together these portfolios themselves. And transparency is there, hedging is there, they can even help you with it. It's education, it's more sophistication, it's more transparency through the technology that's being used to manage accounts. And then it's the evolution of the managers to say, hey, we can actually provide this directly to you. You just tell us what it is that you want and that's part of that solutions providing that managers are now kind of evolved to be doing with allocators.
- [38:40]
Bill Kelly
I appreciate the clarification John, and it sets up maybe the final question around democratization and I'm guessing outside of the wheelhouse of pivotal path, but I think your views would be more informed than others. And I'll preface this by using the GFC as an example. And I think this bet between Buffett and Protege Partners was ridiculous. I think it gave the investor the wrong thought process. And what investor out there, maybe you and I included would have ridden the s and P500 down 55% and the hedge funds drew down pick a number I think in the high teens, but you would maybe know better than I. And off they went. And the S and P beat the hedge fund index over, I think it was a 10 year time frame. So I was on a board of a wealth management shop around this post GFC timeframe where the liquid all craze really started to take off. And on the one hand it's like the movie I'm watching again around democratization. We're giving investors access to something they can't necessarily get in the public markets. But let's take a very sophisticated product with no liquidity, regulatory light or maybe no real regulation, no limits on leverage, not a lot of transparency, and jam them into a daily valued 40 act mutual fund and expect replication of performance. And even if you could do it, the fact it's not a fund of one and that manager's got to manage cash flows, I just don't know if it's going to end so well for the end investor. And now I'm seeing the same thing in private equity. So as you think about this democratization, which is the private markets full on, there's some lessons that we should take away from the first limo to the beach, not the last. Back with the advent of liquid alts. And what are your views? I know you've got an institutional client base, but I said you must have given this some thought.
- [40:30]
John Capless
We've given a lot of thought and I think the way you frame the question, you're probably going to agree with a lot of what I have to say. But I look at it and there's two things that are always the case in finance. There's no free lunch number one, and assets need to match liabilities number two. So to your point, to offer a daily nav on potentially whatever it is, a private credit strategy, a private equity strategy that has liquidity in many years, not even days or weeks or months, it's going to create a mismatch that yes, if everything functions normally in a very full market, it may work. But when things become difficult and liquidity seizes up, who's going to be hurt the most? Unfortunately, it's going to be those investors in the liquid alts. And I don't like using this phrase, but you get what you pay for. And I'm not just talking about fees. I'm also talking about terms as well where some strategies don't lend themselves to daily liquidity. Any institutional investor doesn't even want daily liquidity, certainly doesn't even want a daily nav in private equity because part of the reason that they invest in it is because they don't see that volatility. They don't have access to the cash. I mean, maybe they want it at some point, but there's a benefit to locking up capital. In some ways it's perverse, but it exists. I'd say, look, there are some strategies in the hedge fund space that maybe are more liquid managed futures being One of them where you can do some things in the 40x space or you can create potentially replication strategies that can maybe get to the essence of the strategy. But there are many strategies where it doesn't apply at all. You certainly shouldn't have any structured credit strategies, you shouldn't have distressed debt, you shouldn't have merger arb and a lot of distress, sorry, event driven strategies. Many of these they just don't work in a framework where you have daily liquidity. And as we know we could talk about the bet between Buffett. I mean I couldn't agree more that the premise was flawed completely. There was a misunderstanding of what hedge funds were supposed to do. But if you have multiple levels of investors, think about the fund of funds in 2008 where these funds to funds had their own clients that had certain liquidity and they were invested in hedge funds that maybe had more onerous liquidity. And so there's that mismatch even in a fund of funds that may be monthly liquidity you can still have and we've seen tremendous issues that can occur from that. So now you go down to daily liquidity, leverage, lack of transparency and the fact that there's probably a significant negative selection bias. If you're investing in managers who are well aware of these issues, the high quality managers probably aren't likely to participate in a vehicle like that. So you're left with lesser managers and all of the other risks that you mentioned. It's dangerous and I think there needs to be a lot more oversight. And sometimes it's okay to lock up capital if there's a reason for it. And that reason is the underlying investments don't have the same liquidity as your investment.
- [43:17]
Bill Kelly
Well, I think if you talk to the late David Swensen, the moment that capital comes out of the ground, my irr suffers. So he wants that capital called yesterday in the ground and it's harvested when an asset is sold, not when my co investor wants out. So a good way to leave this discussion. So John, thank you for joining me. I learned a lot. I think our listeners will too. We covered a little bit about your pathway and your purpose in life at Pivotal Path. But some of your observations around what's going on in the broader industry were exceedingly helpful too. So thanks for joining me.
- [43:51]
John Capless
Great Bill, thank you so much for having me.
- [43:55]
Bill Kelly
Thank you for listening to Educational Alpha. I'm your host Bill Kelly. Learn more about the Kaya association and subscribe to the show at kaya. Org. That's caia. Org. See you next time.